Special Purpose Acquisition Companys (SPACs), also knows as blank check companies, have become a popular way to take a company public. It’s a method that bypasses some of the scrutiny associated with a traditional IPO that also provides a better return for the company.

For investors, however, SPACs can come with more risk as the regulatory process has been relaxed compare to what a company must do to go through a traditional IPO. That has changed somewhat as the SEC has added some regulatory oversight to the process but buyers still need to go into this process with their eyes wide open and a full understanding of what they’re buying.

Simon Erickson joined the July 21 edition of 7investing Now to break down how SPACs work and to examine their future place when it comes to taking companies public.

A full transcript follows the video.

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Dan Kline: But uh, SPACs have been that’s been the word of the year, we were going to give a word x. And this is of course, the alternate way to go public. Not the weird little pets. Those are Spats. So we want to be careful there. But our topic here is have SPACs become less attractive. Before we get into that. Simon, why don’t you give us the 10,000 viewers? What is a SPAC? What are those letters even stand for? On? How is it different from an IPO?

Simon Erickson: Yeah, thanks for the clarification doing you know we are talking about SPACs, not specs, not Spock from Star Trek, you know, this is about these special purpose acquisition companies that are all the rage I’m coming public in the last couple of years, I SPAC is a is an alternative to the traditional IPO. Some fun facts that the number of SPAC IPOs in 2021, even though we’re only halfway through the year so far is already 50% higher than it was in 2020. And 2020 was even double what it was in 2019. And so this is really a huge developing trend of companies saying hey, I want to do the SPAC, I’m going to raise money this way, rather than the traditional IPO that we’ve gotten used to. And so I’d like to spend the first part maybe just chatting about what a SPAC is and how it’s different. And why companies might be interested in this.

Dan Kline: Yeah, let me jump in. And these are often called blank check company. So what does that mean? That means that let’s say Simon and I decide we want to invest in companies that have alternative outdoor experiences, so zip lines and, and manmade natural water slides, who knows? And we go, okay. And then we get someone who’s Well, no, we get a Tony Hawk team, and he puts in $100 million, and then we go out and raise half a billion dollars. And we say we have this ready to go public company. And we’re going to go after a private company. And we’re going to say, okay, you’re worth this much. Here’s that money. Here’s money for your balance sheet. Now you are public, and there’s very little scrutiny with this. Am I getting correct, Simon?

Simon Erickson: Yeah, that’s absolutely right, Dan. I like the analogy. And I love throwing Tony Hawk into the description of it as well, even better. I tend to think of it as a swimming pool. This is the analogy that I’ve come up with. It’s not perfect, but it’s the one that I’m going to roll with anyway, so forgive me say that you’ve got a great kiddie pool in your backyard, right? It serves your purposes you jumped in the kiddie pool. It’s great for us in Houston. Probably great for Davenport, Florida, right? It’s sweltering hot outside. Go jump in the swimming pool. You’re totally happy.

But what do you get approached by someone else a SPAC financial sponsor say that says, hey, that’s a great swimming pool kiddie pool you’ve got, but I can build you a much, much larger swimming pool that you’d love even more, and you get more space to swim around in this swimming pool, but you just got to share a little bit of it with my investors here on the side. And we might even bring in some other investors as well, corporations or larger companies, and they’re gonna have a part of the pool too. But this is a much better swimming pool than you’ve got with your kiddie pool in the backyard right now. And that’s kind of how a stack operates in the private companies have got the kiddie pool that are upgrading, they get a higher valuation.

They’re splitting the ownership of the business with financial sponsors who do the deal itself. Sometimes they bring in corporations or other companies that want to get in on this as well. And then as you said, they’ve got their own investors, the SPAC itself is holding funds that investors like you or I could get in as a public shell company as well. So much larger swimmer pool at the end of the day, it’s appealing for everybody, as long as everyone gets along.

Dan Kline: Yeah, so there’s actually an actual swimming pool about 20 yards behind me. So if you hear people screaming, there are lots of kids out playing at the swimming pool. And I actually saw a story today about a potential SPAC, that is the air b&b of swimming pools where if you have a swimming pool in your backyard, you can rent it out, of course, you’re also encouraged to get very expensive insurance through them, because there’s heavy liability. And you can make 10 to $20,000 a month. And that sounds ridiculous.

But if you live someplace like Houston, Texas, or in my case, West, Palm Beach, Florida, and you’re the rare person who doesn’t have access to a pool, oh, boy, do you want to pool and paying 50 $75 for a couple of hours in a pool seems delightful. That’s the type of company that needs capital to grow. It’s a marketing play, you can you can prove the business model pretty quickly. But if it gets three $400 million, it can accelerate. So that’s the positive of what a spat can be. It can take a small company, or growing company and give it cash quickly allow it to grow. Before we get into how a SPAC could be very, very good for the company. I want to talk about some of the risks to investors. So when you do a traditional IPO, you do something called an s one. And s one is kind of like a financial Bible. Now I will point out that an s one is like an idealized document.

