The Benefits and Risks of SPAC IPOs

There are some big potential upsides to SPAC investing, but there are also some big risk factors investors should be aware of as well. In this Fool Live video clip, recorded on March 1, Fool.com contributor Matt Frankel, CFP, and Industry Focus host Jason Moser discuss what investors should know before considering SPACs for their portfolio. 

Matt Frankel: SPAC stands for special purpose acquisition company. It's essentially a company that goes public with no business operations and the reason it goes public is to raise money in order to acquire a private business and take it to the public markets. To really make a long story short, a SPAC is a way for a company, like Payoneer who we just heard from their CEO, to go public without having to go through the traditional IPO process of submitting growth projections and recent earnings and stuff to prospective investors, doing an IPO roadshow. Going public the traditional way is a process, so a SPAC lets a company go public by merging with a company that already exists and is just sitting on a mountain of cash to combine with the new business.

Jason Moser: I thought it was interesting, Scott. I know he mentioned Spotify (SPOT 3.38%) in the interview and mentioned that as an example of a company that utilized a direct listing, which is a bit different than a SPAC, but similar in the sense that you're trying to figure out a way to do this less traditionally. We're going in the direction of trying new things and not this traditional way of getting a company to the public markets and you're right, a company going public, that's a big song and dance. There are a lot of costs, a lot of time that go into that, prepping the roadshow, getting investors on board, going around and explaining your business, pitching the business more or less to investors, then there are costs in actually going public. Then it's a matter of what they're going to do with the money. It fascinates me, this whole SPAC movement. It's something that really has taken off here recently. I found an interesting statistic here. Since the start of last year, investors have poured more than $130 billion into SPACs. This is something that has really taken off in short order. It gets a lot of press, understandably, with the enthusiasm. I do get those advantages. Nothing comes without its share of risks though. What do you feel are some of the risks involved with going the SPAC route?

Frankel: We forget, given the recent environment, that IPOs don't always do well. 

Moser: What? 

Frankel: I know, right?

Moser: Balderdash.

Frankel: We're living in the age where Airbnb (ABNB 1.39%) goes public and the next day it's trading for three times as much. That doesn't always happen, IPOs go down all the time. The market's not always going to receive a newly public company well. The biggest risk is that the stock goes down after the merger is completed. There are other risks to SPACs. When a SPAC goes public, it takes investors' money, usually it's $10 a share is the par value, it takes some money and puts it in an account. From there it usually has about two years to find a company to acquire. In that time that money is just sitting there. So a big risk is your opportunity cost. What could that money be doing in the meantime, instead of just sitting in an escrow account.

Moser: Yes, I mean, you said sitting in an escrow account. It's sitting in something where there's not a company that's making any money. I mean, right?

Frankel: Right.

Moser: Maybe there's an exception there, but for the most, by and large, these SPACs, these blank check companies. This is pre-revenue. It's nothing other than the promise, right?

Frankel: In the meantime, you are essentially leaving your money in a savings account.

Moser: Yeah, yeah.

Frankel: At zero growth. That's one big risk. You don't know what you're acquiring. You don't know if you're going to like the business, which I guess if you don't like the business the SPAC ends up buying you can always just sell your shares.

Moser: Sure.

Frankel: It's called a blank check company for a reason. You're giving them a blank check to buy whatever they want. There are a few big drawbacks to this, but there are some big advantages. It really does democratize the IPO process. Look at DraftKings (DKNG 2.89%) stock price now it's about $60, it's a recent successful SPAC merger.

Moser: Right.

Frankel: Imagine if you had just gotten into the blank check form of that company at $10 a share. Then they ended up taking DraftKings public. If that had gone public on the open markets, like Airbnb did, retail investors would never have been able to buy at the IPO price.