On September 24, Cooley M&A partner, Garth Osterman, moderated a webinar on the current trend in going public: SPACs! Dave Peinsipp, co-chair of Cooley’s capital markets practice group and Rama Padmanabhan, a Cooley M&A partner participated in the webinar which focused on the current wave of SPAC activity and how it compares to prior iterations, in addition to discussing some of the key differences and similarities between SPACs and IPOs, as well as current trends in SPAC business combinations (often referred to as the “de-SPAC” transaction). Key highlights from the webinar are summarized below and a link to the recording can be found here. For more background information on SPAC transactions, check out this report that Cooley co-authored with Deloitte & Touche.
The panelists kicked off with a discussion of the acceleration of the SPAC market over the past twelve months, and how this current wave of SPAC activity—coined by some as “SPAC 3.0”—compares to the prior two iterations of SPAC activity, with the first (SPAC 1.0) starting in the early 2000s and ending around the start of the 2008-2009 financial crisis, and the second (SPAC 2.0) starting at the tail-end of the financial crisis but never getting much traction.
Increased Frequency and Size
A distinct feature of SPAC 3.0 is the increased frequency at which SPAC IPOs are occurring. As reflected in Chart 1, 102 SPAC IPOs have been announced this year as of September 18, 2020—almost double the number of SPAC IPOs in all of last year (and more than double the number of SPAC IPOs in 2018). The amounts raised in SPAC IPOs have also increased exponentially, with the average SPAC trust size nearly doubling since last year, from $229 million to $402 million (see Chart 2). While it may be difficult to determine exactly what factors contributed to this increased wave of SPAC activity, our panelists noted that there is an elevated level of respectability associated with SPAC 3.0. There are currently very few people in the IPO ecosystem that don’t recognize the value of a SPAC as an alternative to a traditional IPO or a direct listing. That level of respectability was likely generated in part when high-quality companies—that could have gone public through a traditional IPO—went public via a SPAC, and in part due to the increasing sophistication of SPAC sponsors and investors who are finding that SPACs present an opportunity to invest before a target’s valuation has largely tapered off and are looking for alternative ways to spend ample uninvested capital.
Competition / Variation
Another feature of SPAC 3.0 is the competition among SPACs for potential targets. Unlike prior iterations of SPAC activity and perhaps unsurprising given the increasing number of SPAC IPOs, the panelists noted that companies considering going public by way of a SPAC are often negotiating with multiple SPAC sponsors in the preliminary phase of a potential transaction. SPAC 3.0 also reflects greater variety in both the SPAC structure and the terms of the de-SPAC transactions, which our panelists attributed—at least in part—to the increased competition for high-quality targets. For example, sponsors are increasingly deviating from terms that were standard in SPAC 1.0 and 2.0 as it relates to both warrants and the sponsors’ promote shares, with such deviations generally resulting in less dilution to the target’s shareholders.
A feature of every SPAC is the redemption right, which gives each SPAC IPO shareholder the right to have its shares redeemed by the SPAC for its portion of the SPAC IPO proceeds (typically $10 a share) after the business combination has been announced (and prior to the consummation thereof). As a result of this redemption right, many business combination agreements require the SPAC to have a minimum amount of cash at closing. To ensure that this condition can be satisfied (and for other reasons), SPACs often raise a PIPE in connection with the business combination. Unlike prior waves of SPAC activity, the panelists noted that they are seeing far fewer redemptions in SPAC 3.0, which is unsurprising considering that the vast majority of SPACs that have announced business combinations are trading above $10.00 share.
SPAC vs. IPO
Given that a SPAC is an alternative means to going public, a significant portion of the webinar was dedicated to discussing some of the key differences—and similarities—between a SPAC and a traditional IPO.
Perhaps the greatest benefit of going public via a SPAC as opposed to an IPO is that the target’s shareholders are able to attain greater certainty regarding valuation, and more quickly. Unlike an IPO, where valuation will fluctuate based on the market at the time of pricing (which happens at the culmination of a four to six month IPO process), a target going public by way of a SPAC is able to obtain valuation certainty fairly early on in the process through private negotiations with the SPAC sponsor and valuation validation and support through a concurrent PIPE raise. Once a SPAC sponsor is chosen, a business combination agreement can typically be lined up and announced within six weeks. The target’s valuation still needs to be supported by the market, but having sophisticated and credible PIPE investors that support the valuation (as the majority of SPAC 3.0 deals do) tends to enhance market support. Given the unprecedented market uncertainty resulting from COVID-19, and future uncertainty associated with the US presidential election, the ability to determine value early on in the process—and with some certainty—is a compelling feature of a SPAC.
