Spring is a time for growth and renewal. Animals come out of hibernation; flowers bloom across the land. So perhaps this is a good time to talk about special-purpose acquisition companies (SPACs), since they’re also sprouting up all over the place.
SPACs are holding companies designed to go public with piles of money first, then acquire a privately held operating company later — which SPACs are doing right now with great alacrity. According to research firm Deal Point Data, SPACs held 247 initial public offerings (IPOs) in 2020 and raised more than $75 billion to go prowling for private company acquisition targets. Another 300 SPACs held IPOs in the first quarter of 2021 alone, according to audit firm EY, raising another $93 billion for private company acquisitions. So, even more prowling, for even more private company targets.
Moreover, if a SPAC fails to acquire a target within two years, it must give its IPO cash back to its investors. So the pressure is there to do deals, and do them quickly.
That raises serious questions about corporate governance and financial reporting issues. In the last six months, for example, the U.S. Securities and Exchange Commission (SEC) has issued five alerts about SPACs, warning about everything from conflicts of interest, to board composition, to internal control and accounting policies, to the role that celebrity “advisors” play for a SPAC.
One truth seems clear: SPACs are here to stay. “In the U.S., this will be a permanent feature of the market,” says Daniele D’Alvia, a teaching fellow at Queen Mary University in London who is CEO of SPACs Consultancy Ltd. and who has served on boards, himself. D’Alvia is bullish on SPACs as an alternative to traditional IPOs, although he does concede, “Many SPACs are good, but some are dodgy.”
PREPARING FOR THE BIG LEAGUES
The most important question for board directors at a private company is whether the organization is fully prepared to merge with a SPAC and live as a publicly traded company. The governance demands placed upon a publicly listed company are enormous, and if the business fails to meet those demands, the directors who agreed to the deal could find themselves facing difficult questions from regulators and shareholder lawyers, alike.
“It’s not about public versus private,” says Ragu Bhargava, CEO of Global Upside Corp., which provides human resources and related back-office functions to companies preparing to go public. Bhargava, himself, has also served on private company boards. “It’s whether you have the right frame of mind, because being public is so very different than being private,” he says. “You have to think so differently about everything.”
When pursuing a traditional IPO, businesses have time to develop that understanding. A traditional IPO might take nine to 12 months, where the board and senior managers work with investment bankers, auditors, and law firms to construct the necessary disclosures, internal control systems, and board composition for life after the IPO. If the process takes more time, that’s not ideal, but typically it’s not a disaster, either.
SPAC mergers invert that process. A SPAC could knock on a private company’s door with piles of cash, and push to close the deal within three months. If the SPAC is near the end of its two-year window to find a target, the pressure to close a deal mounts. The SPAC might offer more money for faster closing — and that’s how mistakes happen.
Even worse, the accounting issues in a SPAC merger are highly nuanced. For example, while the SPAC is the acquirer from a legal perspective, the accounting treatment under U.S. Generally Accepted Accounting Principles is that the private company target is the acquiring business.
We don’t need to get into the details of why that is. The point is that SPAC mergers are complex things, not to be undertaken on a whim. So first and foremost, a private company board should ask itself hard questions about how prepared the business truly is for an exit deal that might come along.
“The most important thing has nothing to do with going public,” Bhargava says. “It’s whether you’re ready to be public. If you’re not, stop right there. Take time and get ready. Then talk about a SPAC or an IPO or whatever you want to do.”
The best way to do that would be a risk assessment from internal audit, answering questions such as:
- Do we have the right senior management — the right CEO, chief financial officer, general counsel, and others? Are they people who have experience taking companies public, or long-time employees accustomed to the private world?
- Do we have the right financial reporting and disclosure controls? For example, is internal control over financial reporting effective? Do we have appropriate conflict of interest policies, and have we disclosed all necessary conflicts?
- Do we have the right board composition, both to decide on a SPAC merger and to continue as part of the listed company’s board of directors? Are they directors who understand, and can fulfill, a publicly listed company’s fiduciary duties?
If companies don’t meet these criteria, and they rush into a SPAC deal anyway, they could find themselves on the wrong end of an SEC enforcement probe or shareholder class-action lawsuits later.
FINDING A GOOD PARTNER
We also should not lose sight of the role the SPAC plays — particularly the SPAC “sponsor,” which is the management team at the SPAC that raises the money, approaches the targets, and closes the deal.
Somewhat like a proposal of marriage, a private company will need to consider whether the SPAC approaching it is a worthwhile partner for long-term life as a publicly listed company. “From the private company’s perspective, it’s not always about how much cash the SPAC can offer,” D’Alvia says. “It’s about the SPAC’s management, who’s going to be there, the SPAC experts, and the solidity of their business plan, so you know what you can do once you’re on the market.”
Evaluating would-be SPAC partners is likely to become more important over time, simply because so many SPACs are pouring into the mergers and acquisitions world, looking for targets. So SPACs’ standards have gone from profitable private companies, to EBITDA-positive companies, to pre-revenue companies.
“That can generate a concern,” D’Alvia says. “That’s more risky, if you’re not taking an operating company. You’re taking a company that’s making a promise.”
What we don’t know is whether the number of SPACs will continue to mushroom, or whether what we see now is a wave that will recede to more normal levels. (According to Deal Point Data, U.S. capital markets averaged roughly 34 SPAC IPOs annually in the late 2010s, before the numbers skyrocketed in 2020.)
It’s possible that traditional IPOs will revive as the pandemic recedes and the rhythms of investment banking return to normal. It’s also possible that recent SEC policy announcements about SPACs will cool the sizzling market of today. Then there are SPAC stalwarts like D’Alvia: “I don’t see this as the next bubble to burst.”
Regardless, some basics of corporate governance will endure no matter what SPACs do next. “It’s all in how you assess risk, manage it, and then represent to someone that, yes, you have controls in place to mitigate those risks,” Bhargava says. “That’s where the real challenge comes from.”
That was true long before SPACs showed up. It’s still true for the board now.