Won't SPAC Down
Updated: Mar 21, 2022
The Role of SPACs in Entrepreneurship and Innovation
Wow - how quickly we went from “Rise of the SPACs!" to “SPACs on their Backs!”
In 2021, there were 613 SPAC IPOs. As of mid-March 2022, there have been only 52.
In 2020, there were 143 SPAC mergers, or “de-SPAC” transactions, and in 2021 there were 221. There have only been 51 closed de-SPACs as of mid-March 2022.
There are currently about 575 SPACs looking for merger targets. Many of these SPACs are struggling to find willing merger candidates and face possible dissolution.
In part, this may be the result of too many SPACs led by poorly qualified SPAC sponsors.
But unwarranted regulatory attacks, broad-brush negative press, and frivolous shareholder litigation have each played a role in driving potential merger targets away from SPACs, driving SPAC stock price declines, and generally harming investors, companies, financial markets, and innovation.
What are SPACs? What are their pros and cons? Do they play a role in financing entrepreneurship, innovation, and job creation? How should the SEC regulate them?
What’s a SPAC?
SPAC stands for Special Purpose Acquisition Corporation. A SPAC is an alternative method for taking a company public so its shares can be traded on a public stock exchange.
A traditional initial public offering, or IPO, involves hiring lawyers, investment bankers, public relations firms, and other experts to prepare a Form S-1 registration statement for filing with the SEC, comply with rules and regulations to get the registration statement declared effective, file for and obtain approval to trade on a major stock exchange, and prepare the company to meet its public company financial reporting obligations.
The traditional IPO process takes at least eight months and currently requires out-of-pocket costs of $2M to $3M for lawyers, auditors, financial advisors, financial printers, and exchange listing fees, not to mention the vastly larger windfall underwriters will receive from the company’s IPO proceeds.
The SPAC process, on the other hand, splits the processes of (i) initially registering shares with the SEC and (ii) determining and approving the company’s business model. In short, a team of SPAC sponsors and their lawyers and investment bankers take a shell company public and then spend up to two years finding and merging with an “operating company.”
Before the publicly traded SPAC entity and the operating company can merge, the shareholders of the SPAC must vote to approve the merger. Voting on the merger requires the SPAC and the target to work together on drafting and filing an SEC Form S-4 registration statement. The “S-4” registers additional shares issued to consummate the merger and also serves as a “proxy statement,” providing information necessary for an informed vote by the SPAC shareholders and by the target's shareholders.
Having participated in a SPAC in late 2020, I saw firsthand how the SPAC structure and processes facilitated the target company’s ability to go public more quickly and with a higher degree of certainty, ultimately providing the company with capital it needed to execute its business plan.
The SPAC IPO path provided the target company with a team of experienced advisors and consultants and spread the up-front costs of going public across both the SPAC entity and the target. The process involved no “short cuts” whatsoever. Rather, the process involved a large, well-funded, and highly sophisticated team of professionals working in a thoughtful and coordinated fashion toward two key goals – going public and preparing the target to meet its public company obligations on day one.
The SPAC Spike
As a former SEC staffer in both the U.S. Securities and Exchange Commission’s (SEC) Division of Enforcement and its Division of Corporation Finance (Corp Fin) and as a fairly keen watcher of financial markets, even I was surprised by the rapid ascension of SPACs in 2020 and 2021.
Despite 2021 being a strong year for traditional IPOs, SPAC IPO volume still eclipsed traditional IPO volume.
SPACs Fill Unmet Funding Needs
The SPAC surge was a logical and innovative response to the nearly insurmountable challenges many businesses face in accessing public market funding. And in many cases, modern SPACs have improved on the IPO process by reducing the time to funding and spreading costs and efforts across a larger, more experienced team.
Due to various factors, U.S. IPO filings have declined for years and the number of publicly traded companies in the U.S. is also substantially down from prior highs.
