SPAC vs. Traditional IPO: Pros and Cons of Investing in Each

When a private company decides to go public, there are several options for making the transition that allows for the general public to purchase shares of the company on the open market.

The most common way this was done in the past was via a traditional IPO. In 2020, the SPAC exploded in popularity as a speedier vehicle to get a company to market.

A third option is a direct listing. It’s also possible to buy shares in some private companies before they go public if you’re willing to take on more risk for potentially higher rewards.

Below, Inyoung Hwang compares and contrasts the SPAC vs. IPO. This article was originally published by SoFi, and you’ll see the wordiest of disclaimers from them at the bottom of the page.

 

 

While sometimes described as a “backdoor” to going public, SPACs have emerged as a major contender to the traditional IPO.

About $60.2 billion in SPACs debuted on the U.S. stock market in the first two months of 2021, far outpacing the $24.4 billion raised by IPOs in the same period, according to a report by the Securities Industry and Financial Markets Association (SIFMA).

In 2020, SPACs represented 97% of the total money raised in IPOs, the SIFMA data show. That compares with just 9.9% in the decade through 2019–a sign of how momentum behind this deal structure has intensified only recently.

While the popularity of SPACs is irrefutable, investors sitting at home may be wondering if they should buy into this trend and whether SPACs represent a better investment than regular IPO companies. Here’s a deep dive into how both SPAC IPOs and traditional IPOs work, as well as what to consider before investing in either.

 

 

What Is a SPAC IPO?

 

SPACs, which stands for special purpose acquisition companies, are shell companies that raise money by listing shares on a stock exchange. They have no operating business–so no gadgets or widgets to sell, no services to offer–but instead go public with the sole intent of finding a private company to merge with.

Once a target company is found, the two businesses–the already public SPAC and the privately held company–merge. Through this merger, the private business goes public and gets listed on the stock exchange.

Here’s a step-by-step on how SPACs work with additional details:

A “sponsor”–typically industry professionals or executives–sets up a SPAC. They can pay $25,000 for a 20% stake in the company–what’s known as the “promote” or “founder’s shares.”

The SPAC lists on a stock exchange with a ticker symbol, raising money through the process. By convention, each SPAC share almost always sells for $10 apiece.

The SPAC hunts for a target business to buy. They usually have two years to complete this search. Otherwise, the money raised in the IPO gets returned to shareholders, typically with interest.

If a target business is found but more money is needed, more institutional investors may be brought in, in what’s known as a PIPE or private investment in public equity.

Stockholders have the right to vote on the proposed merger with the target company. If approved, the merger is completed, and the target company’s new ticker replaces the SPAC’s ticker.

 

Why Do Companies Go Public With SPACs?

 

In recent years, company executives–particularly ones from Silicon Valley leading unicorn companies–have complained about the traditional IPO process. Here are some reasons some CEOs have preferred the SPAC route to go public.

 

1. Faster timeline: A merger between a SPAC and its target can take between four to six months, whereas a traditional IPO can take 12 to 18 months.

2. Less expensive: In a traditional IPO, the cost of hiring the investment bankers or underwriters alone can be 4% to 7% of the IPO’s entire proceeds.

3. To avoid volatility: Traditional IPO valuations can be subject to the mood of the stock market at the moment. Meanwhile, the valuation of the private company in a SPAC deal is typically done in private negotiations, which might help avoid the ups and downs of public markets.

4. Regulatory oversight: The SPAC structure currently allows companies to market themselves using more forward-looking projections than traditional IPOs, which may be preferable to companies still in the earlier growth stage.

 

Benefits of SPACs

1. Warrants: When institutional investors buy SPAC shares, they technically get shares that are called “units.” Each unit typically includes a share priced at $10 and a warrant or a fraction of a warrant that can be exercised when the shares reach $11.50. Some brokerage firms have been allowing retail investors to purchase units as well.

2. Getting in early: SPACs allow retail investors to potentially get in early–so before a target company has been announced–and at just $10 a share.

3. Experienced sponsors: Prominent sponsors have been a key feature in the recent wave of SPACs. Such sponsors could be helpful, experienced advisors to younger companies and may be skilled at finding undervalued private businesses to bring to public markets.

4. New structures: Some criticism has been lobbed at the SPAC structure, and some deals have failed to materialize or handed investors lackluster returns. However, some of the more recent SPACs have attempted to address these issues with investor protections.

 

Risks of SPACs

Here’s what to know about SPACs when it comes to their risks:

1. Failure to find a target: While SPACs pledge to buy a target company when they go public, some fail to do so in the two years they have to find a business. Though investors would get their investment if the two years goes by without a deal, it would still be money that could’ve been invested elsewhere.

2. Dilution risk: While investors can buy shares of a SPAC at $10 when it goes public, there’s a risk that additional funding, such as the PIPE investment, to fund a deal could dilute their stake. Furthermore, warrants getting exercised also pose another dilution risk.

3. Greater regulation: The Securities and Exchange Commission (SEC) announced new accounting mandates in 2021 for SPACs, increasing oversight of the deal structure. Some market observers say greater regulation could be on the way.

4. Lackluster performance: Shares of SPACs have been volatile in 2021 as investors have been disappointed by the performance of some of these new companies.

 

What Is a Traditional IPO?

 

An initial public offering or IPO is the process of a private company offering shares for sale to the public. This is typically done through “listing” shares on a stock exchange, where investors can then buy and sell stakes in the company.

Historically, IPOs have been an important milestone in the American business landscape, signaling a company’s maturity and growth. After going public, companies typically face greater scrutiny both from regulators and investors on their performance and financials.

