There are a lot of SPACs being raised. Last weekend, something like a dozen got filed. By the time you finish reading this post, someone else will probably have raised another one. As we have said before (and here and here), there are plenty of good SPAC groups out there, but it is hard to argue that we are not in the midst of a SPAC Bubble. Every Bubble has its excesses, which leave a price to pay when they burst.
We think there are a few risks companies need to consider before going down the SPAC path, and a few ways this can play out.
First and foremost, at some point, the SPAC mania will end. It could happen tomorrow, it could happen next year, but at some point the window will close. From where we sit, in Silicon Valley Start-up Land, the biggest risk of this happening will be companies getting stranded by a SPAC.
At this point, any company that ever hopes to go public has to at least entertain acquisition conversations with SPACs. There is so much money chasing deals that a responsible board has to at least consider this path. And let’s say those conversations progress to a deal. Between announcing a deal and closing the sale, there is a real risk that a SPAC may run out of money. Investors in the initial SPAC IPO have the right to not participate in the acquisition. In many cases, the hedge funds buying into SPAC IPOs get warrants in the SPAC, which they sell, and then elect to not participate in the follow-on M&A transaction. Those warrants are free money for them, and this is likely part of the fuel behind the SPAC Bubble.
SPACs typically prepare for this eventuality by lining up a PIPE (Private investment in public equity) or other Secondary offering at the time of the “de-SPAC”ing M&A deal. Often, the PIPE provides the entirety of the acquisition funds. So if you agree to sell your company to a SPAC, the risk is that the SPAC cannot raise the capital to close the deal. Today, that seems unlikely, but if the SPAC window closes, it seems highly likely that there will be numerous private companies left at the altar with busted deals. Admittedly, the biggest cost for those jilted will be the amount of management time wasted on the deal. But the targeted company will also have had to reveal a lot of information about itself, helping competitors. And then no one knows what this will mean for a company that then tries to go public a few years down the line. Will they be tainted in the eyes of the Street by a busted SPAC? Maybe not, but no one can say today. Compounding this problem, a SPAC slowdown would likely take place at the same time as a market downturn, so the IPO window may be shut for quite some time for these companies.
Another major problem is that there may be more SPACs than viable targets. The ideal SPAC target is a company that is two years away from IPO. Close enough that they are getting ready, but far enough away that they could not go out on their own, without the SPAC. This is a fairly narrow target environment. This has two implications. First, there is a good likelihood that some of the targeted companies are further out of the range, meaning they are not ready to go public and will stumble quickly. This will poison the well for other SPACs. Secondly, and most painful is the hard reality that more buyers than sellers means valuations are going up. A lot.
For selling shareholders this is great. But in every Bubble someone is left holding the proverbial bag. In this case, the bagholders are future shareholders of the company – both public market investors and employees. Once public on a lofty valuation, the company has to ‘grow’ into that value. In our previous post we mooted a hypothetical example of a company valued at 2025 revenue which was 25X higher than current revenue. Few companies can grow at the pace being projected in some of the announced SPAC transactions. Some can, but not many. So at some point the company will stumble, the stock will take a big hit and many people will be left with a bad taste in their mouth. If the company gets a big pile of cash from the SPAC, it can probably weather the storm, but it will not be easy or fun. Even more pernicious, if the SPAC uses debt to lever up their transaction, the company may be left with a big interest expense that they have to support. And this can obviously lead to all sorts of problems.
As we noted at the opening, companies should at least consider a sale to a SPAC, but they should do so aware of the long-term risks, because it looks like very few people involved in SPACs today are thinking much past tomorrow.