A 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 acquires, or usually merges with, an existing private company, taking it public. Before completing a merger or acquisition, many SPACs provide no indication to investors about the 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. Although SPAC strategies can be complicated, 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 much less than the fees charged for a traditional IPO.
Early-stage companies can more easily comply with the requirements to merge with a SPAC than to complete an IPO.
What happens in a SPAC merger?
What happens in a SPAC merger?
SPACs start by raising capital on a stock exchange, typically pricing their common stock at $10 and offering warrants to buy additional shares as a sweetener to entice investors to buy into the unknown. The initial sale of stock is the SPAC raise, or SPAC IPO, and the money is held in a trust account until a merger partner is found.
The SPAC then identifies and negotiates a business combination with a private company, swapping the cash it raised via its initial public offering (IPO) and its status as a publicly traded entity for a percentage of the post-merger business. Institutional investors are often brought in to provide more cash to the combination, receiving shares of the target company in return.
The starting $10 share price tends to change once investors know the target company and the terms of the deal. Investors gain a better idea of share value, and the share price adjusts accordingly. SPAC share prices tend to soar 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.
Once a deal is announced, the de-SPAC transition begins. There is usually time between a formal merger announcement and the close of a deal when investors vote on the deal and other legal matters are resolved.
One of the first high-profile SPAC deals featured Richard Branson's space tourism start-up Virgin Galactic (SPCE 9.8%). 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 allowing it to trade on a stock exchange.
SPACs generally have between 18 and 24 months to find a merger partner after raising money. If they do not, the funds held in the trust account are returned to investors.
Why would someone invest in a SPAC?
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 raised when it was formed in government bonds or other safe investments to earn a modest return while limiting potential downside while 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, but 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 (DKNG 0.52%), 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.
Expert views
Expert views on SPACs
Jay Ritter, PhD
What do you think makes tech, energy, and healthcare especially appealing for SPAC sponsors and targets?
Jay R. Ritter, PhD: “If individual investors are excited about a sector, it is easier to find operating companies willing to tap into the investor enthusiasm by going public. One of the patterns that behavioral finance researchers have documented is that people tend to chase past returns. During the SPAC boom of 2020-2021, there was a lot of enthusiasm for electric cars and autonomous vehicles, partly fueled by Tesla’s soaring share price. A lot of the startup companies in this sector wanted to grow quickly, and that required cash. Many healthcare companies, especially life science startups, need cash to finance their R&D activities. In all financial markets, a combination of the supply of shares by companies and demand from investors for these shares generates the transactions.”
What should retail investors look for when evaluating a SPAC opportunity today—especially given the steep average de-SPAC losses across most sectors?
Jay R. Ritter, PhD: “Buying a SPAC IPO, which typically is a unit sold for $10.00 that is composed of a share + a fraction of a warrant, is a safe investment that generally returns $10 + interest and gives some additional upside potential. The SPAC IPOs typically are bought by hedge funds, but individuals can usually buy them in the market at a little over $10, such as $10.05. The unit almost always splits into its two parts—the share and the fraction of a warrant. If a SPAC announces that it will merge with a private operating company, the shareholders have the right to ask for their money back with interest, a process known as redeeming. The investor can keep the warrant, which gives some upside. In almost all proposed mergers, 98-99% of the shareholders ask for their money back. At the time of the merger, an investor should look at the price of the stock. If it is selling for just $10 + interest, asking for your money back is the best strategy, and 99% of investors do this. For these deals, after the merger, the stock almost always plummets in price. For a small percentage of deals, however, such as Digital World Acquisition Company’s merger with Trump Media in March 2024, the stock price was well above $10 + interest, so keeping the shares or selling them in the market was a better strategy than redeeming."
Benjamin Kwasnick
Are there any signs that the SPAC model is evolving—perhaps in structure, sponsor incentives, or target selection – to address its reputation for overall poor returns?
Benjamin Kwasnick: “The model is certainly evolving, but most of the changes have been incremental in nature so far. An important thing to remember is that a SPAC is often the quickest way for a company to become a publicly traded stock. This means that early stage companies without fully proven business models are always going to consider a SPAC listing. In 2021, SPACs listed numerous electric vehicle companies (many of which ultimately traded poorly), but many others experienced similar performance through the traditional IPO route...
When the market is enthusiastic about a broad class of early-stage companies, investors should be prepared that there may ultimately be only a few winners from an entire category. SPACs will likely continue to participate in situations like this.”
What should retail investors look for when evaluating a SPAC opportunity today – especially given the steep average de-SPAC losses across most sectors?
Benjamin Kwasnick: “Retail investors are often aware that investing in memes and themes can be a game of hot potato. Investors should be conscious of whether they're buying a trend or investing on fundamentals. When trend investing, investors should know that individual names can have rapid wide swings in price. When investing in fundamentals, investors may want to put more detailed work in on a company's earnings, revenue, and growth trajectory, particularly in comparison with other already existing publicly traded comparables.”
Douglas S. Ellenoff
What do you think makes tech, energy, and healthcare especially appealing for SPAC sponsors and targets?
Douglas S. Ellenoff: “Investors interested in deSPAC transactions generally prefer high return opportunities that are consistent with the profiles of those industries.”
What should retail investors look for when evaluating a SPAC opportunity today—especially given the steep average de-SPAC losses across most sectors?
Douglas S. Ellenoff: “Public investors understand the risks associated with most means of going public, whether it’s a traditional IPO (which performed equally poorly when the bubble deflated) or through a SPAC. Both institutional investors and retail investors want access to high return investments and so long as the associated risks are fully disclosed (as they have been), they are prepared to invest in new public companies, including direct listings, which may performed even worse. When it comes to crypto, any investor must accept that these are relatively new instruments and not withstanding the scarcity value of the number of tokens, all instruments bare the same risk of being able to go down as they have in the past.”
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A word of caution on investing in SPACs
A word of caution on investing in SPACs
Although investing in SPACs theoretically enables individual investors to 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 unimpressive results so far, that regulatory distinction confers a significant benefit.
Exactly how far SPACs are allowed to project is still a matter of debate. We've seen the Securities and Exchange Commission launch a number of investigations into SPAC deals focused on what was disclosed and how realistic it was. Future deals are likely to be adjusted based on how the Securities and Exchange Commission views these things.
SEC (Securities and Exchange Commission)
If nothing else, investors should be aware that the rules are different than with an IPO.
The traditional IPO process is cumbersome and restrictive, partly to ensure individual investors are protected. Investors invariably lose some protections when they invest in SPACs. Investing in younger, less-established companies carries greater upside potential but also greater risk.
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 they were up by more than 600% by midsummer of 2020. Later in the summer, after the merger closed, questions surfaced about the viability of Nikola's products.
By June 2023, shares of Nikola were trading for less than $1, and the company's market capitalization was less than $400 million -- 99% less than the stock's all-time high.
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 before the SPAC merger was completed.