A combination of factors decimated IPO numbers in the early 2000s. The 1980s and 1990s averaged 378 and 560 IPOs per year respectively, while the 2000s and 2010s averaged only 182 and 212 IPOs per year.
Key factors included increased U.S. regulation, such as Sarbanes-Oxley in 2002 and Dodd-Frank in 2010, and the huge growth in capital from private sources, including venture capital, angel investors, and private equity firms.
Additionally, through about 1998, more than half of IPOs were less than $50M.
These days, $50M IPOs are rare and it seems only “unicorns” can afford to go public via the traditional IPO path. In addition to regulatory burdens making smaller IPOs uneconomic, SEC and FINRA (Financial Industry Regulatory Authority) hostility toward smaller brokerages forced banking industry consolidations that removed smaller firms from the IPO ecosystem, along with the smaller IPOs supported by those firms.
Thus, most companies have been effectively priced out of the IPO market. In recent years, many have opted to stay private longer, if not permanently, or to provide liquidity for their investors through an acquisition instead of an IPO.
SPACs were thus rightly seen by many as an innovative shot in the arm for U.S. public markets, rejuvenating overall U.S. IPO activity and providing a welcomed source of financing for innovative businesses.
Public Markets, Entrepreneurship, and Jobs
IPOs play an important role in financing emerging businesses. Pre-IPO companies are financed by private capital. Until a company goes public or is acquired, that private capital is locked up for years in the private company. An exit via acquisition or by IPO frees up that invested capital to be invested again in new businesses.
Strong IPO markets essentially pull investment capital through the system, grow it, and recycle it for future investment in other new businesses. A strong IPO market also gives angels and VCs confidence to raise funds and make new investments.
And according to the U.S. Small Business Administration, small businesses (500 or fewer employees), including startups, create 1.5 million jobs annually and account for 64% of new jobs created in the United States.
The JOBS Act of 2012, or the “Jumpstart our Business Startups Act,” was a kitchen-sink approach to increasing funding for startups and spurring job growth.
Among other things, the JOBS Act forced the SEC to (i) implement crowdfunding, (ii) dramatically increase fundraising limits under Regulation A, leading to the “Reg A Mini IPO,” and (iii) allow startups and others to use advertising to find investors – now enshrined in new Rule 506(c), which permits “general solicitation” if all investors are verified as accredited.
For all of those laudable efforts, it is worth noting that the $246B SPACs raised in business capital over the last two years dwarfs the sum total of all Reg CF crowdfundings, Reg A offerings, and Rule 506(c) offerings in the same period.
So if the JOBS Act still makes sense for supporting entrepreneurship and job creation, it seems SPACS should as well.
The SEC’s April 2021 SPAC-Down
In April of 2021, senior SEC staffers reacted precipitously to the unprecedented surge of SPAC IPOs, leading a full assault on them.
Following several informal and relatively innocuous SEC staff statements providing SPAC accounting and disclosure guidance, the SEC’s Acting Chief Accountant and the Acting Director of the Division of Corporation Finance issued “Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”).”
After years of passivity and regulatory neglect regarding SPACs, this April 12, 2021 SEC accounting statement exemplified the SEC’s tendency to “lead from behind.” The staff’s blunt force approach, presumably well-meaning, was also disingenuous, poorly tailored to the situation, and extremely harmful.
The April 12 accounting statement required more than 700 publicly traded companies (including many in SEC registration at the time) to immediately revise and restate previously issued and/or then-pending financial statements. I witnessed this expensive, disruptive chaos first-hand. The total cost of this shocking regulatory fiat easily ran into the hundreds of millions of dollars.
These wholly unnecessary costs were born solely by the impacted companies and their shareholders. Only lawyers and accountants benefitted.
Was the goal of the SEC staff to alert potential investors to meaningful risks related to SPAC warrants being recorded as equity instead of debt? No, not at all. The potential risk – i.e., that SPACs would be required to cash out investors holding warrants during a tender offer – had never materialized and still has not.