Here’s how a traditional IPO generally works:

A private company typically starts by hiring investment bankers. The process by which investment bankers handle and advise an IPO is called underwriting.

The underwriter helps the company file its S-1 prospectus with the SEC, a document that includes financial data, financial projections, descriptions on what the proceeds of the IPO will be used for, as well as potential risks to the deal.

If the IPO is approved, underwriters typically hold “roadshows”–events in which they present and pitch institutional investors on the company and IPO deal. If institutional investors are interested in buying, underwriters will allocate them a proportion of the shares.

Before listing day, stock exchange and ticker symbol are chosen by the company with the help of the underwriter. The underwriter will then buy shares from the company before transferring them to the public market.

Trading commences on the listing day. Oftentimes, there’s an IPO lock-up period, a stretch of time during which senior executives and early investors aren’t allowed to sell their shares in the open market.

 

Why Do Companies Go Public With Traditional IPOs?

 

Companies have traditionally gone through IPOs in order to raise additional money, provide an exit opportunity and greater liquidity for early stakeholders, and drum up more publicity.

Meanwhile, here are some reasons why a company may choose a traditional IPO as opposed to a SPAC IPO:

1. Sponsor promote: As mentioned, sponsors get a 20% stake of the company’s common equity in SPACs. For companies that don’t want to give up this stake, the traditional IPO may appear to be a better option.

2. Regulatory uncertainty: The SEC has already changed some of the regulatory requirements of SPACs and more changes could come. Meanwhile, for IPOs, the regulatory requirements have been in place for much longer and are designed to protect everyday investors.

3. Cooling enthusiasm: SPAC shares have had a mixed performance in 2021, given the regulatory uncertainty and disappointing performances by some companies. Some startups may want to avoid being grouped with such SPACs.

 

Benefits of Traditional IPOs

1. Get in early: Traditional IPOs can represent an opportunity to invest in a newly public company in its early stages.

2. Stable regulation: Regulations of traditional IPOs are still a tried and true model relative to oversight of SPACs, and they’re designed to protect retail investors.

 

Risks of Traditional IPOs

IPO investing is known to be risky. Some of the most famous examples of investors losing money from IPO investing come from the late 90s and early 2000s when the tech-bubble was raging. Dozens of companies that weren’t yet profitable and sometimes had questionable business models went public, and some individuals suffered losses from these investments.

1. New companies: Businesses that choose the traditional IPO route are still new companies that are untested in their business models and by public markets.

2. Stock volatility: While underwriters try to ensure a first-day pop in an IPO, shares of the company may experience volatility or decline in the weeks or months after listing. Also, a risky period tends to be after the lock-up expires. Early stakeholders selling shares could cause wild price swings in the stock.

 

Investing in SPACs vs Traditional IPOs: How to Choose

 

Here’s a run-down of key attributes for both groups when it comes to investing.

 

Ease

Buying IPO stocks and SPACs is relatively the same and easy for most investors. All that’s typically required is a brokerage account and the ticker symbol.

Additionally, the warrants that are part of SPAC units generally start trading 52 days after the IPO.

 

Prices

SPAC shares are typically priced at $10 apiece. The relatively low share price might make it more accessible to individual investors. However, IPOs are also rarely priced high and this is by design, since underwriters try to underprice shares so that they have an impressive “pop” on the first day.

 

Regulations

SPACs have had more regulatory flexibility when it comes to making forward-looking statements, making it important for investors to weigh the realistic business outlook of the businesses. Investors are also dealing with greater uncertainty with SPACs when it comes to future regulation down the road.

Meanwhile, the regulatory rules for traditional IPOs have been fairly well known and stable, and they’re designed to protect unsophisticated retail investors.

 

Taxes

The De-SPACing process is either when the merger with the target company is completed or if capital is returned to shareholders. Remember, SPACs generally have two years to find a target company to merge with. If it fails to merge, the SPAC is dissolved and investors get their investment money back plus interest.

How the investor is taxed depends on whether they incurred a gain or loss when the money is returned to them and how long the investment was held for.

Remember, in the US, when you profit from an asset after owning it for a year or less, it’s considered a short-term capital gain. Longer than a year, and it’s considered a long-term capital gain. Long-term capital gains tax rates are lower–either 0%, 15% or 20%–and depend on the investor’s income bracket.

When it comes to SPAC warrants, when an investor exercises them, the difference between the strike price and the price of the share is taxable income. This is typically taxed as ordinary income and so at a higher rate.

 

Fees

For the investor, trading costs should be relatively similar. Many brokerages these days also offer zero commission trading, meaning investors can buy and sell shares without incurring costs from the brokerage.

However, brokerages may charge higher commission fees for exercising or trading the warrants that are part of SPAC units. Investors can ask their brokerage firms about what these costs might be.

 

The Takeaway

 

Both SPAC IPOs and traditional IPOs are ways for investors to make bets on newer companies. In 2020, SPACs became a more prominent way for companies to go public and a popular investment vehicle. However, some of the enthusiasm cooled in 2021 amid lackluster performance by some businesses and regulatory warnings.

With both SPAC IPOs and traditional IPOs, investors can benefit from always doing their research: looking into the sponsors, key executives, business model, as well as the performance of the company and its industry. Both SPACs and traditional IPOs tend to be newer companies that have been less tested when it comes to their business model and public market reception, making them vulnerable to price volatility.

SoFi Invest allows eligible users to buy into companies before they begin trading on a stock exchange through the IPO Investing service. Investors can set up an Active Investing account to get access to IPO shares, company stocks, exchange-traded funds, as well as fractional shares.

 

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