A dozen years ago, longtime board director and chairman Stephen Kasnet was involved in a handful of private company-to-public company transformations leveraging a Special Purpose Acquisition Company or SPAC. Among them is Two Harbors Investment, a real estate investment trust, whose board he presently chairs.
“Back then, SPACs were considered an attractive way for a savvy asset manager to raise capital from a list of sophisticated investors, with the goal of finding a reasonably mature private company needing capital and a real board of directors to advise it,” says Kasnet. “Once the company went public, the SPAC sponsor and the investors typically became advisors and board members. It was considered a viable way for private investors to bypass the normal IPO process and tap growth capital from the public markets.”
SPACs are still that today, but the rationale for their formation has altered. Rather than investors investing in a SPAC to acquire a “reasonably mature” private company, they’re plunking down their pennies to buy innovative startups and companies experiencing enormous demand increases during the pandemic that need growth capital—fast.
Speed is perhaps the best advertisement for forming a SPAC, a shell company developed by a fund manager to raise capital from investors to form a public company that subsequently acquires an existing private company. Once acquired, the private company merges with the SPAC and assumes its spot on a stock exchange.
After a relative pause in their formation, SPACs are exploding in number. Active and filed SPAC IPOs in 2020 were on track to become 200 new public companies worth some $300 billion, according to figures compiled in November by Ernst & Young Capital Advisors. Three years earlier, SPAC proceeds tallied a comparatively meager $10 billion.
The big numbers are attracting private company board attention to what has historically been a less traveled road to the public markets.
“Investors eager to do a SPAC transaction are finding eager startups wanting a faster route to an IPO,” says Karim Anani, who has shepherded 45 successful SPACs to the public markets in the last nine years as the co-leader of EY Americas’ SPAC practice. Speed is the reason why. “Compared to the 18 months to two years it takes to go public in a traditional IPO, a privately-held startup can go public in 90 to 120 days,” he says.
Not just startups are keen to prospect in the capital gold rush. “Industies growing during the pandemic like technology and biotech are looking for immediate sources of growth capital to fuel faster growth ahead,” says Nicholas Tsafos, partner-in-charge of EisnerAmper’s New York office. “So are embattled sectors like retail, real estate and hospitality, which are looking for capital to consolidate at bargain prices to be ready for a post-COVID return to some type of normal. In both cases, by virtue of avoiding a time-consuming road show, a SPAC can provide this capital fast.”
The sheer number of deals executed in 2020 affirms this interest. Seemingly overnight, board members are impelled to understand the pros and cons of a capital-raising strategy that many had heard about, but few had experienced. Among them is Barbara Duganier, chairman of the National Association of Corporate Directors and a sitting board director at three private companies and two public companies. “I’ve never come across a SPAC during my board service, although I’m certain at some point one will cross my path,” Duganier says.
To prepare for this possibility, Duganier says she has attended a “lot of seminars lately” on SPAC formations and the liability presented for board members. Other directors should be doing the same thing.
“The challenge with speed to market is that it may not allow enough time for the former private company to put in place the proper governance and infrastructures needed to address complex public company compliance issues like financial statements and SEC filings,” says Derek Malmberg, partner and leader of Deloitte’s US SPAC practice.
These complexities are more intricate in SPAC deals. Public companies created via a traditional IPO, for instance, are granted a one-year waiver to comply with the SEC’s internal control compliance regulations, giving them time to get their house in order. A public company created through a SPAC, on the other hand, must comply with SEC’s rigid compliance timelines from day one, with no grace period. To be ready, the target acquisition must devote considerable time and resources to highly technical accounting and reporting considerations.
Obviously, given the shorter timeframe of going public, these considerations may not be given the attention they require. “By using a SPAC to bypass the normal IPO process, you run the risk of removing several levels of due diligence,” Kasnet says. “If the post-SPAC company isn’t truly ready for public execution, it can put the board directors in jeopardy.”
Speed wins car races but can backfire with an ill-conceived SPAC strategy and execution, says Anna C. Catalano, an independent board director at several public company and privately held corporations, including audit firm Willis Towers Watson and polymer manufacturer Kraton Corporation.