The SEC staff had never raised this warrant issue during its reviews of hundreds of SPAC financial statements. Prior to issuing the April 12 statement, the Acting Chief Accountant allegedly refused to join a call arranged by a group of attorneys and accountants who wished to propose various alternative solutions to the SEC’s warrant accounting concern.
The SEC staff was not using its position and authority to fix an issue of legitimate concern. They were using a fake issue to kill the SPAC market. And they succeeded, at great cost to 700 companies forced to spend hundreds of thousands on restatements and at great cost also to SPAC shareholders and to the pipeline of companies hoping to access public markets.
The SEC staff’s April 12 memo killed countless SPAC deals and heralded a steep decline in SPAC activity, all cheered on by naysayers in the press and academia. The growing vilification of SPACs also led to broad price declines in SPAC shares, directly harming investors.
Kick’em While They’re Down
Anti-SPAC’ers offer a surprisingly wide variety of reasons for disparaging SPACs. One area of focus has been SPACs seemingly poor trading performance post-merger.
Might the full force of the federal government trashing SPACs have played a role in those price declines? Or the resulting negative press or shareholder litigation it helped to inspire?
These naysayers usually ignore the fact that traditional IPOs during the same period have also performed poorly.
For those not paying close attention, it has been a rough couple years – a pandemic, soaring energy prices, record inflation, pervasive labor shortages, epic supply chain disruptions, and the outbreak of war – a lot of variables to account for in fairly correlating stock market performance with corporate management performance and operating results.
And for all of the negativity about SPAC share prices, there is no similar acrimony regarding Reg CF crowdfunding or Regulation A investors' experiences over the same period. I suspect that investment results for SPAC investors on average have been superior to those of Reg CF or Reg A investors.
There have no-doubt been some SPAC dogs. Just like there have always been dogs among traditional IPOs. But there is nothing inherently deficient about SPACs or SPAC processes invariably relegating them to poor market performance.
Broad-brush attacks suggesting otherwise are unwarranted and counterproductive.
The “Circumventing Disclosure” Fallacy
SPAC detractors also inaccurately suggest that SPACs somehow circumvent the full disclosure that companies otherwise provide in a traditional IPO. This is false. The full disclosure picture is simply completed in stages and through different processes.
Companies going the traditional IPO route register their offerings on SEC Form S-1. That’s the “full-blown” disclosure form for going public.
SPACs, on the other hand, have little to disclose on their Form S-1s at the time of IPO, since they do not yet have an operating business.
When the time comes to merge with a target company, though, a SPAC and its target must jointly prepare and file a combined registration statement and proxy statement on Form S-4. They also make other filings on SEC Form 8-K before and after the merger to provide substantial additional disclosures.
The depth and quality of disclosures under Form S-4 are every bit as robust as those required under Form S-1. Both are hundreds of pages long and highly detailed. More and more, they are also prepared by the same top-tier law firms and accounting firms.
The average sophisticated investor would be hard-pressed to tell the difference.
SEC Regulatory Neglect
Strangely, the only thing that might be missing when a de-SPAC Form S-4 is filed is meaningful SEC review.
For reasons that eluded me even as a Corp Fin staffer, the SEC arbitrarily decided long ago that it would generally not give very close scrutiny to Form S-4 registration statements.
When I worked on a SPAC in late 2020, I was surprised to hear the SEC staff had only 11 comments on our initial and very complex Form S-4 filing. No matter how thoughtfully drafted a Form S-1 might be, there are often 50 or more legal and accounting comments seeking clarifications and disclosure enhancements.
Rather than leading from behind and knee-capping all SPACs, the SEC staff could and should have raised the warrant issue years ago in reviewing SPAC filings.
And the SEC likely should have assigned most or all SPAC Form S-4 filings “full review,” as it does with IPOs on Form S-1.
