What is a SPAC? A Simple Guide to This Trending Investment

In recent months, special purpose acquisition companies (SPACs) have been making the news, thanks to celebrity involvement. But what is a SPAC — and is it really a good investment?

While it could seem exciting to participate in what might be the next big thing in investing, it’s a good idea to take a step back and make sure you understand what you’re getting into.

Depending on the situation, investing in a SPAC might not be the smartest idea. Here’s what you need to know about SPACs so you can make the best decision for your personal and financial goals.

What is a SPAC?

A special purpose acquisition company, or SPAC, is essentially a shell company. Sometimes a SPAC is called a blank-check company because it doesn’t have any actual operations. Instead, the company is created for the purpose of taking a private company public.

Basically, the SPAC is created and it goes through the process of getting listed on a stock exchange such as the New York Stock Exchange or Nasdaq through the initial public offering (IPO) process. Later, this SPAC can acquire a target company, defined as a fully operating private company. The two entities now within the SPAC combine and emerge as a publicly listed operating company.

Getting in on a SPAC could be a way for an investor to get into a startup with a lot of potential, and it also helps the company raise capital from the IPO proceeds. Examples of SPACs attracting a lot of attention from investors and the general public are:

• Virgin Galactic made a splash when it went public via SPAC in 2019 and raised hundreds of millions of dollars.
• Diamond Eagle Acquisition Corp. merged with DraftKings and DraftKings’ shares became available on the public market.
• Hedge fund manager Bill Ackman’s Pershing Square Tontine Holdings is a much talked-about example of a SPAC that has not yet merged or announced its target. This SPAC has even spawned its own Reddit subgroup.

While the SPAC IPO process can be simpler for some companies than going through the traditional IPO process, there are some things to be aware of with SPACs — especially if you’re putting your money on the line to invest in one.

How a SPAC works

A SPAC works a little differently from a traditional business. When we think of businesses, we often focus on how a company starts, grows, and eventually goes through the IPO process so that its shares can be traded on a public stock exchange. We see investing money in traditional businesses as a good way to grow wealth because it’s possible to see their track records.

SPACs do things differently, basically setting up an empty shell company that raises cash held in trust via an IPO, and then later acquires a private operating company without building anything operational from the ground up. The SPAC may indicate in its IPO prospectus that it intends to acquire a business within a certain industry or market, but it is not obligated to follow through on that statement.

The idea is that eventually the SPAC will acquire a profitable company and the shares will increase in value as a result — and you could then sell them on the stock market for more than you paid for them.

Here’s how it works:

• A SPAC is created as a shell company that looks for a business opportunity to acquire or merge with an existing private company.
• For the most part, initial SPAC sponsors are allowed to put money into the blank-check company and receive favorable terms for their shares or other consideration.
• There is no underlying operating company at this time. Money is made from proceeds of the interest from various investments made by the management team of the SPAC.
• The SPAC goes public with an IPO, allowing others to invest by buying shares of the SPAC.
• Proceeds from the IPO are kept in a trust account. The trust account can grow in value as a result of how the money is kept in various interest-bearing accounts or other investments.
• Eventually, the SPAC identifies a private business that looks to be a good acquisition target. If approved, the business is acquired and continues operations. The SPAC shares continue to be available on the market but now they are publicly associated with a business.
• If a SPAC investor doesn’t want to be a shareholder in the new, combined company, they can redeem their shares.
• Usually a SPAC has up to two years (although some only allow for up to 18 months) to find a suitable arrangement for a business acquisition. If the time frame isn’t met, the trust account is liquidated and beneficiaries can receive their portion of the funds back.

It’s important to note that an investor’s share of the trust account is distributed on a pro rata basis. This means you get payment for your share of the account based on the IPO price (usually $10 per share for many SPACs), rather than what you paid for it in the open market.

For example, let’s say you paid $15 per share for 100 shares of a SPAC on the market, spending $1,500. However, the SPAC liquidates the trust instead of completing a business combination. Now, because your share is actually based on the IPO of $10 per share (not what you paid for each share), you only get $1,000 back — a $500 loss.

Also, note that there may be different opportunities for sponsors or other investors to purchase the right to buy a set amount of shares at a set price in the future. This is known as a warrant. Stocks and warrants of SPACs can be bought and sold on the market later on.

