Source: Unsplash
TLDR
- Startup founders can use special purpose acquisition companies (SPACs) or initial public offerings (IPOs) when deciding to go public. Some startups choose an IPO, where new shares are created and underwritten. Then, the shares are sold to the public. For others, a SPAC may be the right vehicle to take the startup public.
- A SPAC is "a corporation formed to raise investment capital through an initial public offering (IPO)." So how do SPACs work? According to Corporate Finance Institute, "such a business structure allows investors to contribute money towards a fund, which is then used to acquire one or more unspecified businesses to be identified after the IPO."
- SPACs have no other operational purpose than to raise capital through an IPO for the sole purpose of acquiring or merging with the company choosing to go public. SPACs "raise money largely from public-equity investors and have the potential to [de-risk] and shorten the IPO process for their target companies, often offering them better terms than a traditional IPO would."
- According to Corporate Finance Institute, "when the SPAC raises the required funds through an IPO, the money is held in a trust until a predetermined period elapses or the desired acquisition is made. If the planned acquisition is not made or legal formalities are still pending, the SPAC must return the funds to the investors, after deducting bank and broker fees."
- An initial public offering (IPO) is a limited sale of new shares in a startup that has decided to "go public." The general public and institutional investors can buy IPO shares. An institutional investor is an entity that invests on behalf of its members, such as a pension fund. Once the IPO concludes, the startup is officially a public company and begins trading on a national stock exchange. Additionally, the IPO must comply with all notices and filings required for public-traded companies like direct listings.
- The primary reason startups choose a SPAC over an IPO when going public is the faster time, the ability to raise additional capital through the SPAC after the IPO, lower marketing costs, and access to operational expertise.
- However, there are also risks associated with SPAC mergers or acquisitions. For example, SPAC sponsors "usually own a 20 percent stake in the SPAC through founder shares or 'promote,' and warrants to purchase more shares. SPAC sponsors also benefit from an earnout component, allowing them to receive more shares when the stock price achieves a specified target over a certain time frame, leading to further dilution."
- For IPOs, founders get access to large cash injections with an IPO, creating a favorable financial position moving forward. Additionally, by issuing new shares, the startup protects future trading of the shares instead of buying and selling existing equity.
- On the other hand, IPOs are pricey. Hiring a stellar board and top talent to attract investors in your IPO adds to your costs in addition to underwriters and investment banks. Further, there's significant pressure to deliver success when embarking upon an IPO.
As a startup founder, raising capital is a top priority. So is deciding the best way to "go public" when your startup growth and investor interest permit. After all, it's a big decision to shift from a privately-owned company to a publicly-traded one.
Startup founders can use special purpose acquisition companies (SPACs) or initial public offerings (IPOs) when deciding to go public.
Some startups choose an IPO, where new shares are created and underwritten. Then, the shares are sold to the public. For others, a SPAC may be the right vehicle to take the startup public.
This article will break down the differences between SPACs and IPOs, including the pros and cons.
What Is a SPAC?
To raise money to go public is through a special purpose acquisition company (SPAC). A SPAC is "a corporation formed to raise investment capital through an initial public offering (IPO)."
So how do SPACs work? According to Corporate Finance Institute, "such a business structure allows investors to contribute money towards a fund, which is then used to acquire one or more unspecified businesses to be identified after the IPO."
SPACs have no other operational purpose than to raise capital through an IPO for the sole purpose of acquiring or merging with the company choosing to go public. SPACs "raise money largely from public-equity investors and have the potential to [de-risk] and shorten the IPO process for their target companies, often offering them better terms than a traditional IPO would."
According to Corporate Finance Institute, "when the SPAC raises the required funds through an IPO, the money is held in a trust until a predetermined period elapses or the desired acquisition is made. If the planned acquisition is not made or legal formalities are still pending, the SPAC must return the funds to the investors, after deducting bank and broker fees."
Let's look at how this occurs in graph form.
Although SPACs have been around for decades, they've recently become more popular. According to Harvard Business Review, "although SPACs, which offer an alternative to traditional IPOs, have been around for decades. They've taken off in the United States over the past two years. In 2019, 59 were created, with $13 billion invested; in 2020, 247 were created, with $80 billion invested; and in the first quarter alone of 2021, 295 were created, with $96 billion invested. Then there's this remarkable fact: In 2020, SPACs accounted for more than 50% of new publicly listed U.S. companies."
