Coauthored with Alexander Anderson and Viqar Shariff, O’Melveny

A Special Purchase Acquisition Company, commonly referred to as a “SPAC,” has become so popular that hardly a day goes by without hearing about it in the media. As the name implies, a SPAC is formed in order to acquire another company.

This blog will provide a high-level overview of SPACs and discuss what the increased popularity of SPACs means for middle-market companies.

WHAT IS A SPAC?

The formation and operation of a SPAC are relatively straightforward. In essence, a SPAC is a blank-check company whereby a management team (typically referred to as the sponsors) forms the entity and raises capital through an initial public offering (IPO).

Typically, there are five steps to creating a SPAC:

1. Formation: Sponsors, which may be private equity or venture capital firms, known industry executives, or even celebrities, form a SPAC. At the time of formation, the SPAC is a newly formed shell company with initial nominal capital investment and two objectives:
   1. Conduct an IPO to raise capital
   2. Identify and complete an acquisition of a target company with an actual business
2. IPO: The SPAC will then go through the IPO process. In some cases, a SPAC may identify in its IPO prospectus a particular industry in which it will seek to find a target company. However, the SPAC typically provides a general enough objective in order to have broad discretion as to the industry it ultimately chooses.[1] Generally, investors rely on the sponsors’ ability to find and execute a business combination with a target company. After all, investors are investing in a shell company, expecting the sponsors to use their expertise to enhance its value.
   
   Unlike a traditional IPO, the SPAC offering may be simpler insofar as the SPAC does not have to deal with complicated disclosures relating to its operating history, historic financial accounting or legal issues or risks related to its industry and line of business, which have not yet been determined.
   
   The securities sold as part of the IPO consist of SPAC units (the offering price is usually $10 per unit), which consist of one share of the SPAC’s common stock as well as warrants to purchase fractional shares of SPAC common stock,[2] which are adjusted at a 15-percent premium to the per-unit-offering price. The proceeds from the public offering of units are deposited in a trust account that can be used either to redeem shares of common stock or as part of the consideration for a business combination. After a short time, the common shares and warrants that make up the units are separated and can be traded individually. In addition, each share of common stock can be redeemed for principal plus interest prior to a business combination. This usually does not affect the warrants, so public shareholders of a SPAC can redeem their common stock while holding on to potential upside via their warrants.
   
   The sponsors usually purchase for nominal consideration shares of common stock representing 20 percent of the SPAC common stock. This is referred to as the “sponsor promote,” as it represents the sponsors’ consideration and upside for creating the SPAC and its at-risk capital. The sponsors’ at-risk capital usually consists of funds the sponsors contribute to purchase warrants for $1 per warrant. Generally, this is three percent to five percent of the total SPAC proceeds and is used to pay expenses such as underwriting, legal and accounting fees.
   
3. Identification of a Target; Negotiation of a Business Combination Transaction; PIPE: Following the IPO, the sponsors look for a target company to acquire. SPACs typically have 18 to 24 months to identify a target, which can be extended to 36 months with shareholder approval. A SPAC will have some competition, including but not limited to private equity firms, strategic buyers and other SPACs, in finding a solid target company[3] and effectuating an acquisition. The consideration for the business combination with a target can consist of newly issued SPAC common stock, cash or both. Only 40 percent of SPAC mergers include direct cash consideration, and it is very rare for a SPAC business combination to include solely cash consideration
   
   Since a potential target’s reasons for engaging in a transaction with a SPAC are often tied to creating liquidity and having growth capital, most recent SPAC transactions also include an additional PIPE (private investment in public equity) from new investors, which helps ensure minimum cash despite the prospect of redemptions that may reduce the amount of cash available to the SPAC.
   
4. Shareholder Approval: Once a target company is identified, public shareholders generally have to approve the transaction or elect to redeem their shares. For a public company, the shareholder approval process generally requires disclosures including a proxy statement and/or registration statement to register shares being issued as part of the merger consideration. The proxy/registration statement generally contains a description of the target, the transaction, risk factors and financial information related to the target company, as well as the management’s discussion and analysis.
   
