SPAC Man Begins
Two Truths and a Take, Season 2 Episode 25
Three years ago, Chamath sat us all down at a Social Capital all hands meeting and told us about this great new thing we were gonna do. It was called a SPAC.
A SPAC (“Special Purpose Acquisition Company”, or “blank check company”), he told us, was a new way we were going to help take big tech companies public. Going public is an important moment in a company’s life. It’s a transition from one state to another, it’s a stressful but monumental transition, and the current way we do it - the Initial Public Offering - stinks. Our SPAC, the thinking went, would create a new path for tech companies to go public that could compete with the IPO, and win.
It took a few years, but Chamath got this one really right. At the time, hardly anyone in Silicon Valley had ever heard of SPACs before. But now they’re having their moment, from Wall Street (Bill Ackman’s $4 billion SPAC for finding a “mature unicorn”, lol; David Ubben and Nikola stock making even Elon blush) to Sand Hill Road (Ribbit Capital just raised $600m for a fintech SPAC, and Chamath is doing two more, with more to follow I’m sure.)
SPACs aren’t new; they’ve just traditionally been a grimy, off-Broadway kind of financing. I have some fond memories of heading home to Canada and then talking to these 21 year old university students who were like, "SPACs? Oh yeah, we know what those are. I worked on one during my co-op semester, trying to take a fake mining company public.” (As an aside: did you know that Canada has a stock exchange specially for scams?)
So what are these things? What do they do, why are people all worked up about them, and why might they be here to stay?
When you IPO, the bank doesn’t work for you - it works for the ecosystem
When you IPO, you go through a transition: your company’s shares go from one day being not publicly traded, to the next day having a publicly traded price. There’s some uncertainty as to what your price will be! So there’s a risk involved, and that risk is specifically assumed by the initial public buyer of your stock - the first group of people to say, yes, I will buy this public stock at a certain number, and hope that number doesn’t turn out to be way too high. The IPO process mitigates this risk, but not for free.
The way an IPO works is you hire an investment bank, and say “we think we’d like to go public, we need to raise around X many dollars, do you think you could help us with that” and the bank says “why yes, that’s what we do, we will find buyers for your stock.” And so you go on a road show and pitch your stock to buyers all around the country, and then a few months later, depending on how the show went, you and the bank settle on a number for your initial offering price, and the bank makes a commitment to sell a certain number of shares of you to investors, at that price. The bank’s job is to make sure that this process will go smoothly. The bank will also insist on a number of fine points, like lockup periods to prevent employees from dumping too many shares on day one, to help the process remain orderly and clean.
On the day of the IPO, you show up at the New York Stock Exchange, you ring the bell, and your stock starts trading. And, most of the time, the stock will open quite a bit higher than the price you sold it for via the bank. This is called the “pop”, and it’s really the core part of why businesses grumble about IPOs: they feel like they’ve left money on the table.
Of course, there’s a sensible reason why you should actually expect a pop to happen. The initial investors are taking on risk, by buying a brand new, not-yet-priced stock! So, on average, they should get paid for taking that risk. Banks recognize this, and that’s why they price their IPOs accordingly: they want the pop to happen, because it keeps their clients happy, and coming back for more IPOs.
Sometimes stocks don’t pop, though. From time to time (with Uber last year, for instance) the stock will slide right from the opening bell, if for whatever reason the bank misjudged the public buying appetite. The bank’s job is to help stabilize this. And they do it via something called a greenshoe. The way a greenshoe works is that the bank actually commits to sell more shares than the company issues; in other words, it oversells the offering, and is therefore effectively short the stock on day one. In order to cover that short, the bank also gets (for free!) an offsetting number of call options to buy more stock from the company at the IPO price.
This is a “heads I win, tails you lose” kind of deal. If the stock pops on day one, as it normally does, then the bank covers its short position by simply exercising its free option to buy more stock at the IPO price. So the bank makes money on the difference, and the company grumbles because it has to cough up even more shares at below-market value. If the stock slides, on the other hand, then the bank can buy up shares on the open market. Either way, the greenshoe is nearly risk-free for the bank, the company foots the bill either way, without actually seeing any direct benefit.
Why am I telling you this? Because it’s a window into an important lesson about IPOs: the company might hire the bank, but the bank doesn’t really work for the company. The bank works for the ecosystem. The bank’s job is sort of to make the company happy, but really it’s to make sure that this IPO goes predictably and boringly, and let everyone take their profits. Banks don’t just care about this IPO; they care about getting IPO business generally.
This is largely a good thing, in my opinion: it helps avoid the tragedy of the commons problem. If IPOs were a complete free for all and had no standard rules, and banks worked explicitly for the business to try to maximize their gains (at the potential expense of the buying public), then the IPO would quickly develop a market for lemons-type situation: bad behaviour would potentially drive out the good, and going public would become riskier in more unknown, scary ways.
