How the Derided Reverse Merger is Now the Darling of Wall Street
By: Ayesha Tariq
Tags: IPO, Finance, Stock Market, Investing, Startup

How the Derided Reverse Merger is Now the Darling of Wall Street

Why Startups are loving the SPACs

Photo by Markus Winkler on Unsplash

The last couple of months have brought a new acronym to the forefront — SPAC. We finance people love our little acronyms. They make us feel special and super smart. But, it’s not just the investment community who love the SPACs, the startups are gaining real value out of them as well. SPACs have become a great way for unicorns to go public in a quick and efficient manner.

SPAC is an acronym for Special Purpose Acquisition Company and it’s not a new thing by any means. The financial industry has been spewing out “Special Purpose” companies for ages. It’s our favorite way of carving things out of a part of the company in an attempt to shield the rest of the business.

In the world of debt, we use SPVs or SPEs. You guessed it, Special Purpose… Vehicle or Entity. Why do we establish these companies? Because we are not sure what could happen to the rest of the business. Usually, an SPV is carved out and the debt is borrowed by this entity. Companies love it because it usually means that taking debt only on the SPV doesn’t affect the balance sheet for the rest of the business. Often they get away, with not reporting the debt at all.

So anything “Special” in finance is just another term for “I don’t want you to know too much about this”.

So how did the concept of Special Purpose suddenly creep onto Wall Street? Well, it’s not really sudden. SPACs have been around for a while now, and the consensus seems to be the early 1990s. However, what’s actually been around is the basic concept. But, what we’re seeing these days is the same structure with a twist. If there’s one thing that finance people love more than acronyms, it’s tweaking structures and creating a hype about it.

In the early days, most SPAC IPOs took place under what was called a reverse merger:

According to the SEC, a reverse merger transaction is when “an existing public “shell company,” which is a public reporting company with few or no operations, acquires a private operating company — usually one that is seeking access to funding in the U.S. capital markets.”

Why Were Reverse Mergers So Derided?

Reverse mergers were considered a back-door to listing. All a company had to do was to find a failing listed company and merger with them in order to be on the stock exchange. Since the Public Company in question was already listed, the private company in question could avoid much of the scrutiny of due diligence involved in an IPO. There was less work and often fewer costs.

What would happen then is, you’d find crappy private companies finding their way onto the Stock Exchange. The Public Company itself would have been of questionable competence and then a Private Company would fold into it. You’d find yourself with a listed company that passed all the tests but provided none of the value. It was an easy way for bankrupt companies to get a new life and questionable investors to form shell companies and avoid regulatory scrutiny. There are rumors that even the Mafia got involved.

What’s Changed with SPACs?

For one, the sponsors. SPACs are now clear with their purpose, so to speak. You have strong promoters, with management experience raising funds through an IPO with the clear mission of finding profitable companies to buy. What was lacking before was accountability to shareholders. This no longer seems to be the case.

Now, you have a whole list of platinum names in the investment industry forming SPACs to purchase startups and unicorns, in an attempt to provide shareholder value. The basic premise is no different from a VC fund or Private Equity Fund, except it’s not private.

Shareholder’s benefit from the expertise of established investors looking to place their money in potential unicorns. The public gets the benefit of due diligence done by a strong set management team. Since the management is also concerned about getting a profit out of this, they will likely opt to buy a company with a promising future. Once the company is formed and funds are raised, the SPAC essentially has a blank check to invest, which is what many of these companies are also called.

For a look at how a SPAC manages acquisition criteria, check out Pershing Square Tontine Holdings, a company that’s been in the news quite a lot lately.

There’s much more to the structure than just these few steps. There are issues around pricing and terms. The devil is in the details as they say. But, put simply, it still remains a faster and more viable option for most smaller companies.

SPACs a rather interesting way for public investors to access the private equity and venture capital market.