SPAC stands for “special purpose acquisition company,” and these entities act as a shell that can raise money in order to acquire another active company that wishes to go public.
Companies that want to have an initial public offering (IPO) can use SPACs to make it happen. SPACs themselves are publicly traded, and some investors are buying SPAC shares in an effort to get in as early as possible on companies going public — but it’s rare that the average investor will have access to SPAC shares.
But SPACs, like many investments, are not something you want to jump into without doing some homework first. In addition, the Securities and Exchange Commission (SEC) has proposed new rules to make SPACs more transparent, and limit conflict-of-interest in these mergers.
What Is a SPAC?
SPACs are legal business entities that don’t have any assets or conduct any sort of business activity. In effect, they’re empty husks. That’s why they’re often called “blank check companies.”
As for their purpose, SPACs can be used to take companies public. So, instead of going through the traditional IPO process, many companies are instead using SPACs to get themselves listed on the stock markets.
💡 Quick Tip: Keen to invest in an initial public offering, or IPO? Be sure to check with your brokerage about what’s required. Typically IPO stock is available only to eligible investors.
SPACs and Acquisitions
As for how a SPAC takes a company public, the process is basically a reverse merger, when a private business goes public by buying an already public company.
Here’s a step-by step:
• A SPAC goes public, selling shares and promising to use the proceeds to buy another business.
• The SPAC’s sponsors set their sights on a company it wants to take public — an acquisition target.
• The SPAC often raises more money to acquire the target. Remember, SPACs are already publicly traded, so when it does acquire a target, the target is absorbed by the SPAC, and then becomes public too.
Recommended: What Happens to a Stock During a Merger?
So, why would a company want to use a SPAC transaction to go public rather than go the traditional IPO route? The simple answer is that it can be much faster and easier.
For instance, a merger between a SPAC and its target can take between four to six months, whereas the traditional IPO route can take 12 to 18 months.
How Do I Invest in SPACs?
SPACs are designed to raise money so that they can acquire their target. To raise money, they need investors, which is why they’re generally publicly traded. In theory, retail investors can invest in SPACs — in most cases, a brokerage account is all that’s required. But a 2022 SEC analysis shows that very few retail investors actually gain access to SPAC shares.
5 Things to Know Before Investing in SPACs
Before you pursue what could be a risky investment, run through this list of considerations:
1. Failure to Find Target
SPACs exist for one reason: To acquire a target company and take it public. But there’s a chance that some could fail to do so — something that prospective investors should take seriously. The clock is ticking, too. If a SPAC does not acquire a target within a specific time frame — typically two years — it could liquidate.
💡 Quick Tip: All investments come with some degree of risk — and some are riskier than others. Before investing online, decide on your investment goals and how much risk you want to take.
2. Investor Dilution
SPAC investors also run the risk that their shares could be diluted, or lose value. Meaning: The folks running the SPAC may throw in additional funding that can erode the value of those shares.
That dilution can happen during the merger process. As the merger takes place, fees are paid, warrants are exercised, and the SPAC’s sponsor receives 20% ownership in the new entity. All this can take ownership from investors’ shares, diluting them.
3. Poor Performance
Some companies that go public via a SPAC transaction don’t do so well after the merger. Their stock values don’t perform as many investors have hoped. This is yet another very real risk that SPAC investors must contend with.
As SPAC targets are private companies, investors can be limited in the amount of research they can do on the targets. Their financial records may be difficult to find. As a result, investors are basically relying on the due diligence of the SPAC sponsor. So there’s an element of trust — and risk — at play.
What investors should know is that many companies that have gone public through a SPAC underperform compared to the broader market at large.
4. Big Names Can Cloud Investor Judgment
It can be easy to get caught up in the hype around certain SPACs. Whether the SPAC itself is targeting a particularly noteworthy company to take public, or if it’s being managed by a big-name investor or famous person, the glitz and glamor may blind investors to certain risks.
It may be fun to think that you’re getting in on an investment with a celebrity. But that doesn’t mean that the investment they’re attached to is necessarily a good one, or the right one for you.
5. Uncertain Future
SPACs, in recent years, were a hot commodity. But since there are some significant risks involved in investing in SPACs, regulators stepped in to make some changes that would protect average investors.
Given the lack of transparency around SPACs and the general fast-and-loose approach that the markets are talking to them, the government and other watch dogs are already calling for some reforms.
Among them: Tamping down on SPAC hype, like protecting investors from misleading information or expectations, enhancing disclosures, and being more forthcoming about the risks to investors.
The Takeaway
There’s a lot to consider about SPACs from an investor’s point of view. But the important thing to remember is that SPACs are speculative, risky investments. Investing in SPACs will likely require a high risk tolerance for most investors, and it’s a good idea that you have your other financial ducks in a row before dedicating any money to it.
Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.
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