A SPAC – short for a Special Purpose Acquisition Company – is a publicly listed company established for a single purpose: to find a private operating company and merge with it, thereby taking it public. Special Purpose Acquisition Companies (SPACs), as an alternative investment vehicle, have disrupted securities markets in recent years. These investment vehicles facilitate going public through diversion from the dominant pathway of traditional initial public offer (IPO) and dismantling the traditional capital markets. SPACs are often touted as ‘poor man’s private equity’, for they ease attracting public capital and simplify the legal process of tapping public resources.

Wall Street is gearing up for another wave of blank check companies from seasoned and first-time sponsors, showing the staying power of the vehicles to take companies public — and setting up expectations of more deals.

Special-purpose acquisition company backers have raised more than $1.9 billion this year, adding to the $7.1 billion haul in the final six months of 2024, data from SPAC Research show. That’s on top of nearly 20 firms that have filed paperwork with US regulators to raise another $3.2 billion in the first six weeks of the year.

Unusually, the majority of this year’s SPAC IPOs have come with more attractive terms, which has been a factor in their resurgence. Many blank-checks feature overfunded trusts, meaning the per-share value is above $10, the standard amount investors pay for IPO stock, and most feature rights which owners can pool together to acquire additional shares after a deal is closed. If the regular-way IPO market remains touch and go, expect more private companies to take the SPAC route to getting listed.

How a SPAC works

There are two separate transactions by which a SPAC brings a company public: the SPAC first goes public through its own IPO, and then some time thereafter merges with a private company.

THE SPAC LIFECYCLE

The lifecycle of a SPAC comprises three stages: the initial SPAC stage, which begins when the SPAC launches its IPO and ends when it announces a proposed merger; the deSPAC stage, when it has negotiated, structured and announced the merger deal; and the postmerger stage, when the SPAC and merger target actually combine in what is called an initial business combination (merger), resulting in a new, publicly traded company

In the pre-merger period, the SPAC is a publicly traded shell or “blank-check” company, not an operating business. Its goal is to find a private operating company (the target), negotiate terms of a merger with the target, attract new private capital, win SPAC shareholder approval for the deal, minimize SPAC shareholder redemptions, and retain adequate capital to complete the merger.

SPACs must complete a merger within a specified period of time, or they must dissolve and return funds to shareholders. The merger completion deadline varies from SPAC to SPAC but has ranged from 18 to 24 months and dipped to as low as 12 months in 2022. The completion deadline makes the merger a do-or-die event for the SPAC and its sponsor.

The merger transforms the SPAC from a shell company into an operating business with goods or services to sell. It also transforms the target company from a private company to a public company—with all the reporting obligations and investor protection requirements that come with this new status.

(https://www.bcg.com/publications/2023/blank-check-bust-could-benefit-spac-merger-targets)

Initial Phase

The creation of a SPAC begins with a sponsor forming a corporation and working with an underwriter to take the SPAC public in an IPO. Sponsors are typically limited liability companies organized specifically for this purpose. The parties that organize sponsors range from large private equity, venture capital, or hedge funds, to former Fortune 500 executives, to individuals with no particularly relevant background. Nominally, the SPAC is managed by its own officers and directors, who are selected by the sponsor. Those officers and directors typically overlap with the individuals who own and created the sponsor, and the compensation of the SPAC’s officers and directors typically aligns their interests with those of the sponsor.

Prior to the IPO, the sponsor acquires a block of shares at a nominal price that will be adjusted to amount to 25% of IPO proceeds or, equivalently, 20% of post-IPO equity. This block of shares, known as the sponsor’s “promote,” is the sponsor’s compensation for setting up the SPAC and supporting the SPAC’s management while the SPAC seeks a private company to take public. In some SPACs, the sponsor’s interest increases automatically if additional equity is invested at the time of the SPAC’s eventual merger. In addition, concurrently with the IPO, the sponsor purchases SPAC warrants, shares, or both at prices the sponsor estimates to be their fair market value. The SPAC uses the proceeds of the sponsor’s investment to cover the cost of the IPO and its operating expenses while searching for a merger target, and in some SPACs some of those proceeds are added to the trust in order to subsidize the return to IPO investors.

In its IPO, a SPAC sells units consisting of a share, a warrant, and in some cases, a right to acquire a fraction of a share at no cost when the merger closes. By convention, SPACs set prices of units at $10.00.

The proceeds of a SPAC’s IPO are placed in trust and invested in Treasury notes. Under the SPAC’s charter and the terms of the trust, cash in the trust can be used only to (a) acquire a company, (b) contribute to the capital of the company formed by the SPAC’s merger, (c) distribute to shareholders in liquidation if the SPAC fails to consummate a merger, or (d) redeem shares.