So rather than solve this problem with cumbersome regulation, we instead solve it by essentially assigning the investment banks as gatekeepers of the integrity of the system. They take their hefty take rates, they impose their unfriendly provisions, and they won’t quote you a price until you’re worn out from your road show. But in exchange they effectively guarantee a certain base level of integrity to the process. And that generally-expected level of integrity makes the IPO market run as smoothly as it does, and allows businesses to access the public markets and their cheap capital in the first place.
There is an obvious tension here. If you could somehow go public without the banks, you can theoretically avoid all of this, and that’s good for you. It is the selfish move, perhaps, but that’s fine! Your responsibility is not to preserve the integrity of the IPO process for generations hence.It’s in your shareholders’ interest, and your employees’ interest, and everyone in your world’s interest, to be as selfish as possible here.
SPACs may rip you off too, but they really work for you
So now we can talk about how a SPAC works.
While the normal IPO process starts with a private business who wants to go public, a SPAC is the opposite: it starts with a public business, that is nothing. A SPAC begins its life when a well-known promoter, like Chamath or Bill Ackman, raises money in an IPO with the following prospectus:
“I am raising money to take a company public. I don’t know which one yet; the money is going to go in a bag until I find one. When I do, my publicly traded bag of money will merge with the private business, and in doing so, take them public. You, the investors, will have your SPAC shares convert to shares in the new business, at an attractively negotiated price, plus warrants to buy more so you can profit on the upside.
Because I’m so smart, I’m going to pick a business that’s amazing and that you’ll want to own. If you disagree, you'll have a chance to get your money back. But if I’m right, you’ll make a ton on the upside.” (I wrote this in the first person, rather than in a more business-conventional third person, because SPACs are highly centred around the cult of personality of the sponsor.)
So Chamath or Bill Ackman or whoever goes on a roadshow, raising money for the blank check company. Once it’s fully subscribed, they take a 20% equity interest in the SPAC as payment for doing the work. And then they set out to go find a company to merge with. The bag of money sits there, earning money market interest, and the investors can at least earn that in the meantime (minus 20%, but ah well.)
At this point, the SPAC has some interesting advantages as a route to go public. The first advantage is certainty: in contrast to the IPO road show, where you engage with the process and then only figure out later how much you’re going to raise and at what price, with the SPAC you negotiate one time, you have a price, and it is done. (As Matt Levine pointed out, WeWork is the perfect example of a business who should’ve used a SPAC. Imagine!)
The second advantage is speed: the IPO process takes well over a year, while a SPAC has already done a lot of the work up front (they’re already public!) and can take you public a lot faster than that. (Byrne Hobart calls it “the Vegas Wedding Chapel of liquidity events”, which is perfect.) At Social Capital, we had some serious fun thinking about how to use the SPAC to take a crypto company public before the 2017 bubble inevitably burst. Now that would have been value-add.
The third advantage is brand halo: if a SPAC has an especially charismatic sponsor, they can imbue your business with a certain special kind of charm and intrigue, and maybe vault you into a higher valuation multiple. It won’t last forever, but in the short term, that may be what you need. As Byrne eloquently put it, (paraphrased): “I was long Social Capital’s SPAC before the Virgin Galactic deal was announced, on the simple theory that Chamath Palihapitiya is a) smart, and b) more importantly, very willing to say crazy things on TV.”
The catch to all of these things, of course, is that the SPAC will massively rip you off. First of all, if you look at the terms that the SPAC is offering and what their ownership targets are, they’re seeking a pretty substantial discount as they take you public relative to what you probably feel you’re worth. Second of all, the SPAC sponsor is taking that enormous 20% vig as a promotion fee. In theory, that fee is charged to the investors of the SPAC, not the target business. In practice, that fee gets passed back to the negotiated price with the target. The net result is that instead of going public and feeling ripped off by your investment bank for having sold them shares too cheaply, instead you just directly give the sponsor something like 1% of your business as a tribute offering and go straight to being public.
But then something cool happens. The business and the sponsor, who used to be on opposite sides of the table negotiating against each other, are now on the same team. The sponsor might even become the chairperson of the newly merged public business, like Chamath did with Virgin Galactic. This is very different than the dynamic with banks: it’s M&A, rather than consulting. Your negotiation is more brutal, but then once it’s done, you merge.
Unlike the bank, who never really worked for you anyway; the SPAC sponsor doesn’t just work for you; they ARE you. So there’s no reason for them to keep all of those ecosystem rules, which the businesses hate but the ecosystem collectively wants. No lockups! No greenshoe! None of those stupid things! Most importantly, total price transparency, up front. No bank will ever give you that. But a SPAC can.
