By now, readers would have understood what is SPAC. Research suggests that the economic objective of SPAC is to create an investment opportunity for the investors and at the same time, encourage private equity funds for participation in the equity capital and growth financing in various industries. Therefore, the SPAC attracts risk and reward. The higher level of risk attracts a bigger reward and the lower risk level generates a smaller reward. An investor needs to know the SPAC process and about the SPAC structure.
Published in 1972, Maurice Godlier, “Rationality and Irrationality in Economics” demonstrates the theory of “raison d’etre.” He attempts to find out what is the logic behind it and the underlying necessity for the existence of an economic system to exist or have existed. Applying the raison d’etre principle to SPAC, a SPAC is a blank check company is his raison d’etre. It was created as a blank check company with no business operation that offers a shortcut to a public listing on a prestigious national exchange, NYSE, or the Nasdaq stock exchange, risk investors must recognize and accept. Unfortunately, the doctrine of caveat emptor could not apply. SPACs attempt to raise cash from the IPO and use the money for a merger or acquisition of a target business. The owners or shareholders of the targetted business enjoy substantial cash in return. along the timeline to complete a De-SPAC transaction, risk occurs. Below is an example of a brief process of a SPAC and its structure without a warrant for discussion.
It begins with the Founder Members (SPAC Sponsors). Any person can become a SPAC Sponsor, but the SPAC company needs to have money to finance the go public operation up to the IPO stage. There are preliminary expenses such as the incorporation of a company and registration fees, and as it moves forward, office and administration expenses, and then, the Issue Expenses pertaining to the IPO.
Let’s say, John, Peter, Ben, James, and Paul wish to go for SPAC. Each of them will contribute $5,000, a total of $25,000 as a start-up fund to register ABC Opportunity Corp (“ABC”). In return, ABC issued 7,187,500 common shares to them as the Founder Shares (“Class B” shares). The price per share is $0.003478. The par value per share is $0.001. Class B shares will automatically convert into Class A shares at the time of the initial business combination or earlier at the option of the holders thereof for a one-for-one basis, subject to adjustments.
Five of them also become members of the Board of Directors and as Officers of ABC. The Board has a plan to do business in the IT Industry and contemplating raising $250,000,000 from an IPO with an offering price of $10.00 per share to be listed on the Nasdaq stock exchange. Therefore, the IPO is for 25,000,000 shares (“Class A” shares).
The Board will have to engage a lawyer to prepare and file Form S-1 with the SEC. Sourcing and negotiation for an IPO underwriter are required. Renting office premises, administration overheads, roadshows, IPO registration fees, listing fees, and accounting and audit fees is inevitable and financing is required. Let’s say, an estimated $2,000,000 working capital is required excluding underwriting commission. Since ABC has no income, the five directors may have to provide a loan to ABC or invite someone or an institutional investor to invest by way of a private placement and to become a SPAC Sponsor.
At this stage, there is minimal risk for the Founder Members instead they will be rewarded since the IPO share price is determined at $10.00 per share (Level One – Minimal Risk).
ABC found an institutional investor, Robin Corp (“Robin”) who will provide an interest-free loan to ABC to pay for those expenses. ABC will repay the loan from the IPO proceeds. ABC agrees with Robin to become a SPAC Sponsor and permits Robin to subscribe to 700,000 common shares at $10.00 per share under a private placement agreement as Class A shares, concurrently with the closing of this offering.
ABC also found ZZ Bank (“ZZ”) as the Underwriter for the IPO. The agreed discount and commission (2.0% + 3.5%, total 5.5%) for the underwriting. ZZ also agreed to defer the underwriting commission of 3.5% of the gross IPO proceeds. The five Founder Members agreed with Robin to part in 937,500 common shares out of the 7,187,500 common shares as forfeiture in the event there is an overallotment.
