What Are SPACs and How Do They Work?

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Key Takeaways

  • SPACs provide private companies with a backdoor to the stock market. Instead of entering a cumbersome IPO process , companies can use SPAC funding.
  • Most SPACs trade at $10/share. While it’s not a requirement, most SPACs stick with this conventional price point.
  • A management team decides to start a SPAC to find an acquisition target. The management team pools some money into the founder’s shares.
  • When you buy a SPAC, you don’t just get the SPAC. Investors get a fractional warrant for each share they buy. If each share rewards 1/2 of a warrant, buying two shares of a SPAC lands one warrant.
  • Most SPACs give investors access to reliable companies in their early growth stages. However, SPACs come with a speculative nature. Some investments work out better than others.
  • SPACs became cool again in 2020. SPAC merger activity more than doubled from 2019 to 2020. Discovering how to use SPACs can open up tremendous opportunities.

    The SPAC approach continues to attract many companies. BuzzFeed recently became a public company through SPAC funding.

    Wondering what are SPACs or how do SPACs work? In this article, we’ll catch you up with the special purpose acquisition company boom.

    What Are SPACs?

    SPACs provide private companies with a backdoor to the stock market. Instead of entering a cumbersome IPO process , companies can use SPAC funding. 

    The SPAC route helps companies get public a few months earlier. Those extra few months help significantly with current market volatility. Companies can also begin raising funds from investors sooner.

    For some of these companies, raising funds keeps them in business. We’ve seen a rise in unprofitable growth companies with strong revenue. SPAC funding gives these companies additional cash.

    Going public via SPAC also costs less money than an IPO. SPACs come with less negotiating with underwriters and regulatory filings.

    Each special purpose acquisition company is a blank check company. These shell companies contain no value beyond their raised funds. 

    SPAC management has 18-24 months to select an acquisition target.

    How Much Does a SPAC Cost?

    Most SPACs trade at $10/share. While it’s not a requirement, most SPACs stick with this conventional price point. Some SPACs such as Bill Ackman’s Pershing SPAC bucked the trend with a $20/share unit price.

    If the company fails to yield a SPAC merger, money gets returned to shareholders at par value minus fees. Buying shares of a SPAC company pre-merger comes with few risks. 

    Most SPACs stay flat in their stock price. Rumours and confirmed acquisition targets act as the exceptions to the rule.

    You’ll lose some money if a SPAC fails to find a target. However, the losses won’t be devastating.

    All of the money gets stored in US Treasuries. The capital generates some interest as management looks for an acquisition target.

    The money in US Treasuries will not outpace inflation . The stored money will lose purchasing power over time.

    However, getting some interest in your investment is better than nothing. You might make a significant ROI depending on the acquisition target.

    How Do SPACs Work?

    A management team decides to start a SPAC to find an acquisition target. The management team pools some money into the founder’s shares. Many management companies pour as little as $25,000 into these founders’ shares.

    These shares give them a 20% stake in the SPAC. Management makes an incredible payday if they secure an acquisition target.

    A special purpose acquisition company can merge with any target. The SPAC could merge with a company worth substantially more than its blank check.

    Pershing Square Tontine Holding’s SPAC received incredible attention in 2020. Investors theorized the company would do a SPAC merger with Stripe, Airbnb, or SpaceX. Any of these acquisitions would have significantly increased investors’ money.

    SPACs become volatile during rumours and acquisition announcements. If investors approve of the acquisition target, the shares can quickly rise. Some SPACs turned $1,000 into $5,000 shortly after making announcements.

    These SPACs act as the exception rather than the rule. However, the speculation around SPACs makes them compelling enough to many investors. Getting into a SPAC before a merger announcement minimizes risk.

    Understanding SPAC Warrants

    When you buy a SPAC, you don’t just get the SPAC. Investors get a fractional warrant for each share they buy. If each share rewards 1/2 of a warrant, buying two shares of a SPAC lands one warrant.

    Warrants are similar to options. They give you the right but not the obligation to purchase a share at a set price.

    Let’s assume a warrant gives you the right to buy a share at $10. This warrant doesn’t help much when the SPAC has no acquisition target.