Direct listing, which also had its trendy moment recently, is another way you might get around all of those IPO taxes. But there’s a small problem, which is you can’t raise any money in a direct listing; you just start trading. And often the money, and the momentum and energy around that moment of going public (so you can get more money) is really the point. SPACs are like paying up for the best of both. You get the money, and you get to feel freed from the vague promises and oppressive taxation from the investment banks. You just have to get screwed really badly, one time. But on your terms!
So the real SPAC question actually reveals itself here: how much would you pay to be taken public by someone who actually works for you? Currently, the answer is "it's probably not worth it for most people." It's a bit like "How much would you pay Facebook to get rid of ads", the answer is probably "not an option at any price". But now there is a price!
So now you can see the real appeal of SPACs: they’re a way to go public selfishly. In the SPAC mindset, the IPO ecosystem - managed by a cozy group of investment bank gatekeepers - knew how to keep a good thing going. They knew how to write the rules, how to get everybody paid, and how to keep the peace. They paid for it by taxing the companies as they went public, taking zero risk of their own, and continually passing the bill back to the company for all effort incurred. And those companies didn’t have any other option, so they went along with it.
SPACs give you a way to opt out of this system. If you’re willing to pay a massive, up-front, one-time fee to the SPAC sponsor, then they will take you public as your biggest shareholder, with maximal alignment between one another, and zero obligations to do right by anybody else in the ecosystem. I think that’s a real part of the appeal, not only for the business, but for short term speculators too. SPACs are fun. It’s fun to see something that’s just such a deliberate flipping off of the rest of the ecosystem.
I think the right way to think about SPACs is to say, the transition from private to public will always entail reputational risk; the question is which is more important: reputation among the banks and insiders, or reputation directly between the retail buying public and the company itself. In the past, the second one wasn’t really an issue, because 1) the IPO process was always so intermediated you could never test this theory, and 2) companies typically don’t go public twice. Now we have a way to see!
If Chamath can earn a reputation for pulling these things off, does he become as valuable as the investment banks’ IPO businesses? If we can repeatedly go directly to the retail public and sell these things, what happens if he lowers his 20% fee, to say, 10? Once you really have this process down, could a SPAC start to compete on cost? The conventional answer would say no: you’re still paying the blank check fee to go public, M&A fees for the deal itself, not to mention the promoter fee. But you’d be surprised where cost savings can get found in a new, hungry industry that hasn’t ossified into its Generally Accepted Margins.
SPACs today might just look like a rearrangement of banker fees into a different structure, with costs being disguised rather than saved. That's fair. But there's no way you can convince me that you can't find some real economies of scale in taking the same blank check company public 20 times in a row. Get out of here. At some point, a bank will break ranks and get into the wholesale SPAC listing business. Then we'll see what the margins actually look like.
Anyway, I can’t wait to see where this all goes, and I especially can’t wait for synthetic biology SPACs to hit the mainstream so we can have some companies that absolutely no one understands get taken public on the pure brand strength of a sponsor. We’re about to learn a whole lot about some questions no one ever thought to ask about only a few years ago! And also keep an eye out for those Canadian junior I-bankers. If you’re looking for targets, they are here to help.
Permalink to this post is here: SPAC Man Begins | alexdanco.com
Here’s a neat thing that I just learned: where the term greenshoe comes from. It’s named after the Green Shoe Corporation, predictably enough - the first company to let their IPO bankers do this as they went public. And you know what Green Shoe Corp went on to rebrand as? Stride Rite: the kid’s shoes company. As a parent of a one year old, this amused me a lot.
Also: I never really found a way to work this into the essay, but this little gem from @inagfatt is too good not to share:
Some news from the team at Shopify Money: First, Shopify Payments is now integrated with Google Shopping:
Hey Google, install Shopify Payments
Also, we’re happy to officially announce our partnership with Affirm to power installment purchases in Shop Pay:
Affirm, Shopify partner for new interest-free, zero-fee installment purchases | CNBC
Here is a nice little post from Adam Keesling about the Costco business model, and how they pull off the sleight of hand of getting premium brands to produce white label products for Kirkland Signature, at even higher quality standards, and at a substantial discount - and why brands do this enthusiastically.
How Costco convinces brands to cannibalize themselves | Adam Keesling, Napkin Math
I’ve shared this before but I’ll share it again: a really good introduction & series of thought exercises around information theory from Simon De Deo at the Santa Fe institute:
Information Theory for Intelligent People | Simon De Deo
And finally, today’s tweet of the week. No exaggerating, this made me audibly gasp (and if you’ve read this newsletter for a little while, you’ll know why):
Have a great week,
Alex