The Fleeting Charm Of SPACS

Lax regulations, opportunity-seeking of private capital and early market rebound following COVID-19 contributed to the unprecedented rise of the SPAC in 2020. However, the trend seems to have slowed at the beginning of 2021, possibly signaling a return to “traditional” VC models

Credit: Geektime

Guest Contributor at Geektime / 24 Jun 2021

Written by Lee Moser, founder, and managing partner of AnD Ventures, and Roman N. Lasker, partner at AnD Ventures Studio

2020 will largely be remembered as the year of COVID-19 — from the global health crisis to the countless economic and social issues that followed. However, to millions of investors, 2020 will also be remembered as the year of the SPAC. Indeed, thanks to the rising awareness and understanding of Special-Purpose Acquisition Companies, incredible deals have been emerging in markets around the globe. Last year, in particular, they seemed to appear at a particularly feverish pace.

2020 saw a whopping 320% increase in the number SPACs raised from the previous year. On top of that, the average size of these SPACs was $336M, nearly $106M more than in 2019. As if this weren’t impressive enough, the number of these organizations that were account for by tech grew from 26% to 59%. To the delight of many investors, this momentum has continued into this year. Already, 64% of the 119 SPACs announced and / or going public in 2021 are considered at least “highly likely” to acquire a tech company.

As impressive as all of these figures are, they don’t necessarily account for why 2020 saw such an explosion in SPAC properties. Of course, many experts attribute their rapid growth to the highly unregulated environment. After all, these organizations faced far fewer constraints than traditional IPOs. This is because SPACs operate as “shell” or “blank-check” companies, meaning they have almost no financial statements or operations, which reduces SEC scrutiny. On top of this, SPAC targets boast much higher funding and price certainty, as their sponsors offer fixed prices for the equity shares of target companies.

It’s also important to consider how banks tend to underprice companies associated with traditional IPOs. This, more often than not, hurts their valuation and limits their money-making potential. This doesn’t happen with SPACs, because the underwriters are also the sponsors, ensuring everyone has the same goals and eliminating any potential conflict of interest. Then there are the fees. In SPAC deals, fees are mostly paid as options on equity to the underwriters. And while the amounts are more or less the same for SPACs or IPOs, the former favors long-term investment, saving cash that would otherwise go to the bank. Combine this with the fact that SPACs don’t have to invest in marketing to generate hype for their public debut, and it’s not hard to the potential for big savings.

Changes Affecting the Future of SPACs

Unfortunately, nothing can last forever. Such a free-for-all could not have lasted in any circumstances, so it should come as no surprise that regulators have finally caught on to the increased SPAC-related action. While some experts might see this as an indication that SPACs will disappear entirely, we instead feel that they will remain but change significantly. This theory seemed to be supported by former SEC Chairman Jay Clayton, who said that the agency is critically evaluating SPAC disclosures, especially certain compensation disclosures. In April of 2021, the SEC followed this up with a statement that warrants given to SPAC sponsors as compensation might not be considered as equity instruments, but as liabilities on the companies’ balance sheets.

Further complicating matters is that SPACs are expected to be under significantly more scrutiny from outsiders, but face a number of internal challenges. Firms, for instance, face strict deadlines for concluding their deals, which include targeting a company. Such constraints can give rise to certain moral hazards on behalf of the targeted firm by imposing demands that are not justified by performance alone. This pressure can also lead to bad deals, which not only include bad terms but also lower the standards imposed on the targeted firm.

These challenges clearly prove that the current state of SPACs is temporary — a phase that is probably doomed to dwindle down much like ICOs did in 2017, especially when considering that $10.33B was raised between Q4 2017 and Q1 2018, compared to only $460M between Q4 2018 and Q1 2019. This may pose problems for people who are heavily invested in SPACS currently or plan on investing in them in the near future. Of course, as with any market, where you find an increased risk, you find uncertainty (and vice versa).

The rise of the new VC?

Taking all of this into account, we expect investors to diversify their portfolios rather than simply relying on SPACs at their current state, especially as regulations become more stringent. However, does this reverse mean that it is “back to normal” for the traditional VC models? We believe that these rapid changes are an opportunity for a revamping of the classical VC approach. In a bigger market and tighter competition, coupled with the accelerating development of game-changing technologies, such as AI and Big Data, VCs can take a leaf out of the SPAC book. VCs can create greater value by taking a wider approach to the start-ups — not merely harnessing a technology, but, rather, giving more weight to aspects such as growth strategy and internationalization as well, and do that from the very beginning. VCs should assume their new role as company builders.

2020 saw great investments on the Israeli front, with a record-breaking $10B invested in Israeli tech firms. This was already a significant increase over 2019’s $7.8B but is made even more impressive when considering the limitations imposed by the global pandemic. Now that we are slowly but surely recovering from this global crisis, we need to prepare for several years of drastic changes, which will result from today’s dynamic climate. This change should affect the entire start-up cycle, with a special emphasis on later-stage requirements, such as customer-base growth, international growth strategy, and long-term product development roadmap.

This prediction strengthens our view of supporting early-stage startups in Israel. We do expect SPACs to remain a part of the scene, albeit they will comprise a much smaller fraction of exits in the market and come to more closely resemble IPOs in terms of regulation.

This assumption stems from our abounding faith in these starting firms, their incredible potential for future developments, and our role in growing them into large, international companies. Ultimately, there is no denying that the Israeli ecosystem is booming and thriving, with a large and varied pool of talent and startups. All of these seem primed to continue their growth and expansion for years — potentially decades — to come.

AnD Ventures is an early-stage VC investing in extraordinary people & frontier technologies.