Greenshoe Option is a legal mechanism for price stabilization. Usually, the greenshoe option clause is contained in the underwriting agreement of an initial public offering to allow underwriters to subscribe up to an additional 15% of the IPO at the offering price. Greenshoe Option reduces the risk for ABC IPO shares offering, allowing ZZ, the underwriter to have the purchasing power to cover the short position in the event the share price falls. It would also a risk without the additional shares when the share price rises. Therefore, it is an overallotment option to support shares price after the offering. In 1919, Green Shoe Manufacturing Company (now part of the Wolverine World Wide, Inc.) was the first to apply this type of overallotment option to enable the underwriter’s ability to increase the supply of the shares with a view to stabilizing shares price fluctuation.
Applying the Greenshoe Option principle, ABC agreed to register additional 3,750,000 common shares along with the 25,000,000 common shares (“IPO Shares”) if Robin exercises a 30-day option to cover overallotment. In summary, the Founder Members and the public shareholders in the offering will be:
Shares Purchased Total Consideration Average Price Per Share
Number % Amount %
Founder Members (Sponsor) 6,250,000 19.56 $ 25,000 0.01 $ 0.004
Private Placement (Sponsor) 700,000 2.19 $ 7,000,000 2.72 $10.00
Public Shareholders 25,000,000 78.25 $250,000,000 97.27 $10.00
31,950,000 100.00 $257,025,000 100.00
The above table shows the Founder Members who are the initial shareholders have their shareholdings below the 20% benchmark. They, collectively, owned 19.56% of the outstanding shares after the offering (excluding the private placement shares). The Founder Members and Robin agreed not to transfer, assign or sell any of their shares and any Class A common shares issuable upon conversion thereof until one year after the completion of an initial business combination. The 937,500 common shares forfeiture in the event of an overallotment represents 15% of 7,187,500 common shares. In the event, there is no overallotment option, the forfeited 937,500 common shares will be surrendered to ABC with no consideration.
The 3,750,000 common shares represent 15% of the IPO shares of 25,000,000. Therefore, the total number of common shares submitted for registration as the IPO shares is 28,750,000 at an offering price of $10.00 per share, the total amount is $287,500,000 which will attract a registration fee of $31,366.25.
An analysis of the public offering price and the gross proceeds of the offering is as follows:
Per Share Total
Public offering price $10.00 $250,000,000
Underwriting discounts and commission $ 0.55 $ 13,750,000
Proceeds, before expenses, to ABC $ 9.45 $236,250,000
The IPO shares will be diluted. The implied value per share after the offering and the total funds available for an initial business combination on the assumption that the underwriter agreed to defer underwriting commission 3.5% or $8,750,000, no exercise of the underwriting’s overallotment for the 937,500 common shares and exclude the $2,000,000 working capital are shown below:
IPO Shares 25,000,000
Founder Member Shares 6,250,000
Private Placement Shares purchased by Robin 700,000
Total Number of Shares 31,950,000
Total funds available for an initial business combination $241,250,000
Implied Value Per Share $ 7.55
Public shareholders’ investment per share upon consummation of an initial business combination $ 10.00
Founder Members’ investment per share $ 0.004
Sponsor, Robin’s private placement investment per share $ 10.00
The structure will include the establishment of a Trust Account with FulTrust acting as the trustee for ABC. This is in compliance with Rule 419 under the Securities Act of 1933. The proceeds held in the trust account will be invested only in the U.S. government treasury obligation pursuant to Rule 2a-7, Investment Company Act of 1940. However, the working capital of $2,000,000 derived from the IPO proceeds and the sale of private placement shares will not be held in the trust account. Likewise, any loans made by directors and officers will not have any claim on the proceeds held in the trust account unless such proceeds are released to ABC upon the completion of the initial business combination. Application of the proceeds in the trust account in the target businesses or entities that together have an aggregate fair market value of at least 80% of the net assets held in the trust account (excluding the amount of any deferred underwriting commissions and taxes payable on the interest earned on the trust account). This is 80% of the net assets test. When there are too many public shareholders exercise their redemption rights, ABC would not meet such a closing condition and as a result, would not be able to proceed with the business combination. To avoid SEC “penny stock” rules, ABC would not proceed with such redemption when the net tangible assets are less than $5,000,001 or such greater amount necessary to satisfy a closing condition instead search for an alternate business combination or seek to revise the term of such business combination. In the event, ABC fails to consummate an initial business combination within 24 months from the closing of the offering the trust account will be liquidated, and balance proceeds held in the trust account will be returned to the shareholders.
