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May 7, 2021

Finance: SPAC – Direct Listing – IPO

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Between a record-setting pace for Fintech IPOs, the Crypto Boom, and everything else happening in the world of finance this year, there have been no shortage of storylines. SPACs are just another one of the layers to peel back in the evolution of finance, and that’s why we look at SPACs and other comparative public-offering structures in this post.

What are SPACs?

Special Purpose Acquisition Companies (SPACs) are not new. They have been around for many years. But only in the second half of 2020 did we start to see a SPAC Boom, which has continued through the 1st Quarter of 2021.

Otherwise known as “blank-check companies”, SPACs are companies (in the loosest sense of the word) that go public to raise capital from public market investors with the intent to acquire a private company and bring it public.

Investor Amnesia

SPACs – Morningstar

The pace of SPACs hitting the market continues to ripple across the broader public markets, as the amount of liquidity being pumped into ‘innovative’ companies can alter competitive market dynamics and put pressure on other companies to list publicly themselves. SPACs have been launched across multiple categories, most notably EVs (Electric Vehicles), Fintech, and other frontier categories in the relatively early stages of their inception.

SPACs – Morningstar
INVESTOR AMNESIA

As the market itself has begun to heat up, we have seen professional investors entering the fray with their own SPAC Pools, thereby increasing both the credibility and average deal size in the space. As a counter effect, we have seen short sellers and other prominent investors actively campaigning and launching bets against SPACs.

The end result for top-tier companies is that they have an opportunity to launch in the market using one of three possible structures:

>SPAC

>IPO (Initial Public Offering)

>Direct Listing

The SPAC

SPACs are generally referred to as ‘blank-check companies.’ The “Sponsors” are those investors who are looking for companies (ie. target company) to actively take to market under their own SPAC, which essentially functions as a merger vehicle to list a new company without said company having to go through the lengthy and costly process of doing an IPO themselves.

Generally, a SPAC is formed by an experienced management team or a sponsor with nominal invested capital, typically translating into a ~20% interest in the SPAC (commonly known as founder shares). The remaining ~80% interest is held by public shareholders through “units” offered in an IPO of the SPAC’s shares. Each unit consists of a share of common stock and a fraction of a warrant (e.g., ½ or ⅓ of a warrant).

How SPACs Work

WSJ

The ‘Corporate Leaders‘ (as pictured in the diagram above) have created the SPAC and placed a certain amount of capital in there, which is to be used upon completion of the merger (deadline of 24 months) by the target company. In addition, the ‘Private Equity Firm(s)’ (as pictured in the diagram above) lead a PIPE (Private Investment in Public Equity), bringing an additional tranche of capital into the target company. Finally, when the SPAC lists publicly, ‘Individual (Retail) Investors‘ (as pictured in the diagram above) can invest in the listed share price.

The SPAC Deal: SoFI announced a SPAC merger with Social Capital Hedosophia Holdings V (NYSE: IPOE), led by Chamath Palihapitiya. The merger values SoFi at an equity value of $8.65 billion post-money. SoFi will receive $2.4 billion in cash proceeds, including a $1.2 billion PIPE led by Palihapitiya. SoFi is being valued with an enterprise value of $6.5 billion.

Example SPAC – SoFi/IPOE

Due to the nature of the SPAC structure – as described above in basic detail – there is the potential to create misaligned incentives between the original investors and retail investors, effectively ‘backroom deals.’ The SPAC’s original investors are typically experienced Corporate Investors, Venture Capitalists, and Private Equity Firms. The original SPAC shell acts as the holding company for the target company until the merger is officially completed (must be within 24 months), at which point the shares of the SPAC are converted into shares of said target company. But there are several key differences between an IPO and a SPAC:

>Traditional IPO’d companies are not allowed to provide forward-looking earnings guidance before listing, whereas SPACs can provide forward-looking earnings guidance before listing

>Traditional IPO’d companies cannot promote themselves to the public before listing, whereas SPACs can promote themselves publicly

>Traditional IPO’d companies have much more in-depth disclosure requirements via regulatory agencies like the SEC, while SPACs have lighter regulatory requirements, allowing target companies to get to market much quicker and with greater certainty compared to a traditional IPO

How SPACs Work

These differences combine to create potential problems around disclosures to retail investors and thus can lead to over-inflated valuations.

The success of the SPAC depends on the success of the company it acquires. The research, due diligence and checks behind these acquisitions may not be as stringent as a traditional IPO, or public company acquisition. It again seems like the investor is the loser.

SPACs – Morningstar

Nonetheless, SPACs have allowed companies to raise more than $200 Billion in the last 15 months, and thus are playing an ever-increasing role in capital formation for public markets.

>SPACInsider

>SPACTrack

Where SPACs head from here now that regulators, short sellers, and famous investors have weighed-in, remains to be seen. And they are but one of three possible options for the worlds leading innovators looking to tap into public markets.

Traditional IPO

The first ever IPO happened in 1602 through the creation of the Dutch East India Co.

Investopedia – 1st IPO

Since that time, we have seen several booms and busts in IPOs in relation to various stock market bubbles.