The SEC staff has been silent as to its role in apparently not carefully scrutinizing de-SPAC Form S-4s and how doing so might have produced improved disclosure and compliance results. Whatever these missed regulatory opportunities may have been, the SEC should tighten up any weaknesses to ensure investor protection and help rejuvenate the role and reputation of SPACs.
Sponsor Dilution and Conflicts of Interest
Much is also made by commentators of the ownership interests of SPAC sponsors, which are decried as a form of insidious, secret dilution.
From my limited, direct experience, I can fully appreciate how high quality teams of SPAC sponsors and their advisors can and do add tremendous value to the process and end result. To read some of the press about SPAC sponsors, one would assume they are all modern day blank-check con artists and hucksters.
Having prosecuted a blank-check con artist and market manipulator (See Leslie Darwin Murdock Sentenced, pg 5) formerly as a Special Assistant United States attorney, I know the comparison to be inapt.
In fact, many SPAC promoters have substantial and impressive experience both as business operators and in finance and provide great value to the fundraising process, regulatory and governance compliance, and ultimate operational success.
Given the compensation received by underwriters in traditional IPOs and given the equity positions of many founders at IPO time, I was not surprised at all to learn that sponsor teams end up with roughly 20% of a company’s equity following a de-SPAC transaction.
Dilution issues and others regarding potential conflicts of interest seem easily addressed by the SEC’s power to ensure full disclosure and to bring enforcement actions for any alleged deficiencies.
On this issue of dilution, it is worth highlighting that de-SPAC transactions involve no underwriting fees. A quick review of Robinhood’s recent traditional IPO disclosure documents reveals “… underwriting discounts, commissions and offering expenses of approximately $83.8 million.”
Are those company-paid, traditional IPO expenses somehow not “dilutive” for investors? I believe they are.
The Projections Red Herring
One disclosure difference between traditional IPOs and SPACs that detractors can fairly point to is the ability of SPACs to include financial “forecasts” in a Form S-4 - a type of disclosure common to all mergers.
Forecasting future financial results for companies with limited operating histories and rapidly evolving business models is always tricky. I have heard more than one VC say something to the effect of, “The only thing we know for sure about a startup’s revenue forecast is that it is wrong.”
And no doubt some bad actors jumped into the SPAC market in 2020 and 2021 and issued recklessly bullish forecasts for personal gain.
As with any other disclosure concerns the SEC has with SPACs, the SEC staff have always had the latitude to comment on SPAC projections and to demand disclosure of key risks and assumptions underlying those forecasts. The SEC staff should absolutely do more of that.
Furthermore, the SEC’s Division of Enforcement is fully capable of bringing civil and administrative actions for allegedly false or misleading disclosures or omissions.
But it seems there have only been two recent enforcement actions against SPACs for false and misleading statements or omissions. And neither involved projections.
The SEC has the disclosure and enforcement tools to reign in baseless forecasts and it should use them in a targeted and logical manner to tamp down any perceived misconduct.
The Fake 1940 Act Issue
SPAC detractors are clearly willing to pick up and throw any stone they can find, no matter how absurd.
Beyond the SEC’s warrant accounting flip-flop, the next most absurd claim against SPACs is that the manner in which SPAC IPO trust funds are invested obligates every SPAC to jump through the Investment Company Act’s arcane regulatory hoops and register as an investment company, specifically, as a money market mutual fund.
This claim is driving baseless shareholder litigation and prompted more than 60 top-tier law firms to sign a letter captioned “Over 60 of the Nation’s Leading Law Firms Respond to Investment Company Act Lawsuits Targeting the SPAC Industry.” The letter states, in part:
“Under the provision of the 1940 Act relied upon in the lawsuits, an investment company is a company that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.
SPACs, however, are engaged primarily in identifying and consummating a business combination with one or more operating companies within a specified period of time. In connection with an initial business combination, SPAC investors may elect to remain invested in the combined company or get their money back. If a business combination is not completed in a specified period of time, investors also get their money back. Pending the earlier to occur of the completion of a business combination or the failure to complete a business combination within a specified timeframe, almost all of a SPAC’s assets are held in a trust account and limited to short-term treasuries and qualifying money market funds.