Why are SPACs in the news?

SPACs are getting a lot of airtime right now due to their popularity with celebrities, particularly well-known athletes. For example, Serena Williams is on the board of Jaws Spitfire Acquisition Corp. and Alex Rodriguez is the CEO of Slam Corp.

Some celebrities, like Shaquille O’Neal, have been involved in more than one SPAC. Shaq was involved first in Forest Road Acquisition Corp., which took Beachbody public. Now, he’s a strategic advisor for Forest Road Acquisition Corp. II, which also has involvement from a former Disney executive and Martin Luther King III.

SPACs can have different focuses and purposes. For example, Colin Kaepernick is the co-sponsor and co-chairman of Mission Advancement Corp., a SPAC designed to look for acquisition opportunities in the area of social justice advancement.

Because of the high profiles of some of the sponsors or board members of come SPACs, more investors are becoming interested. However, the Securities and Exchange Commission (SEC) recently issued a bulletin warning investors against investing in SPACs just because of celebrity involvement.

The pros and cons of SPACs

Before deciding to invest in a SPAC, it’s important to consider the advantages and disadvantages, especially if you’re just getting started in the stock market.

Pros

• Gives individuals access to IPOs: SPACs give investors access to IPOs of certain companies when they might not be able to get access to a traditional IPO of a similar company.
• Price is usually more controlled: The IPO price of many SPACs is set at $10. While fluctuations can change the price once market trading starts, there isn’t a way to determine the valuation of the company since it has no track record and the target company is unknown. This set, controlled price can make it attractive.
• Easier to complete the IPO process: A SPAC can complete the IPO process faster and easier than a traditional company. Later, it can acquire or merge with a private company that might struggle to complete the IPO process, essentially transitioning a private company to a public company.

Cons

• Pro rata shares in the trust: If the business combination doesn’t take place within the specified time period, those who own shares in the SPAC are issued a pro rata portion of the money held in trust. This pro rata portion might not equal the initial investment.
• Sponsors benefit more than IPO investors: In general, the sponsors of a SPAC will benefit more than IPO investors. If you invest in the IPO, the interests of the sponsors might not align with yours, and that could mean losses later.
• Warrants have different terms: When investing by purchasing a warrant for SPAC shares, you should be aware of the terms, since they can vary. Additionally, later warrants might not have the same favorable terms as earlier warrants.

How to invest in a SPAC

Because SPACs that have completed IPOs have ticker symbols and trade on major exchanges, it’s possible to buy shares through many brokerages or investment apps. Simply search for the ticker on your brokerage website or in your investment app and indicate how many shares you want to buy. If you have the funds to purchase the shares, you can buy them.

It’s even possible to purchase fractional shares of SPACs using investment apps like Stash and Robinhood.

Understand, however, that SPACs might not be suitable for every investor. Institutional investors that can become sponsors of SPACs before the IPO might be able to invest ahead of time, and reap the benefits. However, individual retail investors might not be able to get in as sponsors, and so might not be able to benefit at the same level.

If you decide to buy shares of a SPAC on the open market, it’s a good idea to carefully consider your investment strategy and goals. Do your due diligence and carefully evaluate the SPAC. Consider its potential for the future and whether you think management is likely to actually complete a business combination that will be beneficial to the stock price.

Depending on the situation, SPAC investing can be appropriate for a small portion of a portfolio or to play around with, while using other investments as a way to more effectively meet long-term financial goals.

FAQs

Bottom line

SPACs are popular on Wall Street right now, thanks to high-profile celebrities and athletes participating as sponsors and/or board members. However, just because a celebrity is involved, doesn’t mean it’s the smart move for you. SPACs can make it easier for a private company to go public, but that doesn’t necessarily mean that investing in a SPAC — especially after the IPO — is the right move for everyone or that it avoids the volatility inherent to investing.

If you’re looking to start investing, buying shares of a SPAC might not be the best approach, especially if you lack the funds to become a sponsor prior to a traditional initial public offering. 

An easier way to start investing might be to consider using one of the investing apps on our list of the best robo-advisors and let them do the heavy lifting. Or you could use one of the apps on our list of the best investment apps to invest in individual equities that have been around for longer and have a proven track record of good business operations.

FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.