    However, the warrant becomes incredibly useful if the SPAC finds a target and shares rise to $30/share.

    Some people will buy warrants instead of shares. If a SPAC’s price skyrockets, the warrant will yield greater gains than the shares.

    Review Each SPAC’s Goals

    Management for a SPAC will state their goals for an acquisition target. Some SPACs focus on a tech acquisition, while others focus on free cash flow .

    It’s vital to review management’s objectives before entering a SPAC. You can see if management’s objectives align with your portfolio goals. 

    Not every investor wants a stable, slow-growth company. Some prefer a greater risk in exchange for a more significant potential payoff. 

    Growth stocks fit this ruleset. They provide considerable payoffs in exchange for more risk.

    Assessing management’s past experience will give you a better understanding of their capabilities. If management has organized multiple SPACs, they know the game. They know what it takes to acquire companies and reward shareholders.

    Before finalizing an acquisition, SPACs will need shareholder approval. Generating enough votes will result in the SPAC merger proceeding to the next steps. Before submitting your vote, make sure the company aligns with the objectives.

    SPACs only take off if management convinces enough people to buy shares. When reviewing objectives, ask yourself if those objectives would convince enough investors.

    You will likely come across a SPAC after it’s received approval from enough investors. However, it’s good to remain in the know with your SPAC investments.

    A Cautionary Tale for SPAC Funding

    No investment comes without risks. If an incredible investment came with no risks, everyone would pour money into it. This cautionary tale demonstrates what can go wrong with SPACs.

    Understanding what is a SPAC will help you identify potential risks. SPACs comes with less scrutiny than traditional IPOs. Some sketchy companies became public due to SPACs.

    Nikola is an example of this trend. The EV company went public via SPAC funding. The company generated plenty of fanfare, rising from $10 to $95/share in less than three months.

    However, the company misled investors about their products and other manners. As a result, the stock began its descent from $95/share to under $10/share. 

    SPAC funding has produced several winners over the years. Many investors consider DraftKings and Matterport as SPAC success stories. Some companies use the SPAC merger approach to enter the market with less scrutiny. 

    Lowering Your Risk

    If you buy a SPAC before acquisition news, these risks become less explosive to your proceeds. However, a SPAC can still tank before the merger gets complete. BuzzFeed and MoneyLion shares both dropped considerably after their completed SPAC mergers.

    The SEC has been looking into SPAC funding to prevent mistakes like the Nikola Motors SPAC. The SEC’s involvement increases safety while letting investors capitalize on the growth.

    Most SPACs give investors access to reliable companies in their early growth stages. However, SPACs come with a speculative nature. Some investments work out better than others.

    SPACs weren’t as safe in the 1990s. Foreign investors often took advantage of them to raise funds and deceive investors. The current players in the SPAC world have better intentions than their predecessors.

    If you invest in an asset like penny stocks , you’re probably used to speculation. Allocating a small percentage of your portfolio minimizes the downside.

    SPAC Share Dilution

    SPACs can issue more shares while looking for an acquisition target. Depending on the acquisition costs, SPACs may issue more shares to raise debt. These additional shares dilute supply and result in a short-term downward motion.

    If a SPAC trades at $13/share, and the company issues shares at $11/share, shares will fall to $11/share. This decline doesn’t immediately happen, and investors can get irrational.

    However, current shares gravitate towards the issued shares’ price point during dilution.

    SPACs will also issue more shares after warrants get exercised. These instances represent the primary reasons SPACs will issue more shares.

    Many company management teams practice share dilution. Companies take advantage of rising stock prices to raise more cash. They use this cash to fund projects and cover expenses.

    Share dilution results in short-term downward movement. However, the money raised from dilution can lead to future stock price appreciation.

    Ready to Invest in SPACs?

    You started this post wondering what are SPACs. When investors discover everything regarding how do SPACs work, they discover new opportunities. Now you know the entire story behind the SPAC boom.

    If you want to enter the SPAC craze and grow your portfolio, we can help.

    Check out our Investment Guide.

    Happy Investing!

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