What is a SPAC?

A special purpose acquisition company (SPAC) is a term used to describe a company that is established for the sole purpose of raising funds to acquire a private company and make it public. This funding is raised through an initial public offering (IPO).

How SPACs work

There’s typically at least one target company in mind when forming a SPAC. The company’s sponsors usually have expertise in a particular area of business. After the SPAC’s formation, it then goes through an IPO process to raise money. Prospective companies are not usually disclosed during the IPO process.

An interest-bearing trust account holds the money raised from the IPO in escrow. This money can only be used after the SPAC acquires a company. Note that in some cases, the SPAC can use the interest gained on the money in the trust account as working capital.

If the SPAC identifies a candidate for acquisition and shareholders approve the deal, it can then make a formal announcement to the public. If, however, the SPAC doesn’t make an acquisition within 2 years, it must return the money it raised to its investors

Benefits of SPACs

Before becoming involved in a SPAC, target companies, investors, and sponsors should understand their potential upsides, as well as their potential downsides.

Let’s start with the benefits SPACs can offer. A major benefit associated with SPACs is that they can make the fundraising process much simpler than going directly through a traditional IPO.

Companies seeking to raise funds directly through a traditional IPO will need to attract investors. They also must overcome numerous regulatory hurdles for the IPO to proceed. To make matters even more complex, companies that choose to go the IPO route without first being acquired by a SPAC must spearhead both of these tasks.

In contrast, companies that go public after acquisition by a SPAC no longer need to worry about fundraising through an IPO as this task will already be done. Moreover, the acquired company can take advantage of the experienced personnel who were part of the SPAC team. SPACs may also be able to provide more capital during the acquisition process to the purchased company.

SPACs also have potential benefits for individual investors. While investors aren’t usually privy to IPOs in their early stages, this isn’t the case with SPACs. With SPACs, individual investors can get on board early on. They can subsequently reap the rewards that come with a SPAC acquiring a company that performs well after its IPO.

Drawbacks of SPACs

While SPACs have several benefits, there are also some downsides you should be wary of. One of the main downsides to keep in mind is that SPACs don’t follow the same rules as companies pursuing traditional IPOs.

Namely, companies pursuing traditional IPOs are prohibited from making speculations about their future financial performance. They can only use financial results from the past.

However, this isn’t the case for SPACs. SPACs can make projections up to five or more years into the future. While this benefits SPACs, it essentially means that things may not work out as projected, which would be to the detriment of investors.

In general, traditional IPOs are more restrictive since they are set up to protect investors. Conversely, investing in SPACs comes with fewer protections for investors.

SPACs are essentially shell companies that exist to acquire a private company and make it public with money raised through an IPO. The SPAC IPO process is simpler than the traditional IPO process. It also provides private companies with an easier method of going public.

While they can be attractive, it’s worth remembering that SPACs don’t provide investors with the same level of protection that’s available with a traditional IPO. SPACs also aren’t required to follow the same rules as a company going through a traditional IPO.

As they can speculate about their future performance, the company’s performance might not meet expectations and investors could ultimately lose out after an acquisition target is made public. That said, if a company isn’t acquired, investors’ money will be returned to them.

Given all of these considerations, it’s vital to consider both the benefits and drawbacks of SPACs before getting involved in one as a company, investor, or sponsor.