It’s like your mortgage application, like on your mortgage application. You don’t point out like Yeah, I just paid off all those credit card bills yesterday, you just like you’re saying like I have no credit card bills, like you are very careful how you present it. That’s what an s one is. So they go out on what’s called a roadshow. And basically the CEO, the CFO, they appear in front of bankers, and they say, Hey, here’s why you should get your class to invest in us. It’s great. And it should be worth this and that when you have a SPAC Simon, you basically put out what like a two-page document a postcard like there’s not a ton of information that comes in.

Simon Erickson: There’s still a regulated sec document and prospectus goes out for a SPAC as well. But it is a little different than the traditional IPO. Like you mentioned in Yeah, maybe to demonstrate this. Let’s go back in time, right, let’s hop in a time machine. Back to 2012. When Facebook did its traditional IPO writing, this is a really big deal. I mean, you guys remember what a big deal it was when Facebook went public, you know, and Mark Zuckerberg was saying, Hey, this is the largest valuation we’ve ever had for an American publicly listed company at an IPO $104 billion. Right.

So this is really, really big deal. And Facebook hires underwriters to say hey, we’re going to sell shares to you for $38 a share. And we’re gonna see 480 million of these and raise $18 billion $18 billion, with a B of capital, they put on their balance sheet to start building up the business. And so JP Morgan, Morgan Stanley, Goldman Sachs all the underwriters said great, okay, Mark, that’s probably higher than we were probably gonna pay for this. But you know, we know you’re onto something here, we’re going to give you a $38 a share. And Zuckerberg also says, Hey, I’m also only going to give you guys a 1% underwriters fee, a percentage of the gross proceeds of the amount that’s raised in the IPO, typically five to 7%. Facebook says, we’re really onto something big, we’re gonna give you 1%, all the underwriters say, Fine.

And the reason that I’m bringing all this up, Dan is because on the very first day of trading, we’ve almost gotten used to that IPO pop, right? Where you see Facebook trade in the first day goes up from $38 a share to like $75 a share $100 a share. It’s just like, that’s what we’ve gotten used to in IPOs. But that’s money that’s left on the table that is not collected by Facebook by selling it $38 a share to its underwriters, that is the market value and access the premium of having your shares public publicly traded that you’re missing out on a traditional IPO. And so I bring up the example of Facebook because on the very first day of trading, Facebook shares closed at $38 and I believe is 24 cents or 23 cents. So there was no IPO pop, Facebook brought all of it into the underwriters of what they paid them up front.

There wasn’t a pop and they paid less of an underwriter speed. This is a more efficient way of raising capital. And other companies kind of use that as a model of saying how can we get away from these limitations of a traditional IPO? And that’s what’s really pushed this back movement which was, which was highly influenced by Sir Richard Branson, bringing Virgin Galactic public tourists back last year, a lot of others kind of use that as the new model of how they want to raise capital.

Dan Kline: It’s also worth pointing out and apologies if I have some internet issues I am, it is very, very hot that appears to be affecting how the waves travel here. But that being said, Facebook was widely considered a failure for two years that was written about as a disaster, because people put all this money in and they didn’t get these big returns. What happened with Facebook also was they had to revise their numbers about a week before they came out. And that was considered a little shady, what actually was the ethically correct thing to do?

They also had a trading glitch at the beginning that was based was due to volume, it was unprecedented volume, that also created the impression that the scales were weighted that things were going on. So Facebook was wildly successful for Facebook. And that’s actually what you want an IPO to be as a shareholder. You want the company to get as much money as it can, and for its returns, and I promise we’ll work Dana Abramovitz in later, she’s gonna be a big part of the show here. But you want the company to get as much money spend it well. And your returns might be three to five years down the road. Simon, how does this back do that differently?

Simon Erickson: Yeah, great. points. Dan, a great segue to so now we have a financial shell company, right? You have a financial sponsor that has a publicly traded, you can buy shares of us a ticker that’s publicly traded on exchanges, where you can buy into the SPAC, you can put your money into this piggy bank, that is SPAC investors that then that financial sponsor, he or she will go out and do a deal on your behalf. They’ll go out in this instance, with the company that you that we’ve started here, Dan, doing Tony Hawk stuff outside stuff, these facts sponsor would come to you and say, hey, I’ve raised $200 million in the shell company, I would like to use that to buy49% of your existing shares out there. And we’re going to transfer it directly.

We don’t care what the climates like in the in the IPO market, we don’t care what public investors or underwriters are going to do, this is going to be a set valuation terms that we’re going to give you it’s going to inject that directly. There are some considerations that I think we’re going to get to in a minute here, when we talk about the risks, but the benefit is, you actually are much more capital efficient in raising money from a SPAC because you kind of get to set the valuation, you set the terms and that money goes straight on your balance sheet as a private company.