The deSPAC Phase

After the initial phase, the SPAC then enters a new and more volatile phase—the deSPAC phase—when it publicly announces it has identified a merger target and has entered into a preliminary merger agreement.

The merger announcement typically sparks an uptick in public trading, with higher volumes of SPAC shares trading hands. This may well be the most intense trading time in the lifecycle of the SPAC—all based on expectations for the still-private target company. In essence, at this point SPAC investors are trading SPAC shares as if they were the shares of the merger target, which remains a private company for several more weeks. As such, the target has never filed any financial or other public disclosures with the SEC.

Though the content of SPAC and IPO disclosures overlap in important ways, significant differences remain in terms of process, timing, and content available to investors during the deSPAC phase. This creates an unusual (if not unique) situation because in other contexts public trading of the securities of private companies is usually prohibited.

Along with the merger announcement, the SPAC often makes public an investor deck, available to any existing or prospective SPAC investors, which seeks to tell a more detailed story about the target and its prospects. Investor decks describe the business purpose of the target company, the market need its product or services intends to fill, and how the target will use the proceeds from the SPAC merger. Investor decks also may present market cap and enterprise value estimates for the new public company under various redemption scenarios. In addition to the decks, the SPAC must file a formal regulatory document with the SEC on a Form 8-K announcing the planned merger.

The gap in disclosures closes partially when the SPAC files a preliminary S-4 merger document or a proxy statement. During this interim window of time— which could last more than a month—is typically the most intense trading time in the life of the SPAC. When the SPAC files a merger registration statement and a proxy statement with the SEC, the gap closes completely. Those filings provide investors essentially the same information they would receive in a traditional IPO. There was one important difference, SPAC merger filings and proxy statements usually used to contain forward-looking statements, whereas traditional IPO statements almost never do. But this was recently rectified by the SEC. More on this will be explained later.

Special Role of the Share Price in the deSPAC

The SPAC’s share price plays a special role in the deSPAC process. It can serve as a barometer for the expected level of redemptions and may be indicative of the quality of the merger target’s business.

Shareholders wishing to divest can do so in either of two ways: by selling their SPAC shares on the open market before the merger closes, or by redeeming them directly from the SPAC for a pro rata portion of the money in the trust (typically $10 per share plus interest). While redemptions will reduce the balance in the trust, selling on the open market will have no effect on the amount in the trust.

If the share price rises much above $10 per share, exiting shareholders should choose a market sale over redemptions. Conversely, if the share price falls much below $10, the divestment strategy would be to redeem rather than to sell.

Data on the actual level of redemptions are often unavailable to SPAC investors before their deadline to exercise their redemption rights. Some SPACs may voluntarily disclose redemption levels before the shareholder vote on the merger, but they are not required to do so. Moreover, redemption levels could change significantly after the disclosure. In lieu of redemption data, many SPAC shareholders look instead to the public share price of the SPAC as one indication of the market’s view of the merger and, therefore, as a good proxy for redemption levels.

Shareholder Vote to Approve the Merger

SPACs typically must clear one final hurdle before they can complete the merger: submitting the deal to a shareholder vote. Failure to receive a majority of SPAC shares voting in favor of the merger blocks the merger transaction from closing.

Naturally, if shareholders believe the proposed merger is a sound one and have decided to hold their shares, they will likely vote in favor of the merger. But even if shareholders view the deal as a bad one and choose to redeem their shares, they also have an incentive to vote in favor of the merger. That is because shareholders can only exercise their rights of redemption if the merger is approved. (The deadline to demand redemptions occurs a day or two before the merger vote, but the actual redemption only takes place upon completion of the merger.) If the merger vote fails, shareholders cannot redeem their shares. This also holds true for other investors with a strategy of disposing of their shares and retaining free warrants in the proposed merger. These investors can only receive their redemption money if and when the merger is completed and can only keep their warrants as upside potential after a merger is approved and completed.

The negative shareholder vote will terminate that particular deal, but then three things could happen: (1) the SPAC could voluntarily dissolve itself and distribute the trust money to shareholders; (2) the sponsor could attempt to find another target, negotiate a merger deal, win shareholder approval for it, and consummate the merger before the SPAC’s merger deadline passes; or (3) the merger deadline will expire. Shareholders could get their money back only after the earliest of these three possibilities takes place. This forces a shareholder wishing to redeem to wait out the clock before they can actually do so.

In a previous generation of SPACs, shareholders could only redeem shares if they voted against the merger. But in recent years, shareholders have had the right to redeem their shares whether they vote in favor or against the merger.  The SPAC may require that shareholders cast a vote to be eligible to demand redemption, but how a shareholder votes (for or against the merger) does not affect shareholder redemption rights.