Transaction Timing / Readiness
Despite common misconceptions, the timeline for completing a de-SPAC transaction and an IPO are comparable—often between four to six months, although that timeframe can vary depending on SEC review and comment (discussed more below). In a SPAC transaction, parties can expect to take approximately four to six weeks to negotiate a business combination agreement and line up a PIPE, and then another two to four months to prepare and file a joint Form S-4/proxy and deal with any SEC comments. Just as it would in a traditional IPO, the target must be prepared to provide the required financial information and other documentation necessary to operate as a public company, including PCAOB financials. For additional information on the type of financial information that will be required as a public company and a typical timeline, refer to this report that Cooley co-authored with Deloitte & Touche.
Another common misconception is that public filings in a de-SPAC transaction will be subject to less SEC review than in an IPO. That may have been the case in prior iterations of SPAC activity, as the SEC traditionally has not scrutinized S-4s/proxies in the same light as documentation filed in connection with an IPO financing event or a direct listing, but our panelists have seen and predicted greater SEC scrutiny as part of SPAC 3.0. Given that documentation filed in connection with the de-SPAC transaction is the target’s first foray into public disclosure, Cooley is advising target companies to expect the SEC to review every set of SEC documents that are filed in a SPAC deal and to assume a full SEC review process which, like in an IPO, is 30 days for the first set of comments, and often a second set of comments. Lending credibility to that prediction, on the same day as our webinar, SEC Chairman Jay Clayton spoke to CNBC regarding SPACs, and indicated that the SEC plans to pay particularly close attention to disclosure regarding the incentives and compensation received by the SPAC sponsors—both at the IPO and de-SPAC stages of the transaction. He also stated that the SEC will be reviewing documentation to ensure that investors are getting the same rigorous disclosure that they would get in an IPO transaction. For more on Chairman Clayton’s remarks regarding SPACs, see this Cooley Pubco post.
Ineligible Issuer / Rule 144 Limitations
While transaction timing and SEC review are comparable between a SPAC and an IPO—even more so in SPAC 3.0—the panelists briefly touched on certain limitations that a company will face when going public by way of a SPAC as opposed to a traditional IPO. There are certain SEC rules that have made it easier for large issuers to access the public markets without prior SEC review, however “ineligible issuers” are unable to utilize those rules and all SPACs, including a target company that goes public by way of a SPAC, are ineligible issuers for at least three years following the consummation of the de-SPAC transaction. Companies going public by way of a SPAC will also face limitations under Rule 144, which provides holders of unregistered securities the right to resell those securities without registration. As a result, the combined company following a de-SPAC transaction may consider filing a resale Form S-1 registration statement that allows for greater flexibility of sales of the combined company’s shares in the market. Given the increasing sophistication of SPAC sponsors and targets—and the increasingly rigorous scrutiny de-SPAC transactions are expected to receive from the SEC—it’s difficult to see the value in some of these lingering limitations, but at least for now they are limitations target companies should be mindful of.
Another common feature of SPACs and IPOs is the lock-up. In a SPAC transaction, many of the SPACS from 2019 and early 2020 provided that the SPAC sponsors are subject to a one year lock-up period following consummation of the business combination, while at least a portion of the target’s shareholders (often limited to directors, officers and holders of more than 5%) are subject to a 180-day lock-up period. The lock-up period for the target’s shareholders is comparable to what they would experience in a traditional IPO. The periods described above are typical, but there are certainly variations. For example, SPAC sponsors may be subject to shorter lock-up periods if certain pricing triggers are met, or the target shareholders may be subject to a longer lock-up period to align with that of the SPAC sponsors.
Revisiting Governance Documentation
Although an IPO and a de-SPAC transaction both result in the target’s stockholders owning equity in a publicly-traded company, it is very possible that a target’s existing governance documents, including stockholders agreements, do not account for a de-SPAC transaction in the way that they would an IPO. These documents often contain rights that are extinguished or triggered upon the occurrence of an IPO or a change-in-control transaction, but a de-SPAC transaction is unlikely to be covered by either of those categories given that the target’s shareholders tend to hold 60-70% of the combined company post-closing, and the target’s shares are not the shares that are listed on an exchange. For that reason, we are advising target companies to revisit their governance documents, including stockholders agreements, early on in the process to see whether any modifications are required to account for a de-SPAC transaction. Given the increasing popularity of SPACs, even if a company is still several years away from any significant corporate transaction, it may make sense for it to revisit its governance documents to ensure that they account for this type of transaction (where appropriate). The panelists noted that several practitioners and organizations are currently revisiting their forms to consider these sorts of changes.
