What is a SPAC?

A SPAC, or Special Purpose Acquisition Company, is a publicly traded company created specifically to acquire or merge with an existing private company. Often called a "blank check company," a SPAC raises money through an initial public offering (IPO) before it has any actual business operations or even a specific acquisition target in mind. For the full cycle in more depth, see how does a SPAC work, or start from embarc's SPAC overview.

The Basics of SPACs

Think of a SPAC as a shell company with a very specific mission: to find and acquire a private company within a set timeframe, typically 18-24 months. The SPAC raises capital from public investors who trust the people behind it, the sponsor and its officers and directors, to find a good acquisition target.

Here's what makes SPACs unique:

• No business operations: At IPO, a SPAC has no commercial operations—it's just a pool of cash looking for a company to buy.
• Trust-based investment: Investors are essentially betting on the SPAC sponsors' expertise and track record.
• Time-limited: SPACs typically have 18-24 months to complete an acquisition or return money to investors. Shareholders can vote to extend the deadline, but the exchanges require a deal within three years of the IPO.
• Redemption rights: Investors can get their money back from the trust (plus interest) when a deal or an extension is put to a vote, whether they vote for it or not.

How SPACs Work: The Life Cycle

1. Formation and IPO

A SPAC begins when sponsors (typically experienced investors, executives, or industry experts) create the company and file for an IPO, with an underwriter running the offering. The sponsors usually pay a nominal amount, often $25,000, for “founder shares” equal to about 20% of the SPAC's equity after the IPO, and buy private placement units or warrants to fund expenses. Some sponsors are serial issuers, such as Gores and Churchill Capital, each of which has run many SPACs.

During the IPO, the SPAC sells units to public investors, typically at $10 per unit. Each unit usually consists of:

• One share of common stock
• A fraction of a warrant (often 1/3 or 1/2) that allows purchasing additional shares at a set price (typically $11.50) in the future

Many smaller SPACs substitute rights (each converting into a fraction of a share at closing) for warrants, or include both. The S-1 spells out the unit terms, the founder share count, and the underwriting fees, including the portion deferred until a deal closes.

2. The Search Period

After the IPO, the SPAC's cash is placed in a trust account while the sponsors search for a target company to acquire. During this period:

• The money in trust earns interest (typically invested in government securities)
• Sponsors cannot touch the trust money except to complete an acquisition or return it to investors
• The SPAC's shares and warrants trade publicly on stock exchanges
• Sponsors work to identify and negotiate with potential acquisition targets

3. The De-SPAC Transaction

When sponsors find a target, they announce the proposed merger. This triggers several important events:

• Disclosure: The target files a registration statement (usually Form S-4 or F-4) jointly with the SPAC, with audited financials, risk factors, and a proxy for the vote
• Shareholder vote: SPAC shareholders vote on whether to approve the merger
• Redemption option: Shareholders can choose to redeem their shares for cash (typically $10 plus interest) rather than participate in the merger
• PIPE financing: Often, additional funding is raised through a private investment in public equity (PIPE) to replace cash lost to redemptions

4. Completion or Liquidation

If the merger is approved and completed, the private company becomes public, taking over the SPAC's stock exchange listing (see what is a SPAC merger). That is how Social Capital Hedosophia Holdings became Virgin Galactic. If no suitable target is found within the time limit, the SPAC liquidates and returns the trust money to investors (see what happens in a SPAC liquidation). Size is no guarantee: Pershing Square Tontine Holdings, the largest SPAC IPO, liquidated without completing a deal.

Advantages of SPACs

For Target Companies:

• Alternative path to public markets: A negotiated merger rather than a marketed offering, though with the target now a co-registrant under the SEC's 2024 rules, timelines and diligence look more like an IPO's
• Negotiated valuation: The valuation is agreed upfront with the SPAC sponsors, though redemptions decide how much cash actually arrives
• Expert partners: SPAC sponsors often bring valuable expertise and connections
• Projections, with less protection: De-SPACs commonly disclose financial projections, but since the 2024 rules the PSLRA safe harbor for forward-looking statements no longer covers them, and the bases and assumptions must be disclosed

For Investors:

• Downside protection: The ability to redeem shares at the IPO price plus interest provides a floor
• Upside potential: Warrants provide additional upside if the merger is successful
• Access to private companies: Opportunity to invest in companies that might not otherwise go public
• Transparency: Detailed disclosures before voting on the merger

Risks and Considerations

Dilution Risk

One of the biggest risks for SPAC investors is dilution. The sponsor's promote (typically 20% of shares), warrants, rights, and deferred underwriting fees are fixed costs, so the more shareholders redeem, the larger the share of the remaining company they represent. The 2024 rules require a SPAC to disclose dilution at a range of redemption levels, at the IPO and again at the merger.

Sponsor Incentives

Sponsors have strong incentives to complete a deal—any deal—because they typically lose their entire investment if no merger occurs. This can lead to overpaying for targets or pursuing suboptimal acquisitions.

Limited Time and Information

The pressure to find a target within the deadline can lead to rushed due diligence. Additionally, investors have limited time to evaluate the proposed merger once it's announced.

Post-Merger Performance

Historical data shows that many SPAC mergers underperform the broader market after the de-SPAC transaction completes, particularly after redemptions and sponsor lockups expire.

The SPAC Boom and Evolution

SPACs experienced explosive growth in 2020 and 2021, with hundreds of SPACs raising billions of dollars. This boom was driven by:

• Low interest rates making yield-seeking investors more willing to take risks
• Market volatility making traditional IPOs less attractive
• High-profile sponsors bringing credibility to the structure
• Success stories of companies like DraftKings and Virgin Galactic going public via SPAC

However, the market has since cooled due to regulatory scrutiny, poor post-merger performance of many SPACs, and rising interest rates. This has led to evolution in SPAC structures, including:

• Lower sponsor promotes
• More investor-friendly terms
• Smaller deals and more frequent deadline extensions
• New SEC rules, adopted in January 2024 and effective in July 2024, that make the target a co-registrant, remove the projections safe harbor, require detailed disclosure of sponsor compensation, conflicts, and dilution, and set a minimum 20-day period between sending the merger proxy and the vote

Key Takeaways

Questions to Ask Before Investing in a SPAC

1. Who are the sponsors? What is their track record and expertise?
2. What are the terms? How much dilution will occur from sponsors and warrants?
3. What's the timeline? How much time remains to find a target?
4. What's the focus? Does the SPAC have a specific industry or geographic focus?
5. What are the redemption terms? When and how can you get your money back?
6. What happens to warrants? Understand the warrant terms and exercise conditions