SPAC, or special purpose acquisition company, is another name for a "blank check company," meaning an entity with no commercial operations that completes an initial public offering (IPO). After becoming a public company, the SPAC then merges with (or acquires, but usually merges with) an existing private company, thereby taking it public. Prior to completing a merger or acquisition, many SPACs provide no indication to investors about what type of company they plan to merge with or buy.

In effect, the "special purpose" of a SPAC is to bring a promising private company to the public investment market. While SPAC strategies are in some respects complicated and multi-step, they tend to take less time to complete than traditional IPO listings and can be cheaper. The advisory fees associated with going public via a SPAC tend to be far lower than the fees charged for a traditional IPO. Early-stage companies can more easily comply with the requirements to merge with a SPAC than they can successfully complete an IPO.

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What happens in a SPAC merger?

SPACs typically price their stocks initially at $10 apiece, and they often offer warrants to buy additional shares or provide some other sweetener to entice investors to buy into the unknown. The SPAC then identifies and negotiates with a private company, swapping the cash it raised via its IPO and its status as a publicly traded entity for a percentage of the post-merger business. Sometimes the financial structure of the merger also includes money from outside investors, who provide additional funding in exchange for shares in the public entity.

The starting $10 share price tends to change once investors know which private company the SPAC is merging with and under what terms. Investors gain a better idea of what each share should be worth and the share price adjusts accordingly. SPAC share prices tend to soar higher when the acquisition target is announced, but if sentiment changes or the deal overly dilutes the value of the original shares by including too much money from new investors, a SPAC's share price may decline after the deal is announced.

One of the first high-profile SPAC deals featured Richard Branson's space tourism start-up Virgin Galactic (NYSE:SPCE). In late 2019, venture capitalist Chamath Palihapitiya formed a SPAC called Social Capital Hedosophia Holdings. The SPAC merged with Virgin Galactic, taking it public. Shareholders of Social Capital Hedosophia Holdings received a 49% stake in the combined company, while Virgin Galactic received about $800 million in cash and a public ticker.

Why would someone invest in a SPAC?

Investors who buy into a SPAC prior to the announcement of a merger or acquisition are relying on the SPAC's sponsors — its management team — to choose an attractive target. For that reason, it matters who is sponsoring a SPAC. Many SPACs are backed by high-profile investors like Palihapitiya, while others affiliate with celebrities or famous athletes to attract attention.

SPAC share prices tend to be relatively stable before the merger. A SPAC typically invests the money it raises when it is formed into government bonds or other safe investments to earn a modest return while limiting potential downside during the time it searches for a merger partner.

Buying shares in a new SPAC amounts to a leap of faith, but the payoff can be substantial. The change in share price can occur immediately once a deal is announced, and the only way for an individual investor to fully benefit from that rapid price increase is to invest when the SPAC is still searching for a deal.

DraftKings (NASDAQ:DKNG), the nearly decade-old company focused on fantasy sports, became a public company by merging with a SPAC early in 2020. The company's valuation quickly ballooned from about $3 billion to $13 billion in a matter of months. That's the sort of growth SPAC investors are trying to capture by committing money early.

One major benefit of not buying shares of a SPAC until after a merger is announced is that you know exactly what you're buying. But the rest of the market does, too, and the SPAC's share price likely already reflects that knowledge.

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A word of caution

While investing in SPACs enables individual investors to, in theory, gain portfolio exposure to young companies in red-hot sectors, it's important to remember that disclosure rules for SPAC deals differ from the disclosure rules governing IPOs. 

For IPOs, companies are permitted to share past financial results and talk broadly about the markets in which they operate, but they are prohibited from projecting future financial performance. In contrast, a company going public via a SPAC deal is allowed to present detailed revenue and profit projections that are forward-looking by five years or more. For young, pre-revenue companies that might prefer for investors to focus on their potential instead of their so far unimpressive results, that regulatory distinction confers significant benefit.

The traditional IPO process is cumbersome and restrictive partly in an attempt to make sure individual investors are protected. Investors invariably lose some of those protections when they invest in SPACs. Investing in younger, less-established companies carries greater upside potential but also greater risk for your portfolio.

A cautionary tale is the SPAC merger deal between VectoIQ (NASDAQ:VTIQ) and electric truck start-up Nikola (NASDAQ:NKLA). VectoIQ shares rapidly increased in value in March 2020 when the merger deal was announced, and, by midsummer of 2020, they were up by more than 600%. Later in the summer, after the merger closed, questions surfaced about the viability of Nikola's products. The stock's price has since returned nearly to its starting point as more negative information about Nikola trucks has been released.

It's impossible to know whether an IPO would have raised enough red flags about Nikola for investors, but, in hindsight, clearly insufficient due diligence was conducted prior to the SPAC merger being completed.