“Road shows take time but that’s not necessarily a bad thing; they force a narrative to tell your story,” says Catalano. “The story helps you prepare to answer tough questions from multiple (investor) audiences, creating a depth of thought that is healthy,” she says. “If the SPAC sponsor isn’t well versed in going public and doesn’t have its act together, it can create serious issues for board members.”
Caution and Care
Any time an alternative way to access growth capital from the public markets attracts wide attention, board members need a splash of cold water in the face. Although SPACs have been around for a generation and enjoyed a previous spurt prior to the financial crisis, their current popularity warrants a reality check.
“There haven’t been many D&O (directors and officers) liability claims in this space to date, which is encouraging, but there are ways that board members can really stub their toes,” says longtime D&O attorney Dan Bailey, partner at law firm Bailey Cavalieri.
Bailey pointed to two serious liabilities, one generated by board of director disclosures and the other on director mismanagement—a breach in the members’ fiduciary duty that results in a shareholder derivative lawsuit.
“All IPOs are viewed as a high-risk exposure for board members from a disclosure standpoint, since you’re a fresh company moving from a relaxed regulatory environment to one that is highly regulated and scrutinized,” Bailey says. “In a SPAC context, due to the accelerated process, I would make the argument this exposure is a notch higher. Speed often equates to cutting corners, which can result in disclosures that are not as robust as they should be.”
“Speed exaggerates the need for directors to be more careful and informed,” says Donald Mrozek, chairman of law firm Hinshaw & Culbertson. “Any time you put a short timeframe on things, which is what the fund manager is selling when it puts together a SPAC, it can backfire (for board members), creating the potential for a violation of their fiduciary duties.”
A bigger board concern is alleged director mismanagement. Both the boards of the SPAC and the private company with which it will merge are subject to this liability. “Once the SPAC’s board raises the capital to acquire the private company, the question arises over the level of due diligence they performed in investigating all possible merger candidates,” Bailey explains.
He pointed out that a SPAC sponsor, by law, has two years upon the development of the SPAC to complete an acquisition’ otherwise, the SPAC is dissolved. “If the target acquisition hasn’t been selected at the eleventh hour, the SPAC may rush into a deal without the requisite due diligence,” Bailey says. “If they pick a loser, the SPAC directors could face a mismanagement exposure.”
“A concern with a SPAC is will the private company trade well once it becomes public,” says Jonathan Foster, who sits on nine private and public boards and is the founder and managing director of M&A advisory firm, Current Capital Partners. “A few years ago, for example, we saw these cupcake bakeries explode on the scene. SPAC sponsors successfully marketed the companies to investors. And then the bubble bust.”
Foster is referring to gourmet cupcake bakery Crumbs Bake Shop, acquired by a SPAC in 2011 for $66 million. Three years later, Crumbs declared bankruptcy after the cupcake-craze fizzled. Although some Crumbs shops later reopened, they closed for good in 2017. “You need to focus not just on doing the acquisition but on whether or not the operating company has reasonable growth prospects to trade well in the marketplace,” Foster says.
Director mismanagement exposures also confront the board of a private company acquired by a SPAC. “The directors need to thoroughly vet who they’re getting in bed with; they need to be perfectly comfortable with the SPAC sponsor’s experience, expertise, reputation and track record,” says Bailey. “If not, and the marriage goes forward and founders, it could be construed as an alleged breach of fiduciary duty.”
He adds, “I don’t want to overstate things, but SPACs are a potential minefield if board members aren’t careful.”
To avoid tiptoeing into one, investors in a SPAC that join its board, and the board members of private companies targeted by a SPAC sponsor, should consider retaining outside independent counsel to vet all aspects of the transaction, ensuring the valuations and pricing are fair and the disclosures are up to snuff.
“In terms of the operational distractions and regulatory oversight, you’re looking at a completely different set of rules and ways of doing business,” says Bailey. “A lot of private companies aren’t prepared or know what they’re getting into. It’s a brave new world.”
Emphasis on brave.