SPAC fever 2021: Recommendations for early-stage start-ups
Special Purpose Acquisition Companies ("SPACs") are companies that are listed on the stock exchange as empty shells and are used to raise capital which, at some stage, is invested through a merger with an operating company, saving the operative company the complex procedure needed to become listed on the stock exchange. In 2020, 248 SPACs went public in the US, raising around USD 83 billion in capital that they used to acquire (mostly) technology companies.
While the focus of SPAC activity has clearly been the USA until now, since the end of 2020, there has been a significant increase in activity in Europe, too. Rocket Internet recently established a SPAC, HelloFresh founder Dominik Richter also established a SPAC together with another investor, and J.P. Morgan Chase announced that it was establishing a growing team of specialist consultants to advise only SPACs in preparation for what they expect to be a SPAC-led takeover boom in Europe (Börsen-Zeitung, 17 February 2021, pages 9 respectively 16).
This is good news for the venture capital sector in Germany and Europe as it means there is now a third significant exit option in addition to a trade sale to a private investor/purchaser and the classic IPO (Initial Public Offering, the first time shares are offered to a capital market as part of an increase in capital stock). Access to capital for start-ups and scale-ups is improved and flexibility for investor strategies is increased, as more and more SPACs are established as an acceptable exit variant. They even make venture capital and private equity investments more democratic because shares in a SPAC that is listed on a stock exchange can be acquired by anyone. Such investment options and strategies are otherwise only available to classical venture capital or private equity fund investors after they have made a high minimum investment.
Against this background, some founders or early investors might ask themselves whether the SPAC boom could have an impact on the equity story of their own company. The simple answer is: unless there is an impending exit, no. However, it is worth looking at the situation more closely and working out possible indirect effects and recommendations for action so that the start-up is optimally positioned to profit from the capital available via SPACs.
1. Basic "SPAC" Exit Option
First, we recommend that founders and early-stage investors generally address the possibility of introducing a SPAC at some point in the company’s equity story. Of course, we don’t mean that you should address this exit variant in detail when working on the proof of concept. However, you should recognise and be open to the possibility and act accordingly. When it is the right time, things often have to move quickly, so it will be vitally important for transaction security, in other words, the likelihood that a merger with a SPAC will be completed successfully, that the company is compatible as a takeover target. In this respect, the operative and legal/financial structures of the start-up will be important.
2. Establish Operative and legal compatibility
By operative compatibility, we naturally mean that the SPAC management must have confidence in the product or service of the start-up. It is also important that the start-up has sound economic organisation, which is par for the course for most of the founders that we know.
Rather than focusing on legal issues, the first workshop in our series of free workshops developed for early-stage start-ups focuses on how the internal forecasts can be drafted from the start in such a way that they can be used as a reliable and flexible planning tool. This makes it easier to ensure that the company valuation is correct and can be relied upon during negotiations with investors and makes a good impression on early-stage investors. You can find more information about our workshop series under: Start-ups & Venture Capital | BEITEN BURKHARDT (beiten-burkhardt.com).
On the legal level, the recommendations are only little different to normal:
We recommend that almost every start-up prepares its documents primarily in English (with the exception of the articles of incorporation or other documents that, for compelling reasons, must (also) be in German) to make it easier for foreign investors to carry out their due diligence and make the company more attractive to such investors. This recommendation becomes more important where the potential takeover by a SPAC is concerned because even European SPACs often have a foreign legal form and thus have to provide their legal documentation in English or otherwise decide to do so.
We also recommend that the circle of shareholders is kept small or at least easy to manage. If there are already numerous shareholders, from multiple founders and family and friends to the first business angels and even several venture capital funds, voting pools, appropriate spokespersons and powers of attorney can be used to signal to potential purchasers that you have thought about ensuring that the shareholders are well organised so that takeover talks can be held efficiently.
A further issue, which is already finding more and more consideration for VC investors and start-ups, irrespective of the SPAC phenomenon, is ESG (Environmental, Social and Corporate Governance ("ESG") are sustainability criteria which more and more frequently play a role in the fitness of a company for an investment, and may even be decisive, especially when the result of an ESG due diligence is negative). Recently, ESG compliant companies have shown better returns on equity than companies that don’t comply with ESG so that the point of ESG is not merely about improved reputation. As SPACs are (1) listed on the stock exchange and are thus listed companies, (2) most have an Anglo-Saxon legal form, and (3) the takeover target will automatically be a publicly-traded company after the takeover, the fulfilment of ESG criteria is an obligatory condition. In this context, the timing of an acquisition by a SPAC may be crucial: At least under U.S. capital market law (and most currently active SPACs are subject to US law), a SPAC only has an 18-month window after listing on the stock exchange to invest in a suitable company. A large part of this period will be spent searching for a suitable target, so the length of the transaction process can become very relevant. If ESG criteria have to be implemented first, this can be a dealbreaker due to time constraints. On the other hand, the chances of an exit via a SPAC are very positively influenced if ESG is lived and implemented in the company from the very beginning.
You don’t need totally new measures to make a start-up “fit” for takeover by a SPAC, just the considered implementation of largely well-known recommendations.
In one respect, SPACs are similar to an operative start-up: As it is purely an acquisition vehicle and, at the time of listing on the stock exchange, i.e. when the investors decide for the first time whether they want to invest money in the SPAC, it is not clear whether and when the takeover of a promising company will be successful, the success of the SPAC will almost exclusively depend on the ability and the network of its management or the founders of the SPAC. For this reason, SPACs that are formed by successful companies or investors and listed on the stock exchange are particularly sought-after, collect above-average levels of money and, with greater resources, then have a larger choice of potential takeover targets. Above all, as with investments in start-ups, SPAC investors must have trust in the team.
Optimistically, you can speculate: Perhaps this common benchmark, against which SPAC management and a founding team must be measured, will ensure that SPACs and start-ups have comparable mindsets and that, over time, SPACs will become an ideal exit option for start-ups.
SUMMARY / TIPS:
(i) Consider a “SPAC” as a basic exit option: All decisions with an effect on the exit situation should take the new SPAC variant into account. Of course, this should not be the dominant issue in the early stage but merely requires that decisions which would be taken anyway take this additional criterion into account.
(ii) Establish operative and legal compatibility: The start-up still has to be “found” by a SPAC first, but, once the transaction has started, is very likely to want to successfully conclude it (which is mutual). For this to happen, the business model, which catches the attention of the SPAC, must be anchored in a solid business and legal structure. From a legal perspective, this means in particular: (a) best practice documents, where possible from day 1, (b) contractual documents in English, (c) a small or efficiently structured circle of shareholders (“Keep your cap table clean”), and (d) the early implementation of ESG criteria.
Dr Mario Weichel