Although there are other SPAC structure factors to be considered, the brief SPAC structure above, the risk under Phrase Two is considered low (Level 2 – Low Risk) for SPAC investors. ABC has complied with Rule 2a-7 of the Investment Company Act of 1940 which is a risk-limiting condition, a trustee appointed and trust account established, Founder Members’ investment within the 20% rule, and Robin’s investment is insignificant. Since ABC has no business operation, SEC will not prolong the evaluation and assessment period. there is nothing to ask about. Obtaining the SEC declaration of effectiveness of the registration statement of ABC reckon about six months from the date of filing.
Once the SEC has declared the registration statement effective, the management team of ABC would probably work closely with ZZ to promote the offering by way of roadshows. At the same time, they will be looking for target businesses for a merger or an acquisition.
However, in a certain situation, a SPAC structure may not have an underwriter. This is because one of the SPAC Sponsors could be an investment bank or fund manager or a group of hedge funds capable to subscribe the entire IPO shares under a private placement arrangement. Arguably, having substantial investment in its SPAC at the time of an IPO could probably avoid underwriting commission and cover expenses the SPAC would incur during the search for a target business. Underwriting commission depletes cash.
At this stage, the risk identified will be from the time of IPO and until it is merged, that is, the business combination completed. It has time to complete a business combination, that is, 24 months from the closing of the offering. Ideally, public investors should take a look at the SEC Form 13F filing. It would reveal the ownership of the SPAC, disclosing their shareholdings on a quarterly basis. But, there are circumstances that some shares owned by 13F filers are held by wealthy individuals and institutional investors that not required to file Form 13F. The SEC Form 13F is a quarterly report that is required to be filed by all institutional investment managers with at least $100,000,000 in assets under management.
One of the main features of SPAC is the redemption right the investor had. The redemption rule is stated in the prospectus. Investors can redeem all or a portion of their shares upon the completion of the initial business combination for the $10.00 price sold in the SPAC IPO plus interest payable in cash, equal to the aggregate amount then on deposit in the trust account calculated as of two business days prior to the consummation of the initial business combination, including interest earned on the funds held in the trust account, divided by the number of then outstanding IPO shares, subject to limitation rule.
It is common for a dissatisfied investor to seek redemption, or there may be many investors seeking redemption. This puts the SPAC management to raise new equity by private placement from third-party investors or a loan from the SPAC Sponsors or both. Without cash replacement, the initial business combination may fail. To avoid failure, SPAC Sponsors may enter into some kind of arrangement or side payments to existing shareholders in exchange for commitments not to redeem or dispose of their shares. It is unlikely that the SPAC management made the disclosure for such an arrangement. It appears a loss to redemption.
At this stage, investors encounter a medium risk (Level 3 – Medium Risk). SPAC IPO and its financing of a target business are empirical matters that cannot be treated as two separate issues.
In Phrase Three above, the investors may lose their investment when SPAC does not merge. Phrase Four is when the SPAC IPO shares are already listed and traded. It is a matter for the secondary market. Investors no longer can redeem. The trust account no more, liquidated. What would b the post-merger return to SPAC shareholders?
SPAC focuses on the sponsors of high net worths or qualified individuals with deep experience in his field of expertise and creditability. Performance matters. Is it mandatory for a SPAC sponsor to be affiliated with a fund listed in the PitchBook or has been a former President or CEO of a Fortune 500 company? Arguably, it is not true, but a majority of investors believe that SPAC with wealthy and experienced sponsors could produce greater post-merger returns. The selection of a sound attractive target for a merger or acquisition is important as it will trigger a rise in the share price, that is, above the redemption price. there will be less redemption. On the other hand, sound management with corporate governance and managing ongoing business help to attract private investment in public equity (“PIPE”). This added value to the SPAC. Investors must understand that there are uncertainties that beyond control. Trading securities on the secondary market always carry a high risk. Investors rely on the information published publicly and historical financial statements. Continuous monitoring of the performance of the SPAC is required. This is a Level 4 – High-Risk category. The approach to determining return to SPAC sponsors is different.