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Going pulbic is the ultimate graduation for an entrepreneur. The black belt. The Academy Award. The olympic medal. Listing your company in the New York stock exchange.
And it’s also one of the most complicated, expensive, and dangerous processes a company can go through. Last year, WeWork almost went out of businesses because they tried to go public.
More recently, as with everything in business- somebody found a legal way to cheat their way to going public, a method called a SPAC; and it may be one of the drivers to the new stock market bubble of the decade.
But to understand SPACs we need to understand everything from publicly listed companies, so let’s look into the process a company like us would take to get here in today’s company Forensics.
Alright, so let’s level the playing field first. Start with the basics.
2020, the extra Trillions of dollars the US printed as CoVid relief, have given the stock market a wave of new investors who are, for the first time, buying stocks.
I’m not saying you are one of them, what I’m saying is that they are there, and that some of them may end up watching this video. So I’m going to get down to the basics to make sure we are all on the same page.
Going public, means a company is offering its shares of capital stock to the general public." This has plenty of implications, for example, data about the company needs to be public: that’s why companies release quarterly updates which can of course, really affect their stock price, if they meet or fail expectations.
Another implication is that executives in the company are limited in how and when they can sell company shares, or they risk jail time for insider trading (that is, trading company shares with knowledge not available to the public).
Public companies face a lot of regulations and scrutiny.
Now, Before going public, a company is private. So, it's a limited number of shareholders. Quite literally what we at Slidebean do for a living is help companies with their pitch and storytelling to get money from those private investors (yeah, Youtube is not how we pay the bills).
This group of private shareholders can include the founders, maybe family and friends, Venture Capitalists, and Angel Investors.
Now, before we go any further, I want to highlight a crucial point here. Most companies don’t go public. Most companies ‘graduate’ by getting acquired. This is called an Exit.
That is, a larger company, buys all the shares from the shareholders and takes control of the company. For example, when Facebook acquired Instagram, or when Microsoft acquired Skype, and ruined it. Go watch that video.
And this is a pretty great outcome for everyone involved, assuming that acquisition price is good. You get cash in your bank account, and you retire. Or you get a head start, capital to pay your bills and invest in your new business.
We also made a whole video about that if you want to check it out.
We entrepreneurs don’t intend to work for 20 years in the same company. We build something, launch it, get it to scale, and move on!
But sometimes the company is too big, and nobody can acquire it, and that’s one of the two most common reasons to go public. These investors need a way to sell their shares and ‘cash out’.
Another reason to go public is that the company needs to raise more money to expand, and it’s reached a certain scale where they can raise money from the public, because now "anyone" can own company shares, in a stock exchange.
Most companies doing that will run that fundraising process via an IPO, initial public offering. Ironically, most of the money raised on an IPO doesn’t come from the public, but I’ll get to that.
So again, IPOs are mostly, for companies that need to raise massive amounts of money from investors, and no longer want to limit that to private firms.
Doing an IPO is no easy endeavor. A company needs to be healthy, because everyone will get to look at their numbers. It needs to prove to the world that it either has thrived or has the potential to so.
And there’s a long and hard and expensive process to list the company. And we’ve summarized it for you.
Because going public involves so much money, companies usually need to partner with a bank to get them through the entire process. There are big names in investment banking. Some of them include Goldman Sachs, Credit Suisse, JP Morgan, and Morgan and Stanley.
Everyone, but especially banks, wants the IPOs to succeed. So, it's common for the bank to assign a team of underwriters, including lawyers, accountants, PR, and SEC experts.
This team makes sure that everything goes well. And, most important, the goal is that stocks sell at the right price. Now investment banks don't work for free. They charge between 3% and 7% of the IPO's total sale.
Based on that metric, on Airbnb’s IPO, for example, the underwriters which were mainly Morgan Stanley and Goldman Sachs, could have made between $105 and $200M dollars.
In case you're wondering where the term underwriter comes from, here's a fun fact. Back when shipping was essential and much more dangerous, wealthy people were willing to cover the risk ships faced in storms.
Shipowners would write a document describing the ship's worth and estimate a value. For a profit, rich businessmen assumed the risk associated with a specific shipping route. They would sign their name under the amount they were willing to put up. Hence the name. So, they became insurance agents of sorts.
Another fun fact, Stratton Oakmond was the underwriter of the Steve Madden IPO. Wolf of Wall Street story. The guy ended up going to jail for faking documents and pumping the value of their stock.
But well, with the occasional exception, the underwriter guides the company through the entire process, and, underwrites.
That is, they provide a guarantee to the firm to sell a specific quantity of stock during the IPO process.
Remember an IPO looks to raise capital by selling shares to new investors..
So should they fail to convince prospective investors to buy a certain amount of shares, the underwriter must buy the surplus shares themselves.
Which is generally bad business.
To avoid having to spend a lot of money on a failed IPO, the underwriter must therefore work especially hard to sell all available shares. Them, and company executives often go on a roadshow across the country, to get firms to commit to buying shares at the IPO event.
