What is a SPAC?

Many individuals would love to get in early on an initial public offering (IPO) — a company's launch on the stock exchange — before the shares are publicly available to trade. But pension funds and other institutional investors usually get there first, leaving retail investors picking up the post-offering breadcrumbs, and often paying a higher price.

But a back-door, formerly out-of-favor IPO approach known as a SPAC offers an opportunity for small investors to get in on the action from an earlier point. SPACs can also help private companies go public without as much of the legwork required for an IPO. However, SPACs can be risky and expensive for some investors, and the limited transparency can make it hard to know if the investment aligns with your goals.

In this guide, we'll take a closer look at what SPACs are, the pros and cons of SPACs, and more.

What is a SPAC?

SPAC definition

A special purpose acquisition company (SPAC) is basically a publicly traded company that has no operations, no assets — other than a war chest of cash — and just one stated business plan: to eventually buy (or merge with) another company.

Another way to sum up a SPAC's meaning is that it is basically a shell company, i.e., an organization that exists on paper but lacks operations or substantial assets, other than to find a target company.

The SPAC simply exists to go public and raise funds so that the capital can be used to acquire another company, and since the SPAC is already public, that acquisition then effectively becomes publicly traded while bypassing the typical IPO process.

A 'blank check' company that raises funds through an IPO

A SPAC is often called a blank check company because there's no specific business behind the SPAC other than to acquire and take a company public. That said, a SPAC is generally formed by a group of managers or investors, frequently referred to as sponsors, with a strong background in a particular industry or business sector.

The management team will put together an IPO prospectus, which might provide details on the industry where the SPAC intends to pursue an acquisition, but that still gives the SPAC a lot of flexibility in terms of which company it tries to acquire.

Goal: to find and merge with a private company

The sponsors raise most of the funds from other investors and use the money to acquire an existing, privately held company. External investors typically acquire about an 80% stake in the SPAC, while 20% goes to sponsors, even though sponsors might not put in that much money.

When they launch the SPAC, the sponsors generally either don't have a specific target in mind or they're not ready to name it in order to avoid the extensive paperwork and disclosures required by the Securities and Exchange Commission (SEC). They're also not required to stick with the targeted industry.

The early-bird underwriters, institutional investors, and retail investors who generally come in later typically have no idea exactly how the sponsors will spend the money. So early investors are basically relying on the sponsors' reputation in the hope of snagging a good investment.

But they've got to be prepared to wait. Even after a SPAC goes public, it can take quite a while (frequently up to two years) to pick and announce the target company it wants to acquire, or technically speaking, merge with (the corporate charter specifies the exact timeframe, per SEC regulations). If it doesn't, the SPAC is liquidated, and the funds it raised are returned to investors.

But if an acquisition is identified and ultimately is completed, the SPAC goes through what's known as a de-SPAC process to dissolve the SPAC so that the acquired company becomes the publicly traded company.

How do SPACs work?

Formation and IPO

SPACs are formed by groups of individuals frequently referred to as sponsors. These individuals usually have experience in a specific industry that qualifies them to be part of the management team of a SPAC. Sometimes this involves celebrities or well-known leaders to help attract interest in the deals.

This management team usually puts up a fraction of the total funds needed to make an acquisition. The shares held by these sponsors are frequently described as founder shares.

After forming one of these companies, the management team will then attempt to raise a certain amount from investors for the purpose of acquiring, or merging with, a privately held company.

These shares, which are available to the public, are frequently described as public shares.

The founding team may also offer early investors warrants, which give their owners the ability to purchase shares of the SPAC at a specific price, which is often higher than the price the shares had when the warrant was issued. This approach can help draw more investment and reward early investors if the SPAC's share price rises as it starts raising funds from the public.

The terms of these warrants can vary significantly, so interested parties can benefit greatly from conducting their due diligence. Investors should keep in mind that warrants can potentially dilute (reduce) the value of shares, since exercising these results in the issuance of new shares.

Searching for a target company

Once a SPAC has raised the desired funds, it places them in a trust or escrow account so they can be used for the purpose of acquisition. After raising the money, the SPAC has a specific time period (usually up to two years) where it can use these funds. If it has not used this money at the end of this period, the capital will be returned to investors.

Investors have the right to vote on potential acquisition targets. However, the sponsors may present potential targets that these investors don't like, and they have the option to back out and redeem their capital. Still, if the majority of shareholders vote in favor of a merger, it will go forward.

The merger: If successful, it takes the private company public

If the investors vote to approve a merger, the SPAC will combine with the company in question, at which point the formerly private company's shares will be accessible to the investing public. Typically, the SPAC goes through a de-SPAC process during this time to essentially let the company it's acquiring become the public company, while the SPAC dissolves.

SPACs vs. IPOs

SPACs are often used to raise money and take a company public more efficiently, with fewer regulatory hurdles than a traditional IPO.

More specifically, a SPAC merger can take place in a matter of three to six months, whereas the process of preparing for and holding an IPO often takes around 12-18 months. While regulations have increased in recent years around SPAC disclosures, including for companies targeted by SPACs, they're still generally faster and have less oversight.

