After our post on SPACs last week, we had a few people reach out to us asking for more information about SPACs. Apparently our previous point was not entirely clear because most of these questions were in the form of “How do I raise a SPAC?” and “How do I sell my company to a SPAC?”. So we are going to drive the point home a bit more bluntly – with numbers.

Happy Joyful Acquisition Corporation goes public with a SPAC (Ticker: HPY! [Not a real ticker]) and “raises” $500 million in proceeds. Note the quotation marks around raises, the sponsors (i.e. owners) of HPY! do not actually get those proceeds. Investors only have to pony up the cash when the SPAC closes an acquisition. And HPY! has 18 months to make that happen. The clock is ticking and they go on the prowl.

The equity markets are hot, so big companies are looking for acquisitions they can make with their highly valued equity. There are also dozens (hundreds?) of other SPACs out there with the same time constraints. So the M&A team at HPY! has to kiss a lot of frogs to find their prince. They have a target list with hundreds (thousands?) of potential targets on it. Their short list is measured in dozens. They talk to everybody. Three deals seem close, then fall through for various reasons at the last minute. Then finally, HPY! finds a target – Magic Unicorn Electronics.

Magic Unicorn makes the world famous SmartHorn^TM, a device that is all things to all people. Magic Unicorn sold 30,000 units last year, netting $18 million in revenue, but they decided to go all-in on building up a pipeline of products SmartHorn 2, SmartHorn 3, and a line of accessories. They also spent heavily on marketing and sales. As a result, they lost $10 million last year. They are planning on launching these new products late this year, which means they will probably lose money this year on flat revenue. Growth should come, but not until next year. But then things really kick in, and by the time they get to Smart Horn 4 in four years, they think they will have the Holy Grail of tech – a Platform. And with that Platform they will be hugely successful and profitable. If they stretch really hard and don’t look too closely at their bankers’ spreadsheet, they forecast they can reach $500 million in revenue by Year 4. HPY! and Magic Unicorn hit off it. The two Boards reach a deal for Magic Unicorn to go public via an acquisition by HPY!.

Now the bankers have to determine a value for the deal. They could value Magic Unicorn at 10x current revenue or $180 million, a wild metric in normal times, but on par for the current market. But the Magic Unicorn Board feels that doesn’t fully value their Platform. Also, unspoken, that does not use up all of HPY!’s proceeds. So the two teams agree that Magic Unicorn should be valued at 3x its Year 4 revenue or $1.5 billion. (One banker we spoke to described current SPAC deals being valued on 1999 Multiples.) Adding up all the shares (more on that below), they end up with 150 million shares in the company, or $10 a share.

The deal structure is also…let’s call it… different from typical structures. Magic Unicorn shareholders will now own 60% of the new combined company. HPY! shareholders will own 25%, and the HPY! management team will own 5%. HPY! will also sell a $100 million “PIPE”, a private investment in public equity, in exchange for 10% of the new entity’s shares. So far this is fairly straightforward. The shareholders of Magic Unicorn are essentially selling 40% of the company and get a big cash infusion. HPY! hands over its cash pile – which is nominally $500 million, plus the proceeds of the PIPE. So Magic Unicorn should start life flush with $650 million in cash.

But let’s dig into the details a bit. First, there are fees. The cost of the IPO, the acquisition and the PIPE could easily total something like $50 million for the bankers and lawyers. (Part of the reason SPACs are so numerous today.) Second, why did the deal include a PIPE? Magic Unicorn only forecasts they will need $100 million or so to reach profitability. HPY! already had far more than that, but they want out and raised even more money. As Matt Levine pointed out most of the participants in the original SPAC may not participate and so that $500 million does not materialize in the end. The company risks being left with ‘just’ the PIPE proceeds, which cover their actual fundraising needs and, of course, the banker fees.

Then comes the magic day when the deal closes and HPY! changes its ticker to UNC! [not a real ticker]. And reality starts to creep in. For the sake of argument here, let’s just assume that HPY! had been trading around the $10 price the banker’s estimated was the value of the combined entity. The market cap is $1.5 billion, and the enterprise value is that figure minus whatever cash actually shows up.

UNC! is a public company and has to start reporting quarterly results just like every other public company. When they pitched the acquisition they made a smart move by forecasting flat revenue for the current year. Presumably they were also smart enough to forecast that number because they had a high degree of confidence in actually achieving it. So they have a few quarters to really get things going. They also have four quarters to build credibility with investors. This is going to be important, because every investor now looks at their current revenue of $18 million for this year, and then they draw a line from $18 million to $400 million. That roughly translates to $180 million in Year 2 and $340 million in Year 3. So come the first quarter of next year, everyone will expect UNC! to report $45 million ($180/4 quarters) in revenue, and then do it again for the next 12 quarters. Some companies may be able to achieve that, but it is not easy. And given that UNC! is trading at a precarious multiple, any deviation will likely be punished savagely.

There is a lot of stretching in this, fairly realistic example. There are lots of deals being done with metrics that look like this, or more so. And as far as we can tell, almost no one is thinking much past getting the SPAC acquisition done. So surely, CEOs of potential targets should steer clear of this tightrope? Well, maybe not. Valuations are at historic highs. If you run a company and someone is offering to pay really good money for it, you have a fiduciary responsibility to at least consider the offer seriously. There is no reason to think the IPO market will be anywhere near this favorable four or five (long hard slogging) years from now.

And then there are the personal incentives. Shareholders in an IPO are typically locked-up, or prevented from selling shares, for six months after the IPO. But M&A law is different from IPO law, and here lock-ups are determined by a negotiation between target and acquiror. So the Magic Unicorn executives could sell stock right away. The same is true of the SPAC sponsors.

And there is one more wrinkle. Remember that cash pile? What if the original SPAC IPO participants actually do choose to participate. They like the story, they love the growth. Maybe they get some extra shares. So they decide to pay up. That means UNC! may actually have more money than they need, potentially much more. The Board probably will not let them give everyone a giant raise, but the Board is made of SPAC sponsors, who own a lot of shares personally. So maybe it is time for a special dividend. If UNC! has a few ‘extra’ hundred million dollars, why not give every shareholder $2/share. That works out to $300 million, or $75 million to the SPAC sponsors and $180 million for the original Magic Unicorn shareholders, which likely include the executive team. Sounds far fetched? We didn’t think of this, at least one SPAC we know of has already done something similar.

SPACs in themselves are not a bad thing. They are just a financial tool. But the regulatory arbitrage and immense wave of money out there are highly likely to attract their share of bad actors. We are not painting all SPACs and SPAC sponsors this way. They are for the most part fully ethical and moral people, but there is clearly room for some of these deals to end in tears.

And finally, the question becomes who pays that price? That is likely to be shareholders, both the public markets and company employees, who have to bear the immense risk built into the financial projections which underpin the whole structure. Again, we are not saying all of these deals will break. Some will undoubtedly be great successes, but a lot of them will face a much more challenging path.

Photo by Maria Teneva on Unsplash