Investor Amnesia

IPOs are led by underwriters in the investment banks who take a fee of ~7% of funds raised for leading the IPO process. This typically consists of a multi-week “Roadshow” where the underwriters take the company’s executive team on the road to meet various institutional investors and present the business for investment. The underwriters basically take orders from those institutions (ie. 1 Million shares at $100, or 2 Million shares at ‘market’) and start to create a trading range for the stock. There is usually an initial filing range that is laid out in the S-1 regulatory filing with the SEC in the US. Then there is second price where the company sells the stock to investors. Finally, the third price is the opening price of the stock on IPO day.

The companies generally rely on the expertise and experience of the investment banks to set the price with their book of institutional investors; however, this also creates potential incentives to underprice the stock for the Buy Side (institutional investors) and to create the optics of a big pop on the first day of trading.

The above fact, combined with the high fees, have led some companies to start analyzing other options for listing publicly, including SPACs and a Direct Listing.

Direct Listing

As the name suggests, Direct Listings involve taking the company directly to investors on public markets, rather than going through the underwriters (major banks) who ultimately set the IPO price.

The issue with IPOs, as seen by many pundits, is that there is an incentive for the underwriters to underprice the stock on the first day of listing, thereby creating a higher likelihood of a large pop that serves to benefit professional investors on the Buy Side of the IPO itself.

Collosus – Bill Gurley Interview

At the end of 2020, the NYSE (New York Stock Exchange) was approved for Direct Listings by the SEC, which paves the way for many more companies to go public via Direct Listing in the future.

The change, following months of industry haggling, will help reduce what critics call excessive underwriter fees, a major barrier to companies looking to go public. It is especially important to technology companies and start-ups, both of which would stand to gain greatly from the new SEC ruling.

Reuters

The main benefit to companies who are able to go public via Direct Listing – such as Spotify, Slack, and others – is the potential to unlock much more value for the founders, employees, and early-stage investors of the firm because of better price discovery.

… it is a crucial innovation for private companies breaking into public markets. “Some of them will continue to choose a traditional IPO but others will have this as an alternative if they want to reduce their cost of capital and they want to have a democratized access to their company on the first day,” she said. “I do think there’s an improvement that is welcome in the IPO arena.”

CNBC

In a Direct Listing, the investment banks still play a role, but not as an underwriter. They play a role more as capital market advisors because the company is not actually selling shares to institutional investors as they do in an IPO. Thus there is no need to “bookbuild” with their roster of investors; the market making activity is handled by a software algorithm on the listing exchange. In line with SPACs, companies are also able to provide forward guidance on their future earnings in a Direct Listing.

The company doing the Direct Listing also publicly provides prospective investors forward-looking financial guidance — in a form similar to earnings calls and press releases — whereas in a traditional IPO, no forward-looking guidance is issued until after the IPO has been completed (usually at the first quarterly earnings release). This is because in an IPO, the S-1 registration is filed, but not declared effective, until the night of pricing (the day before initial trading); therefore, the company can’t provide advance guidance without violating SEC rules. In a Direct Listing, however, the registration is effective well in advance of trading (10 days prior in the case of Slack), so the company can provide such forward-looking guidance before the stock starts trading.

A16Z – DIrect Listings

Just like the other aforementioned options for going public, there are risks to a Direct Listing, such as those related to the company effectively flopping on the day of listing without there being the backing of underwriters and their respective partners to come in and buy up shares. Unlike an IPO, where the underwriters act as a somewhat neutral party in presenting the information to investors, the companies themselves present the information to investors in a Direct Listing (including forward-looking earnings guidance), which leaves the door open for gaps in disclosure and other problems that can occur when educating investors.

SPACs, IPOs, and Direct Listings – Oh My!

In aggregate, while IPOs remain the most popular way to take a company public, each mechanism has its own pros and cons.

Collosus – Bill Gurley Interview

We have seen SPACs boom in the second half of 2020 and through the 1st Quarter of 2021, but now start to cool off recently. One of the most-anticipated public listings this year was Coinbase, who opted to go with a Direct Listing. Meanwhile, companies like Airbnb that have gone the traditional IPO route have seen their stock soar and are now among the new market darlings in the eyes of the the public and media.

Furthermore, there is seemingly unrelenting appetite for IPOs among retail investors on platforms like Robinhood and SoFi, who are themselves now in the process of trying to “democratize” the IPO process and allow users with as little as $3,000 in their accounts to bid on IPO Listings. While the plans have yet to be officially approved by the regulator, it is yet another signal that innovation is coming from multiple different levels in order to list companies publicly.

Retail brokerages — like Schwab, TD Ameritrade, and E-Trade — offering their customers shares from IPOs is nothing new. But two of the largest startup brokerages are now looking to open up the IPO market to much smaller investors, while traditional brokerages typically require customers to have upward of $100,000 in assets to participate in premarket offerings.

Business Insider

The challenge for the industry as a whole is less about finding the most innovative way to bring a company to market and more about shielding against the fallouts that typically come during the Booms and Busts in the market, as we have seen repeat throughout the history of public markets. The best companies will be able to choose the best option presented to them. Yet, there will also be a host of lousy companies who are compelled to cash out their chips (insider’s shares) and list only because they can, leaving retail investors to pick up the bag.

Overall, SPACs add another layer of intrigue to public markets. With some top-tier companies and investors jumping into the market, there is a chance that SPACs will become a key part of the new fundraising landscape for public companies. On the flip side, SPACs may prove to be problematic down the road, and become the least enviable for the world’s best companies when they decide to list. Time will tell!

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