However, investors might not always benefit from this process. With a SPAC, for example, there's an incentive for the company to make an acquisition, rather than returning capital to shareholders. But perhaps the terms of the deal aren't all that appealing to some investors, and had you known that's what the SPAC would have invested in, you would have put your money elsewhere.

In contrast, with a traditional IPO, there's more transparency from the outset of the filing process regarding the private company's operations and investors can decide if it's a good fit.

To better understand why SPACS might be used vs. IPOs, it might be helpful to delve into their history.

A history of SPACs 

If the SPAC set-up sounds like a situation ripe for abuse, it once was. Back in the 1980s, a lot of fraud surrounded these blank check companies, as they were then often known. Many were purely shell companies set up to trade penny stocks. Often, these firms either absconded with investors' cash or engaged in overvalued insider deals that left many investors with a bagful of nothing.

Since then, however, SPACs have become more regulated and enjoyed a boom during the pandemic years, particularly 2020 and 2021, as strong market activity prompted many companies to try to go public quickly.

While SPAC activity has cooled down, and SEC regulations have increased, such as around disclosures from the SPAC and its target company that more closely resemble traditional IPO disclosures, there are still SPACs that go public every year. That's because there can still be advantages outside of regulation, such as how SPACs can set their own price for acquiring a company, rather than a private company's valuation initially being set by public market investors.

What are SPACs' pros and cons for retail investors?

Like any investment, SPACs have advantages and disadvantages. Aside from the pros and cons of SPACs that private companies might experience from going public this way (e.g., efficiency but also potential dilution), individual investors might face ones such as the following:

Advantages of SPACs

• Low cost per unit: Many SPACs are initially priced at $10 per unit, which is essentially one share of the trust account of the SPAC. That's well within the reach of retail investors, as some brokerages only let you purchase whole shares, meaning you might not be able to buy shares of more expensive stocks. Keep in mind that the price per unit/share, however, doesn't mean you're getting a deal per se, as what matters more is the valuation. One share at $100 is worth the same as 10 shares at $10, for example; it's just a matter of being able to buy in initially. However, SPAC prices tend to stay low for a while, so even if you can't get in right away, you can often buy shares for close to $10.

  "SPAC IPOs on average don't jump on the first day of trading," notes Jay R. Ritter, the Joseph B. Cordell Eminent Scholar Chair at the University of Florida's Warrington College of Business, who researches IPOs.

• They invest in hot areas: While not guaranteed, SPACs often invest in exciting areas such as tech or consumer fields, which could give you the opportunity to invest in a promising company. At the same time, however, that can also create the risk of investing in a speculative company, and many once-promising startups ended up faltering once going public via a SPAC.
• They're open to individual investors: Even though institutional investors usually go to the front of the line for SPAC offerings, the time between going public and making an acquisition can make it easier for smaller investors to get a piece of the action before the acquired private company becomes public, compared to retail investors trying to invest in a traditional IPO.

Disadvantages of SPACs

• Blind investment: SPAC investors usually don't know how their money will be used — they don't know what the SPAC's target company is (often, the sponsors don't know either). So the deal's impossible to evaluate in terms of deciding whether the SPAC's pre-acquisition valuation accurately reflects the valuation of its future target.
• Opportunity cost: There can be a long lag between the time investors allocate money into a SPAC and when it actually buys up a company and starts operations. Your money may sit for up to two years in an escrow account. If no acquisition happens, your funds are returned, but idling capital for that long may be painful, as there's an opportunity cost; it could have earned more in other investments meanwhile.
• Shaky track record: In many cases, SPACs underperform traditional IPOs. While part of that could be due to bad timing, such as the SPAC craze during the pandemic coming just before a steep market downturn in 2022, the overall track record isn't great, and even the subsequent bull market did not turn things around for most. A 2024 analysis by FTI Consulting found that 85% of SPACs that completed reverse mergers by 2022 were trading below their IPO price, with the average one trading at just 43% of its IPO price.

Of course, some SPACs do better than that. For example, fintech company SoFi went public via a SPAC in 2021, and while it's been through some significant ups and downs, it's currently trading above its initial public price.

How to invest in SPACS

Getting into a SPAC before it acquires a target is not as simple as buying regular equities: Hedge funds, mutual funds, and other deep-pocketed institutional investors typically get access to a new SPAC first. As a result, interested retail investors can benefit from leveraging any relationship they have with the sponsor of a SPAC.

But if celebrities aren't among your contacts, there are other ways to break into the world of SPACs:

• Your broker or wealth manager: Ask them to keep an eye out for offerings
• The websites of IPO-oriented investment banks: One SPAC specialist, Early Bird Capital, lists companies that are actively seeking targets.
• The Nasdaq website also lists upcoming IPOs, including SPACs, which can be identified by ticker symbols that generally end with a "U."
• Industry associations like SPAC Research sometimes highlight S-1 filings, which give formal notice of a SPAC's intention to go public.

Remember, though, that SPACs can be risky and have had a shaky track record in recent years. If you're new to investing, this might not be the best place to start. Even if you're an experienced investor, you can still lose money investing in SPACs, so consider consulting with a professional, such as a financial advisor.

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