5. Completion or Liquidation: Once the acquisition is approved and closes successfully, the target company becomes a public entity as a successor to the SPAC. If the deal does not go through within a specified time, the SPAC will have to liquidate and refund the invested capital to the shareholders.

SPACS’ IMPACT ON THE MIDDLE MARKET

A number of SPACs have raised an enormous amount of capital over the past few years. According to The Wall Street Journal (WSJ), SPACs raised more than $130 billion since the beginning of 2020. As of March 2021, the WSJ also reported there are more than 500 active SPACs. By definition, these SPACs will have to find target companies to acquire.

While SPACs may be known to focus on startup technology, biotechnology and green energy companies, among others, they are not limited to such industries. Many solid middle-market companies could become prime targets for SPACs. Therefore, there is likely to be a great deal of M&A activity in this sector in the foreseeable future.

As mentioned above, a solid middle-market company already attracts private equity firms and strategic buyers, so a SPAC can be viewed as another viable option. However, “selling” to a SPAC will have a few wrinkles different from those of a traditional sale to a private equity firm or a strategic buyer.

DEAL NATURE

It is likely that the owners of a middle-market company will not be able to sell their entire company for cash and thus will be rolling over some portion of equity. Once the deal is consummated, the owners should own stock, which presumably is liquid, in a publicly traded company. However, there is generally a lockup period, which is typically 180 days, before they can sell the stock received in exchange for the merger. Moreover, there may be disclosure requirements if they want to sell stock in the company.

FINANCIAL DISCLOSURE

As part of becoming or as a public company, a middle-market business will have to have more robust policies and procedures in place, which may not have been necessary for a private concern. In particular, there will be financial reporting, Sarbanes-Oxley compliance and other disclosure requirements.[4] Moreover, financial statements will have to be audited. The target will also be traded on the New York Stock Exchange or Nasdaq, which requires board composition that meets the relevant listing requirements, including as relates to independent directors and committee expertise. Thus, a company may consider obtaining additional resources to meet such requirements.

TAXES

A public company will most likely be treated as a C corporation for tax purposes. Thus, middle-market companies that were previously partnerships or S corporations will have to analyze the tax impacts of this change. The owners should obtain the right tax advisors to ensure the rollover consideration is structured in a tax-efficient manner.

While the owners may get compensation from the company to the extent they provide services, Internal Revenue Code section 162(m), which generally limits tax deductions for certain “covered employees” of a publicly traded corporation to $1 million, will have to be completed. Moreover, as a public company it will have more disclosure of tax-related items.

PRESSURE

As SPACs are gaining popularity, the SEC has suggested its intent to put more scrutiny on them.[5] It is likely that there will be more requirements for SPACs to follow; however, it is too early to tell how much impact this regulatory pressure will have on the overall SPAC ecosystem. That said, the SPAC market has shown some resiliency. Deal activity appears to have picked up again after the initial chilling effect of the SEC’s comments in April 2021 related to certain accounting treatments of SPACs.

SUMMARY

Despite some of the differences, SPACs can be an attractive option for some middle-market companies and should be evaluated in a liquidity event. Given the nature of SPACs, it is even more important to obtain the right advisors with experience dealing with the tax, accounting, legal and business issues relating to SPAC capital structures and business combinations.

If you have questions about SPACs, please reach out to our Transaction Advisory team or O’Melveny.

[1] In fact, there are cases where a SPAC originally intended for a certain industry ends up acquiring a target in a different industry; for example, Leisure Acquisition Corp. acquired a bioscience company and another SPAC originally intended for cannabis is in the process of acquiring a space company.

[2] Each warrant usually allows the holder to purchase between one-third and one-half of a share of common stock at a price of $11.50 per share.

[3] The Securities and Exchange Commission (SEC) requires the fair market value of a target company to be at least 80 percent of the SPAC’s total investments, but SPACs generally acquire target companies double their size.

[4] The SEC appears to have increased scrutiny of SPACs, as evidenced by the April 12, 2021 statement on accounting and reporting considerations for warrants issued by SPACs.

[5] The SEC appears to be interested in potential conflicts of interest by sponsors, adequacy of disclosures in mergers and proper accounting treatment of sponsors’ warrants, among other things.