Dan Kline: Yeah, so Dana owns a Fitness Studio. And if Dana decided she wanted to sell half her fitness, she doesn’t let arbitrary bankers decide what the price might be. She makes the best deal possible. So that’s great for the company. Here’s the potential negative a SPAC or an IPO, but it’s harder with an IPO can be used to transfer risk from venture capitalists, to individual investors. And what do I mean?

Most not most, many SPACs that come out, are absolutely IPO global companies, and they’re taking a better slash easier route. I have seen quite a few specifically in my space of media, where a bunch of companies that could be profitable, but aren’t going to be huge growth engines, go Geez, how do we get $300 million? Well, if BuzzFeed and the athletic and I love the athletic, I don’t mean to diss any of these companies. If you roll up a bunch of these companies, well, there’ll be back office, or getting rid of some accountants isn’t going to make these companies high growth companies, they’re, you know, maybe they can co market and there’s some efficiencies, but you do see, and this is a shark tank term.

You see a lot of good businesses use SPACs as a way to cash people out when there’s not a lot of upside for investors. So that’s where you need to be careful. And where you need to evaluate, you know, what are the long term opportunities, we see a ton of questions and comments coming in, we will take them towards the end of the segment. So Simon, the positive is you get the most money possible. The negative is you might not be buying an actual company. As an investor. How do you counteract this? I know I have a strategy for it. But how would you counteract buying into a company? That sounds good? Wow. It’s BuzzFeed meets the athletic being bought by the New York Times it’s like, maybe not so great. How do you go around that one?

Simon Erickson: Yeah. And then I should dispel a lot of kind of the adjectives that are used to describe SPACs out in the media right now, right, SPACs are not good or bad. They’re just more complex and different than what we’ve gotten used to. And so back to that swimming pool, you’ve got to know who you’re swimming with, right? Are the kids that are coming to the pool from the investors, are they, terrorists, they’re throwing things at you, and now you don’t like being a part of this business with them. I mean, a big part of this is the terms of the deal itself. For one, there’s a lot of money chasing after companies right now. Interest rates are very low.

A lot of financial dealmakers are looking to spax as a way that they can pad their pockets, and they’re giving to high evaluations for unsustainable companies. And so one thing you should really be watching if you’re looking into a SPAC is If you see that hockey stick, right, if you see the projections of the revenue and the EBITDA, a lot of times this isn’t just a year or two out, then they’re forecasting like 2027 2028. And saying, Hey, we might be very small today, you might be paying 200 times sales today. But look at the potential as this ramps up. That is very, very hard to do. It is very, very hard to grow exponentially for a five-year period, all at the same time. So I think that you have to have kind of a boulder of salt, when you look at a lot of those projections that are that most of those companies are not going to reach those.

Dan Kline: Yeah, and the reality is, we we don’t invest in most publicly traded companies, we do our due diligence. So I don’t generally invest in IPOs, or SPACs, but here’s my exit. Not that I don’t like the companies. I’m going to wait until I’ve seen two quarters of reported earnings, gotten a feel for the CEO. But in my case, it’s I’m gonna let you jump in here and Dana, feel free to weigh in here. I think there are exceptions. So if a leader I truly love creates a SPAC with the idea that he’s gonna use it to buy copies that he’s gonna run or be a key advisor to, I might buy that on faith and the person so john Legere who left T Mobile as CEO, decided, or Patrick Doyle, who ran Domino’s for many years, created stacks in an area I felt comfortable investing in, I probably buy their SPAC day one because I trust their long term track record. I think the same could be said with some of the serial investors who are backing SPACs, you know, if you want to back Richard Branson, I don’t think that’s absolutely crazy. So in some cases I’ve been we’re kind of throwing our rules out, right?

Simon Erickson: Yes, the financial sponsor themselves really matters. And Dana, please jump in if you’d like me to not monopolize this conversation here.

Dana Abramovitz: I’m sitting here nodding my head.

Simon Erickson: Richard Branson, you know, and Chamath Palihapitiya, which is the financial sponsor, he worked with a Social Capital. Chamath is a very different type of investor than Bill Ackman is right. Bill Ackman has been an activist investor was trying to wring out synergies from very mature operating companies. Chamath is investing in the space economy, you know, in climate change and stuff. That’s, that’s very less established today.

So who is the person that’s doing the deal on your behalf and what kind of companies are they looking for, is very important. And there’s just one more thing that I maybe want to call a lot of investor attention to this very, I think it’s something we should really put a lot of scrutiny under is the dilution that is inherent in the deals that are being done for a SPAC. What I mean by dilution is when you’re buying in a SPAC, most of them are being sold at $10 a share, if you’re buying into the shell company, when it actually completes the merger.

