I. SPAC and de-SPAC Background
A special purpose acquisition company, or SPAC, is a public company with no operations, products, or assets. Unlike a traditional public company’s initial public offering (IPO), a SPAC’s primary function is to raise capital that is deposited into a trust account and to seek out and combine with a private operating company to take that private company public, avoiding the traditional IPO process for the private company. Upon merging with the SPAC in the “de-SPAC” transaction, the surviving entity assumes the business operations of the target company and continues as a publicly listed company, with the proceeds held in the trust account being used towards funding the target company’s business.
It is well known that the insatiable appetite for SPAC IPOs that dominated the U.S. capital markets in 2020 and the better part of 2021 waned in late 2021 and contracted further in 2022 and the first half of 2023. With the drop in SPAC IPOs also came a decline in the resulting initial business combinations, or IBCs, between the SPAC and the target operating company, with a peak of 200 IBCs closing in 2021, as compared to just one half that number in 2022 and just 40 de-SPAC transactions in the first quarter of 2023. Additionally, unlike earlier de-SPACing transactions, most recent de-SPACing transactions have seen the SPAC shareholders exercise their right to have the IPO proceeds returned to them, while also voting to approve the merger. While recent IBC’s are therefore not a source of significant capital for target businesses, many of the recent transactions have been accompanied with separate financing transactions, described more fully below, occurring concurrently with the IBC.
A number of companies that went public through an IBC during the past two years have not performed well and thereby contributed to the negative perception of the SPAC structure in recent quarters. However, while the frenzied market of 2021 and 2022 may have resulted in some companies going public pre-maturely through the de-SPAC process, the SPAC structure itself is not primarily to blame for their subsequent performance. Rather, this performance can be attributed to a number of other factors including that many targets were early-stage technology or biotech companies whose challenges can be attributed to current macro-economic conditions, in particular the difficulty of satisfying their intensive capital requirements, rather than their association with a former SPAC.
II. Recent De-SPAC Trends by Way of Flexible Alternative Financing Structures
De-SPAC transactions have the ability to acquire additional financing for their mergers through private investment in public equity (PIPE) transactions, wherein the SPAC issues new securities to institutional accredited investors contingent upon the closing of the IBC. PIPE investments help to both fund investor share redemptions and finance the merger itself. As it is uncertain how many stockholders will redeem their investments prior to an IBC, the resulting amount of cash available in the SPAC’s trust account at the closing of the de-SPAC can be unknown immediately before the merger. Arranging PIPE financing helps to mitigate the risk that insufficient cash will be available for the de-SPAC transaction. While some of these PIPE transactions involve straight common equity, de-SPAC transactions have increasingly used alternative, creative financing structures. Some SPACs have raised funds through the issuance of convertible debt or preferred stock, or entry into forward purchase agreements, with favorable conversion features, while others have issued warrants in their common equity deals.
In de-SPAC transactions, earnouts refer to the right of target company stockholders to receive additional equity once certain milestones are met, usually based on share price or financial metrics, with a certain number of shares being issued as additional consideration when the target company share price reaches a specific threshold, or at various share price thresholds through a tranche structure or the applicable financial metric is satisfied. Earnouts can help bridge a valuation gap between targets and buyers by reducing a sponsor’s or target shareholder’s compensation unless these share price targets are met, which in turn reduces the parties incentive to enter into bad merger agreements. Another financing development involves the SPAC obtaining commitments for the issuance of convertible notes with semi-annual interest make-whole payments in cash depending on when the notes are converted.
While business combination transactions are being announced with traditional PIPEs, it is clear that the de-SPAC market continues to allow SPAC’s and target companies fluidity and alternative financing structures that are being utilized where appropriate.
III. Looking to the Future of de-SPACs
Many of the SPACs that went public in 2021 and 2022 are now nearing the end of their hunting period to identify and complete an IBC prior to the time that they are required to wind-down the SPAC and return the IPO proceeds to investors.. Around 300 SPACs have deadlines to merge with an operating company by the end of 2023, making this small window of time opportunistic for de-SPAC transactions. Additionally, the economics of the SPAC structure, which provides significant incentives to SPAC sponsors to consummate an IBC, result in the SPAC sponsors being highly incentivized to negotiate terms of an IBC that are favorable to the target. While the volume of SPAC’s has and may continue to decline, there are still opportunities for highly motivated SPAC’s and strong target companies looking to come to market. Despite its decline in volume, SPACs have been around for decades and provide an important function in capital markets, providing an alternative form of venture capital financing that still have advantages over traditional IPOs to bring private companies public.
SPAC companies nearing their de-SPAC deadlines should be on the lookout for these mature private companies that are ready to tackle the public capital market. 2023 could be a breakthrough year in the de-SPAC process, showing a greater percentage of successful de-SPACed companies.
Seward & Kissel will continue to monitor the development of de-SPAC transactions and the way they continue to evolve during this opportunistic time.
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