These considerations explain why the shareholder vote fails to serve as a disciplining measure on sponsors to avoid proposing transactions with weak merger targets.

The Post-Merger Phase

The merger completes the SPAC lifecycle and, with it, the purpose of the SPAC: to merge with a private operating company (the target) and take it public. In place of a blank-check SPAC, the target becomes the public company with an operating business with products or services to sell. The name and ticker symbol of the post-merger company will change from those of the SPAC. The new company assumes the remaining money left in the SPAC trust along with the proceeds of PIPE investments, as well as the obligations embedded in outstanding SPAC warrants and rights. The new company also takes on the reporting, internal control, auditing, and other investor protection obligations that come with its new status as a public company.

Once the merger is complete, the underwriter of the SPAC’s IPO receives the balance of its compensation (typically set at 3.5% of the IPO proceeds). The deferred fees for the SPAC underwriter and all professional fees/expenses of the deSPAC are paid from the remaining money in the trust after redemptions.

Under the terms of the merger, the owners of the target company usually exchange their shares for new shares in the post-merger company. As a result, the owners of the former target company usually end up owning a large, majority stake of the post-merger equity. SPAC shareholders who did not redeem their shares become shareholders in the new public company. The founder shares owned by the SPAC sponsor (along with the founder shares transferred to other investors) automatically convert from Class B shares into Class A common shares of the new merged company upon completion of the merger. One or more of the executives who managed the sponsor (and thus controlled the pre-merger SPAC) may sit on the board of the post-merger company.

The sponsor’s shares remain private securities, and sponsors must wait for the company to register those shares before it can sell them. Even then, sponsors typically commit to lockup agreements that allow them to sell shares only after a specified period of time, often one year following the merger. The PIPE investors typically have no lock-up agreements once the merger is completed. But the PIPE’s shares in the new public company remain private shares until the company registers them in a follow-on action. This will take a few months, and until then PIPE investors cannot sell their shares. Once that happens (the PIPE share registration becomes effective), it is not unusual for PIPE investors to exit their investment.

Key Features

Redemption Rights

A key investor protection feature of the SPAC process is the redemption right. After the SPAC announces a proposed merger deal and it is approved by SPAC shareholders, those shareholders who have elected to redeem their SPAC shares have the ability to tender such shares to the SPAC and receive their applicable portion of the cash proceeds held in the SPAC trust.

The deadline to demand redemption expires a day or two before the shareholder vote to approve the merger, but redeeming shareholders will only receive their money back if and when the merger is completed. This has been touted as a money-back guarantee: if shareholders are not satisfied with the proposed deal, they can get their money back.

Because the SPAC itself has no business operations and the target company isn't known at the time of the IPO, investors have the opportunity to redeem their shares prior to the business combination for a pro-rata share of the funds in the trust account. These redemption rights help incentivize investors by providing a "money-back guarantee" of sorts, allowing them to redeem their shares at the original IPO price — typically a nominal $10 per share. This redemption feature offers a unique investor protection that traditional IPOs do not offer and has been one of the important selling points used to attract public investors to SPACs.

Shareholders can rely on the redemption option because the SPAC places all of the IPO proceeds into a trust. The trust then invests the money in short-term Treasury securities. This practice stands in stark contrast with traditional IPO public companies, which use their IPO proceeds to fund and grow their business. The SPAC is able to place 100% of the IPO proceeds in the trust, because the sponsor uses its own funds to pay the set-up costs and expenses of the IPO and to cover the SPAC’s premerger operating expenses. Sometimes the sponsor tops up the trust with an additional contribution, so that the money in the trust equals 101% or 102% of the IPO proceeds.

Shares and Warrants

SPAC “units” are typically what are issued in a SPAC IPO. The unit is a bundled security comprising two components: shares and warrants. The warrant gives the holder the right, but not the obligation, to buy a specified fraction of a share at a certain price (for SPACs, typically $11.50 per share) in the future, post-merger company. After about two months, unit holders are allowed to detach the warrants and trade them separately. After this time, any investor buying shares on the public market will receive no warrants along with them—even if they pay $10.

Later, at the merger stage, anyone who purchased units will be allowed to redeem their shares for the full amount ($10 plus interest earned in the SPAC trust) and still retain their warrants. This feature has been successful in attracting investments from initial IPO investors: typically, professional traders and hedge funds. The SPAC structure is attractive because the guaranteed redemption option—which professional investors and hedge funds almost always exercise—protects their downside risk (even if the public share price falls below $10), and the warrants they retain provide them exposure to potential upside if the post-merger company succeeds. This strategy would not be available, however, to investors who purchase shares instead of units, including retail investors who purchase shares after the merger announcement.