If the underwriter ends up with a lot of unsold shares, they can still sell them in the market- but they need to be careful, because suddenly dumping a lot of shares can drag the price down, hurting everyone in the transaction.
The next step is fascinatingly bureaucratic.
Of course, you cannot put aside paperwork. And, a lot of an IPO is just that: paperwork. About three months before the actual IPO date, the team must present documents that include:
- An engagement letter
- Letter of intent
- Underwriting agreement
- S-1 Registration statement
- Red Herring document
Let's talk about the S-1 Registration, which we've mentioned multiple times in our episodes.
It's a crucial bit of information. If companies want to be a part of a national exchange like NASDAQ, they have to turn in this form. It's the company saying: hey, I'm might go public. So, news outlets are always on the lookout for when S-1 statements come in.
The most important part of the S1 form is the prospectus: a legal document that requires information on the following: business operations, the use of proceeds, total proceeds, the price per share, a description of management, financial condition, the percentage of the business being sold by individual holders and information on the underwriters.
Oftentimes, an S1 filing is the first look the public gets and what’s really going on inside a company. It was the absolutely ludicrous S1 form filed by WeWork that brought the company down.
In it, the company acknowledged how much money it was burning, the insane spending by the CEO and the unrealistic company vision. More importantly, it revealed how WeWork was this standard real estate company disguised in fancy tech terms.
Another important document in this part is the Red Herring document. It's a prospectus that contains most of the company's information on operations and prospects. But, it leaves out information such as the share price and amount offered. It creates interest but doesn't reveal much.
So, once all of these documents are ready, it's time for the next step.
You might have heard this in the news. X company has filed its IPO.
Well, it's all of these documents in order and delivered to the SEC.
The SEC does a thorough revision of all the documents to ensure that everything's in order. It's common for us to hear about the SEC regulating this or checking that. And, yes, the Commission has the party-pooper image, but it has a point.
During this time, the company must enter a Quiet Period, in which information disclosed by the company must follow careful guidelines.
At this point, the team is hard at work defining the number and price of the shares they will put up for sale.
The catch with this step is that each IPO is different. It depends on many variables that change from company to company.
Of course, the investment bank needs to make money to make up for the underwriting and, hopefully, make a profit.
You have to consider factors like the project demand: do we expect people to buy these shares?
Then, there's the market itself. An IPO before the dot-com crash isn't the same as months after the bubble burst.
Finally, there's the challenge of setting the price. The initial share price can't be too high.
Otherwise, people won't buy stocks. If it’s too low, then the company effectively leaves money on the table.
Some notable examples: Facebook IPO’d at $38 per share and closed at $38.23. This could be seen as a well-priced transaction.
Airbnb on the other hand priced its IPO at $68 per share, and closed the day at $146. I’m oversimplifying here, but this potentially means that they under-priced their IPO. There was more demand for their shares than they anticipated.
This is a very delicate game, aided by a process called Stabilization.
All this work can go belly up in a matter of days, maybe hours. So, immediately after the IPO, underwriters can take part in a process called stabilization.
In short, the underwriters buy enough shares for the market price to stabilize. Supply-and-demand.
If the shares aren't selling, then the prices will drop. So, underwriters can do a series of purchases and sales to make it seem as though demand is up. And, yes, it does sound like cheating. But it works.
There are two ways about it.
The first way is by using the Greenshoe option. Underwriters can sell more shares than initially planned. But then, they repurchase them at the original IPO price.
If the share price decreases, the underwriters buy the excess shares. Because they sold them for more, they make a profit.
If the share price increases, the underwriters can buy the shares at the original IPO price and avoid loss.
Then, there's another way: The Lock-up period. This period lasts between 90 to 180 days after the IPO.
In this option, insiders with shares before the IPO cannot sell their stock for a determined amount of time.
If the IPO is a huge hit, pre-IPO shareholders might want to dump their shares for a profit. The market floods, and the price drops. The Lock-Up prevents this.
Now, all of this sounds like a cheat code. But, it's legal, and the SEC allows it. All the underwriters have to do is set the conditions in the contract.
Once this period is over, everything is public. The underwriters no longer have control, and the market dictates whether the stock goes up or down.
Winners are winners. Losers are losers, and the stock market continues its crazy ways.
After that, it’s smooth sailing.
Let’s talk about direct listings now.
Direct listings are used when the company wants an exit, but doesn’t need to raise money.
Let’s say the founder of a company owns 10% of their business, after going through multiple rounds of funding. That business, according to the latest valuation, is worth, say, $500M. This founder’s net worth is $50M, but he can’t really do much with that money.
Does he believe in the company? Yes. Will he or she hold most of their shares, because they believe they can continue to increase value? Yes.