Key Trends in De-SPAC Transactions
Of course, perhaps the biggest difference between a SPAC and an IPO is the M&A component of the SPAC transaction, where the target company goes public by virtue of a reverse merger with the SPAC. The panelists spent some time discussing certain key trends in de-SPAC business combination agreements, and the de-SPAC transaction process more generally.
As illustrated in Chart 2 above, the average amount of the PIPE raised in connection with the de-SPAC transaction has increased by more than 50%, from $185 million in 2019 to $282 million in YTD 2020. This data highlights the critical role the PIPE plays in the de-SPAC transaction to backstop any redemptions and also to validate the target company’s valuation for the market. Expect this trend to continue as SPAC sponsors increasingly seek to combine with higher-quality targets.
Target Company Earnouts / SPAC Sponsor Vesting
While greater valuation certainty is often a compelling reason to choose a de-SPAC transaction, that doesn’t mean that target companies going public by way of a SPAC are exempt from valuation uncertainties, just that the de-SPAC process is able to proactively address some of those uncertainties. One way that valuation uncertainties can be addressed is through an earnout. Earnouts were employed in nearly 50% of the SPAC business combinations that were announced this year. With an earnout, target shareholders are rewarded with additional equity if certain milestones are met. The vast majority of transactions utilizing an earnout contain milestones that are triggered based on the combined company’s post-closing stock performance, but milestones could also be revenue-based or, as is common with life sciences targets, triggered by the achievement of certain regulatory or development events. It is common for stock performance-based earnouts to have multiple pricing triggers (e.g. one when the stock hits $15/share; a second at $19/share; a third at $23/share, etc.), and to be measured during a consecutive trading period (often 20 days within a 30-day consecutive trading period). The earnout period is often three to five years, but the panelists noted that they have seen earnout periods as short as one year and as long as ten years.
Additionally, an increasing percentage of de-SPAC transactions require the SPAC sponsors to forfeit a portion of their promote shares, either indefinitely, or with the option to earn them back through vesting, often based on the same milestones as the target shareholders’ earnout. Through sponsor vesting and modifications to the traditional warrant regime, SPAC sponsors are increasingly willing to take less upfront equity in exchange for greater consideration if the combined company’s stock performs well post-closing.
Given the competition for quality targets, SPAC 3.0 tends to feature more public style acquisition agreements, where the representations and warranties expire at closing and the target’s shareholders do not provide any type of indemnification. According to Deal Point Data, less than 20% of business combinations announced this year featured an indemnity.
As with any M&A transaction involving a public company, parties can now expect to encounter litigation once the business combination has been announced. Understanding that litigation is a component of virtually every public M&A transaction, parties should carefully review all documentation submitted to the SEC in connection with the de-SPAC transaction to ensure that adequate disclosure of material information has been made, particularly as it relates to the SPAC sponsor’s post-closing equity and compensation.
Considerations for Life Sciences Companies
Given Cooley’s client base, the panelists also spent some time discussing SPAC 3.0 as it relates to the life sciences industry. Prior to SPAC 3.0, the primary option for an early stage life sciences company seeking to go public—but lacking a sufficiently developed track record for a traditional IPO—was a reverse merger. Structurally, a reverse merger and a SPAC are very similar (with the target company going public by virtue of its merger with an existing public company), but unlike a SPAC, where the acquiror is a blank-check company with no existing operations, the acquiror in a reverse merger is typically a former operating life sciences company with a failed product that has nominal operations and assets. A reverse merger has the benefit of giving an early stage company access to the public markets, but there are potential liabilities that need to be considered because the existing public company will have failed operations that need to be wound down (e.g., a clinical program), and is often the subject of securities and other lawsuits, having suffered a significant drop in its stock price as a result of those failed operations.
With the foregoing background in mind, the panelists discussed whether these early stage life sciences companies would be attractive targets for a SPAC sponsor. For SPACs with a significant trust size, probably not, because their early stage makes it difficult to support a high valuation (and a target company’s valuation can be no less than 80% of the SPAC’s trust size). In that case, a reverse merger will continue to be a compelling path forward. However, the panelists noted that there is substantial excitement from life sciences executives and other experienced professionals in the healthcare space who are looking at the market, and seeing an opportunity to become a sponsor of a life sciences-focused SPAC. As SPAC sponsors, these executives can gain support from investors by highlighting their acumen for evaluating early stage life sciences companies, and may be better positioned to attract target companies looking for an experienced partner. Accordingly, the panelists expect to see more SPACs that are a better fit for a wide range of life sciences companies, including smaller SPACs focused on early stage companies.