The Venture Capitalist View On SPACs
When I heard that Shaq and Ciara were sponsoring SPACs, I was worried. It looked like a beloved financial vehicle was jumping the shark. But Warren Buffett reassured me. When he called SPACs “ a killer” for his business because they were undercutting Berkshire Hathaway on deals, I knew it would be okay. In my opinion, it’s unwise to bet against Buffett, but anyone outcompeting him is doing something right.
Instead of another primer on SPACs, I’ll share the venture capital (VC) view, which is what I know best. VC is ambivalent about SPACs. There are tradeoffs involved, and tradeoffs are what negotiation, economics and decision-making are all about, and those things are what VC is all about, so our ambivalence cuts to the core of the SPAC phenomenon.
SPACs Are Exits, And Exits Are Good
Why do VCs simultaneously love and mistrust SPACs? Glad you asked.
Exits are when startups mature, go public and move into their own place. They transform years of hard work by VCs, employees and founders into cash. That cash lets VCs impress our limited partners (LPs) with handsome returns, reinvest in our next fund and pay our children’s tuition.
SPACs are exits. Exits are the goal.
Exits have to be done right. They need to pay everyone for the value that their years of work have generated. However, SPAC performance is very inconsistent, and VCs and SPAC managers have conflicting motives.
With regards to performance, one study found that only around a third of SPACs outperformed the S&P 500 — a low bar indeed — and 60% never even got around to investing. With such results, the average investor should be disappointed, and the average VC should be fired.
Sometimes SPAC sponsors aim for the lowest valuation possible for the sake of an IPO pop, which gives them and their shareholders the greatest possible profit. From the VC perspective, however, an IPO pop means the stock is sold at a discount.
SPACs Are A Natural Move Downstream
True, founders and VCs can hold the stock after the SPAC merger until its price attains what they consider a fair value. But time is money. If a SPAC merger delays the VCs’ exit by 6 or 18 months, their LPs will have to wait for their returns, and the VCs’ IRR — their key metric — will suffer.
Some VCs are angels, others wait for the growth stage and still others bet on the unicorns ready to grow another 10x. VCs using SPACs to reap exit returns have simply moved downstream. Many SPAC sponsors, such as Vinod Khosla, Chamath Palihapitiya and Peter Hébert, are also capable (but fallible) VCs.
Image Is Everything, For Better …
And while the conflicting motives described above still apply, every VC investing in a later round tries to buy at the lowest valuation possible, and every VC who’s already invested tries to achieve the highest possible valuation in any subsequent round. That’s just the game.
SPACs also have the advantage that they can trade on image. Conventional IPOs are highly regulated, and the auditing requirements are no joke. Companies going public conventionally have to trade on their past results. A company exiting via SPAC merger, by contrast, has greater leeway to release and emphasize projections of future earnings.
That’s good news for VCs. If they’re lucky, some of their company’s future growth will be priced into its exit today. And less stringent regulations should, in theory, reduce the cost of exiting.
… Or Worse
And a SPAC run by Vinod Khosla is likely to be managed efficiently and professionally. SPACs give average investors a chance to profit from such acumen, which is normally reserved for select LPs. A manager’s good reputation can help the SPAC trade on that image and help non-professionals choose sound vehicles. In that sense, SPACs seem to be democratizing private equity, shifting opportunities from investment banks to retail investors. There’s no reason for us VCs to object.
Democratization is great, but democracy must be more than two wolves and a sheep voting on what’s for dinner. In many SPACs, non-professional investors are just targets for dilution. And institutional investors can lose, too. When investors redeem their shares days before finalizing a merger — redemptions exceed 60% now — PIPE remains committed to a suddenly shaky proposition. But the celebrity sponsors win regardless. SEC should definitely tighten the rules here.
Image is overshadowing reputation. While this trend is not new, it has only recently become the whole point. Investors prizing celebrity brands instead of balance sheets are new. Image has always mattered, but it hasn’t always been the only thing that mattered.
Haste Makes Waste
The problems from a VC perspective are inefficiency and hype. SPAC managers typically pocket around 20% of the post-IPO value. Shaq’s SPAC is aiming to raise $250 million. How much does Shaq deserve for endorsing a deal that, presumably, would make sense without his affiliation? Fifty million? Really? Investors and those using SPACs as exit vehicles suffer. In my opinion, hype is only good for those collecting the 20% hype premium.
Like IPOs 25 years ago, SPACs have become a brand in themselves, something that even lay investors have become familiar with and excited about. What’s good for SPACs is good for finance, and what’s good for finance is good for VC.
But finance, like evolution, is subject to the Red Queen hypothesis: the most important factor in any market (or ecosystem) is what the other actors are doing because everyone is trying to eat everyone else’s lunch. (Warren Buffett’s sandwich is delicious.) SPACs are helping companies make fast, sometimes profitable exits, but investors need to make sure they are the beneficiaries and not the product. It’s easy to promise fabulous returns, especially for celebrities, but much harder to deliver them.
Smart VCs treat SPACs as one exit option among many — not a profit-generating panacea — and they’ll continue to evaluate each deal one by one on its merits.
Originally published at https://www.forbes.com.