Consistent with longstanding interpretations of the 1940 Act, and its plain statutory text, any company that temporarily holds short-term treasuries and qualifying money market funds while engaging in its primary business of seeking a business combination with one or more operating companies is not an investment company under the 1940 Act. As a result, more than 1,000 SPAC IPOs have been reviewed by the staff of the SEC over two decades and have not been deemed to be subject to the 1940 Act.”
The absurdity of the 1940 Act issue is obvious on its face. What investor protection risks are at stake? And what actual risks would be mitigated by SPACs incurring the substantial expense and distraction of registering as investment companies?
The answers are “none” and “none.”
The Way Forward
The popularity of SPACs in 2020 and 2021 provided undeniable evidence that SPACS offer immense value to businesses desiring access to public financial markets and that SPACs meet needs not served by the enfeebled traditional IPO market.
If we believe the innovations ushered in by the JOBS Act are meritorious, how could something arguably 10x more successful at meeting unmet financing needs not also be meritorious?
The clearest path forward for SPACs simply requires greater SEC engagement. I recommend the following:
Make sure SPAC Form S-1 IPO filings clearly disclose the equity positions, financial compensation, and possible conflicts of interest of all SPAC sponsors.
Review de-SPAC Form S-4s with the same rigor received by IPO Form S-1s and compel filers to include all disclosure enhancements the SEC’s legal and accounting staff members feel is appropriate to ensure a complete picture for investors. Particular focus should be paid to projections and other disclosures where unwarranted hype might be lurking.
SEC Corp Fin staff should work closely with their Enforcement colleagues to consider potential enforcement actions when developments or disclosures reveal that a Form S-1 or Form S-4 contained materially misleading disclosures or omissions.
The Enforcement staff should also be on the lookout independently for potential insider trading or market manipulation on the part of sponsors or other insiders, particularly around the time of announcements regarding potential targets. The task of “blue-sheeting” brokerage firms to view trades before and after announcements is a well-established practice.
In a perfect world, the SEC staff would rescind the April 12, 2022 accounting statement, but nobody likes to admit a costly mistake, and that one was a whopper.
This article is unlikely to impact how the SEC regulates SPACs or how SPAC detractors view SPACs, but hopefully other readers gain a more balanced view of the role SPACs can play in a healthy and vibrant public financing ecosystem.
Feel free to reach out to share your own opinions and experiences, or corrections to anything in the article. Comments can be sent to firstname.lastname@example.org.
Links to Sources and Materials:
What’s in Store for SPACs in 2022: Woodruff Sawyer Interviews Attorney Doug Ellenoff
SEC: Financial Reporting and Auditing Considerations of Companies Merging with SPACs
SEC: SPACs, IPOs and Liability Risk under the Securities Laws
SEC: Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies
SEC: What You Need to Know About SPACs – Updated Investor Bulletin
SEC: Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”)
CNBC: SPAC Transactions Come to a Halt Amid SEC Crackdown, Cooling Retail Investor Interest
SPAC Litigation Outlook: 2021 Trends Lead to 2022 Predictions
Mayer Brown: De-SPACing: Overview, Securities Law & Financial Statement Considerations; De-risking with a PIPE Transaction
Harvard Law School: Special Purpose Acquisition Companies: An Introduction
SPAC 2021 Year-End Review and 2022 Preview: Tailwinds, Headwinds, and Regulatory Landscape
Paul Swegle has served as general counsel to numerous tech companies and advises a dozen others as outside counsel. He has completed $13+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott.
Paul speaks regularly at top law schools and MBA schools, where his popular business law books are widely used in courses focused on entrepreneurship and business law.
Startup Law and Fundraising for Entrepreneurs and Startup Advisors
Contract Drafting and Negotiation for Entrepreneurs and Business Professionals