The Sponsor

In the first, pre-merger stage of a SPAC, shareholders invest in SPACs based on the capabilities of the sponsor, which creates, organizes and runs the SPAC public company. Sponsors typically appoint the SPAC’s board of directors and arrange for financial, legal, and accounting advisers. In addition, sponsors fund the pre-merger operations and lead the search for the merger target. Once identified, they negotiate the terms of a merger deal, support preparation of extensive legal and regulatory filings, and work to ensure shareholder approval of the merger.

While the sponsor is usually a limited liability company, the term “sponsor” typically refers to the individual (or individuals) who leads both the sponsor entity and the SPAC public company. These individuals often serve as CEOs and board chair of the SPAC itself. The sponsor, along with the board of directors, controls the SPAC.

A wide variety of individuals have served as the sponsor. These include famous celebrities, such as entertainers, sports figures, and former politicians or well-known professional investors. Others come from the world of hedge funds, private equity funds, and venture capital funds. Still others are former CEOs and top executives, who have expert knowledge and long experience in particular industries.

As compensation for its work, the sponsor receives what is called a promote. The promote consists of founder shares, which the sponsor takes for a nominal fee. The founder shares amount to 20% of post-IPO equity. The founder shares—along with any warrants that the sponsor acquires at fair market value—are at-risk capital for the sponsor. This means they will have no value if the SPAC fails to complete a timely merger.

The founder shares are Class B shares, whereas public shareholders own Class A shares. Upon completion of the merger, the sponsor’s founder shares convert from Class B shares into Class A common shares. Unlike the SPAC shares that the public buys, the sponsor’s shares cannot be redeemed. The founder shares and warrants provide the sponsor a strong financial incentive to complete a merger before the completion deadline expires.

Minimum Cash Condition

Cash contributions to the merger from the SPAC (and other capital providers, as noted below) are critical to successfully closing a merger. Cash is the tangible value that the SPAC can offer in exchange for a percentage of the enterprise value of the target company. Furthermore, the SPAC can bring other benefits to the target. The merger enables the target to become a public company, the SPAC sponsor may bring valuable industry and management experience to the target, and the SPAC can bring public company know-how to an inexperienced target. While those aspects are important, it is the cash merger consideration provided by the SPAC that receives the most attention from potential targets.

As part of the terms of the merger, target companies negotiate a Minimum Cash Condition, which requires that the SPAC provide a specified minimum amount of cash to complete the merger.14 Redemptions take on special importance in light of the Minimum Cash Condition. If the redemptions are too high, they will deplete trust fund money to a level below the minimum cash condition, and the target company has the right to back out of the deal.

Hedging against the Risk of Redemptions

If a large percentage of shareholders choose to exercise their redemption rights — which has been the case for several SPACs as of late — this can drastically reduce the cash proceeds that the combined company will have available for its future operations. If the redemption rate is exceptionally high, the SPAC may be in danger of failing to meet its minimum cash condition. To reduce that risk, SPAC sponsors attempt to avert, or at least have a backup plan for, high redemption levels.

SPACs often seek to supplement the money in the trust by raising additional cash through private deals with institutional investors, sometimes at a discounted rate. These private deals are called PIPEs, short for private investments in public equity. Therefore, the PIPE capital adds to the trust money and can help to compensate for trust redemptions. And, whereas the SPAC IPO trust money can be redeemed, PIPE capital is generally locked in to complete the merger. PIPEs also serve an additional important role as a signal of deal quality and may thereby indirectly reduce the level of redemptions.

SPACs also use non-redemption agreements and forward-purchasing agreements, sometimes in combination, to assure adequate cash to complete the merger. In a NonRedemption Agreement, a large investor makes a binding commitment not to redeem its shares until the merger is completed. In a Forward Purchase Agreement, a large investor typically makes a tentative agreement to purchase a set number of SPAC shares at a future date that will occur before the merger is completed, assuming such investor is satisfied with the quality of the proposed merger target.

Both types of agreements help to top of the cash that the SPAC can count on to deliver and helps the sponsor hedge against the risk of large redemptions from other shareholders.

SPACs can also set a limit on the percentage of total outstanding shares any single shareholder (or shareholders acting as a group) can redeem. This limit is set forth in what's known as a "bulldog provision" and usually falls between 10% and 20% of the total outstanding Class A Stock.

SPAC roadshows

SPAC and target management actively market proposed mergers to potential investors, going on what are referred to as “SPAC roadshows.” The roadshow has two objectives. One is to attract interest in the public market. SPAC sponsors much prefer that the IPO investors sell and thereby leave cash in the SPAC to be invested in the merger. Consequently, they devote considerable effort to developing interest among potential buyers of the SPAC’s public shares. The second objective of the SPAC roadshow (or in some cases a separate roadshow) is to attract private investment in the proposed merger.