Harvard Business Review notes that "we believe that SPACs are here to stay and maybe a net positive for the capital markets. Why? Because they offer investors and targets a new set of financing opportunities that compete with later-stage venture capital, private equity, direct listings, and the traditional IPO process. They provide an infusion of capital to a broader universe of startups and other companies, fueling innovation and growth." In other words, "SPACs have allowed many companies to raise more funds than alternative options do, propelling innovation in a range of industries."
What Is an IPO?
Now, let's move on to IPOs.
An initial public offering (IPO) is a limited sale of new shares in a startup that has decided to "go public." The general public and institutional investors can buy IPO shares. An institutional investor is an entity that invests on behalf of its members, such as a pension fund.
Once the IPO concludes, the startup is officially a public company and begins trading on a national stock exchange. Additionally, the IPO must comply with all notices and filings required for public-traded companies like direct listings.
To complete a successful IPO, startups need to complete the following process:
- Due Diligence: As a startup moves from a private company to a public company, it should conduct due diligence, where it discloses financial, management, and business documents. These documents are presented to investment banks for further review.
- Underwriting: As we've noted, startups wishing to undergo an IPO must participate in underwriting. An underwriter is a financial professional that guarantees the startup's value to investors. Underwriters may work for investment banks, or they may be certified public accountants (CPAs), lawyers, or other financial professionals well-versed in SEC requirements and IPOs. Remember that underwriters often charge three to seven percent per share for their services.
- FIling IPO Documents: Next, the startup must file all of the appropriate applications and documents required by the SEC. For example, startups must file an S-1 Registration Statement, which includes a prospectus of the startup for disclosure to regulators.
- Marketing Your IPO: Startups don't want to keep this process quiet. Instead, they should market and advertise the IPO to the public, getting investors excited about the startup going public. The founders will need to convey their valuation during this process, hoping that the IPO will live up to those numbers.
- Set the Date of the IPO: Once you have all documents filed with the SEC and you've completed the underwriting process, you set your IPO date. However, once you place your IPO date, you may have to delay the IPO date for various reasons, such as valuation issues or lack of interest.
SPAC vs. IPO
More of a summary view, notice how SPACs and IPOs stack up against one another in the chart below.
What Are the Pros and Cons of a SPAC?
Let's now look at some pros and cons of SPACs.
First, the pros. The primary reason startups choose a SPAC over an IPO when going public is the faster time, the ability to raise additional capital through the SPAC after the IPO, lower marketing costs, and access to operational expertise.
However, there are also risks associated with SPAC mergers or acquisitions. For example, SPAC sponsors "usually own a 20 percent stake in the SPAC through founder shares or 'promote,' and warrants to purchase more shares. SPAC sponsors also benefit from an earnout component, allowing them to receive more shares when the stock price achieves a specified target over a certain time frame, leading to further dilution."
Additionally, although the SPACs are more time-efficient, it creates a "[c]ompressed timeline for public company readiness," such as creating internal controls and establishing a qualified board of directors and leadership team. Also, because the SPACs don't "require the rigorous due diligence of a traditional IPO, [the lack of these processes could] lead to potential restatements, incorrectly valued businesses or even lawsuits."
Finally, SPACs don't require underwriting, meaning that an underwriter guarantees the stock prices. According to KPMG, "[i]n a traditional IPO, the underwriter makes sure all regulatory requirements are met, but the target company doesn't have an underwriter because a SPAC is already public."
What Are the Pros and Cons of an IPO?
Let's now look at some pros and cons of IPOs.
For the pros, founders get access to large cash injections with an IPO, creating a favorable financial position moving forward. Additionally, by issuing new shares, the startup protects future shares trading instead of buying and selling existing equity.
Marketing your IPO and having a successful launch can create quite the buzz for your company, creating additional publicity for your startup.
On the other hand, IPOs are pricey. Hiring a stellar board and top talent to attract investors in your IPO adds to your costs in addition to underwriters and investment banks. Further, there's significant pressure to deliver success when embarking upon an IPO.
We can help!
At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most—your business.
If you want to learn more about SPACs and IPOs, we can help you draft the appropriate documents for your startup. Additionally, we can get your documentation ready, shepherding this process to ensure it's done right. Get in touch to learn more!
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