A lot of times, there are sweeteners for the deal, where there will be additional shares that are issued to the private company that agrees to come public, to the financial sponsor who does the deal. And to you as a SPAC investor, where you can get awarded more shares if the price hits a certain threshold. Right. And these are known as warrants, those are typically included when you’re buying into a stack, and is this back in the first place. But we’ve really got to pay attention to how diluted is the pie going to get and who’s getting the benefit of those warrants? Are we just loading up the financial sponsor that does the deal with a whole bunch of warrants? If it goes through?

Are we giving it all back to the private company? Where they say, Okay, yeah, I’ll go, I’ll agree to go public with you. And if it hits this price, then we all make a ton of money and cash out? Or are you getting a fair and equitable part of that as well, as an investor in the back? I mean, all of these are considerations. You can’t just say, okay, everybody’s got the same terms. For everyone, these factors, they’re all very different. And it can make a huge impact on your returns.

Dan Kline: Yeah, this is an area we have to do your due diligence. And some of that is the financial terms. Some of that is the company. And I think you need to remember, these are structured. So your payoff as an investor is going to be long-term, we see a bunch of questions. A lot of the questions in the queue are about specific companies. And I’ll leave it to Simon, Dana, if they if they, if they know any of those companies, tell me which ones and I’m happy to talk about it. But I don’t want to introduce sort of discussions on which SPAC is better than the other. But I do see some questions I am going to take in a broader sense as we move through, but Simon, the SEC has actually cracked out on this a little bit. So SPACs, we were at a blistering pace.

And it actually slowed down in April. And the reason for that is, the SEC is looking at whether bags are sometimes on multiple sides of the deal. This happens in IPOs, too, it’s called a Chinese wall, where part of the bank is taking it public and telling you it’s great. The other part is analyzing it and deciding if it’s great and they’re not supposed to interact. We worked in a company that had a Chinese wall for part of its business. It’s not an exact science like I had coffee with someone on the other side of the Chinese wall at every visit. Now. Did we talk about things we shouldn’t know? But could we have? Absolutely and if we’ve stood to make millions, maybe we wouldn’t have like so. Just so what is the SEC doing and is this going to long term slow down this back market? Or is this just sort of a reasonable regulatory bump in the road?

Simon Erickson: I think it’s a regulatory bump in the road, that’s very necessary, it’s going to cut out a lot of the bad actors that don’t want to do their homework and actually have kind of a methodical process behind their forecasting. Right? So you can’t I mean, like, it’s less stringent on the forecasting of revenues, and EBITDA for SPACs than it is for, for operating companies where you can show, okay, here’s our cash flows, here’s, you know, here’s their operating history, it’s more, okay, if you’re a SPAC that’s going for the gold, but you don’t have a whole lot of history to raise money that way.

And that’s why you see those hockey sticks. That’s why you see such frothy projections a lot of the time. And I think that what you say is very true that there needs to be a little bit more attention on the actual business itself, rather than just the projections. And the other thing is related that I’ve done, I’ve been watching with the SEC guidelines for this. And the statement they made back in April, was the way that they’re classifying warrants. So again, back to Hey, we get more issue more more equity.

I’ll start that over it more shares of this company issued if it hits a certain price that needs to be tied to the fundamental business itself, right. Like, you can’t say, Hey, we’re gonna issue more shares to Facebook, if Apple’s shares go up to $18, a share or whatever it is, it needs to be tied directly to the company that would be registered and listed on an American exchange and equity exchange. And a lot of times there were other factors characteristics of the SPAC of the financial sponsor of the investment vehicle that were not tied to the operating company. And the SEC says, Hey, we’re going to be taking a much closer look at this. And a lot of those creative dealmakers kind of said, okay, maybe we should go back and do a little bit more homework, make sure that we’re compliant.

Dan Kline: More regulation is not necessarily a bad thing. And again, when you look at sort of SPAC projections, it’s a little bit like being a venture capitalist yourself. And you know, Simon, you’ve worked on business plans, I’ve worked on data, you’ve worked on business plans, when you read a business plan, the first three years are like your realistic growth, because that’s where the money you actually get is going to go. Your year four, and your five, you’re like, well, I’ve six franchises on Mars, like, like, I’ve done it a bunch of times. And that’s just how it works. Everyone knows those numbers aren’t real, you know, they’re their absolute best-case scenario projections. That’s kind of how you have to look at some of this and be wary of, let’s call it industry opportunity, where someone just says,

Wow, sports betting is gonna be huge, where sports betting invest in us that is, I hate to pick up that particular space cannabis, you know, this the space industry, just because Simon and I create Tony Hawk is even more money and we create space Hawk, and we say we’re going to focus on our unique experiences in space, doesn’t mean we’re actually going to create a rocket ship or, or make a spacescape, or whatever it’s going to be.

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