But they also probably want to pay their mortgage and diversify their portfolio, or I don’t know, get that Tesla they’ve been wanting, invest in other startups, attend Wimbledon before Roger Federer retires, because it’s his idol and he’s tried to fly to see him play twice, but the plans were ruined by a military curfew in Bogota, then him getting knee surgery, and finally, and a global pandemic.
The most commonly used approach to sell those shares is to do a Direct Listing, which is what Spotify and Slack did to go public.
Both of these companies had a significant presence in the market, and in people’s mindsets. They were doing well. At the time, there was no possible buyer- but the founders and the stockholders needed a way to cash out of their investments.
The steps to doing this are pretty similar. You have to file an S1 with the SEC, get it reviewed, go through a Quite period. A boring deja vu.
The biggest difference is that there is no underwriter, the company saves a lot of money by not going through a bank, but at the same time, the transaction is much riskier.
Unlike an IPO in which the share price is negotiated beforehand, in a direct listing the price of the stock depends solely on supply and demand. This increases volatility, as the range in which the stock is traded is less predictable.
In both cases, the added costs of being a public company, including financial and compliance experts, filings, advisers, more experienced executives.. adds around $2.5M to the company costs.
Let’s say that you want to skip all this hassle and get right to business. That’s pretty much what SPACs are about, and why they are so risky.
The process for a SPAC is pretty simple. Spac stands for special purpose acquisition company.
1- A well-known investor, which we will call the Sponsor, decides to raise funds for their SPAC. The SPAC is essentially an empty company that doesn’t do anything, it just has funds, provided by the investors.
2- The purpose of this shell company is to buy another, real, operational company. But disclosing what that company can be is not really possible.
The whole idea here is that if the investors can raise the funds for the SPAC, say, $100M, it will take this shell company public. If they disclose what company they intend to buy, regulation makes it more complicated.
So hence the common name for SPACs, blank check companies.
3- This IPO is very easy. The company has no trade, no historical numbers, it’s just a pile of cash, so going public is easier and cheaper.
4- Once the company is public, the pile of cash can be used to acquire a real company. The two companies merge and now the real company that they just acquired, becomes the public company; but it effectively avoided the S1 filing, the scrutiny, the underwriters!
SPACs are usually launched with a simple, round $10 per share price. So you, average investor, can get in on that company when it gets listed on the stock exchange.
But again, there’s no way of knowing which company will be eventually acquired. You are just putting your trust on the sponsor.
And there’s a celebrity variable here: Shaquille O’Neal, Stephen Curry, Serena Williams, and even Colin Kaepernick all have been involved in SPACs.
Now, if we look at the rules for SPAC, we can begin to find stuff that raises eyebrows.
The person who launches the SPAC, ie the Sponsor, and their first investors get a heavy discount on their shares. Essentially they get to buy 20% of the company for fractions of a dollar, while all the other investors have to come in at $10 a share.
While the company that gets acquired doesn’t suffer from this, the SPAC investors do. Their cash essentially gets diluted 20%.
Another rule is that the SPAC needs to complete a company purchase within 2 years, usually. If that doesn’t happen, there’s a clause that returns the money to the investors.
That’s all great, but if SPAC manager has, of course, an incentive to get A company, any company, so that they can make that beautiful 20% commission.
The investors on the SPAC do get to vote on what company gets purchased, but the clock is ticking and that might put pressure on doing a deal faster.
That’s just my skepticism on the basic rules of a SPAC, but let’s look at some data, and some examples.
First, some examples of companies that have gone public via a SPAC.
Nikola is an example, we made a whole video about them. If you look at the chart, you’ll see the period at $10, before the acquisition was completed- and then an insane spike in value, up to a peak of $64. Then, down, back to $11 as of writing.
The seemingly most successful SPAC in 2020 was a company called QuantumScape, focused on battery technology, that reached a peak value of $84 and is now down to $32.
A brighter story is DraftKings, a digital sports entertainment company that went from $10 to $57 and seems to continue to grow.
Virgin Galactic also went public via a SPAC. The stock went up 35% in 2020, reached a peak of $54 in February 2021- but then crashed back down to $21 at the time of writing.
But what does the aggregated data tell us?
Of the 313 SPACs IPOs since the start of 2015, Renaissance capital analyzed 93 have completed mergers and taken a company public, as of October 2020.
Of these, the common shares have delivered an average loss of -9.6% and a median return of -29.1%, compared to the average aftermarket return of 37.2% for traditional IPOs in the same period.
Only 31.1% had positive returns as of that date.
Harvard went even further with a study of 47 SPACs that happened between January 2019, and June 2020. This paper (which I’ll link in the description) drew a line between ‘high quality’ SPACs, which are those sponsored by high-profile private equity firms, or former CEOs of Fortune 500 companies.
‘High Quality’ spacs - had a return of 31% by the three month mark, 15% at the six-month, and -6% at the 12 month. Low quality was always negative, going from -4.6% at three months, to -34.6% at 12 months.
The data doesn’t really lie here, everyone seems to agree that these transactions don’t perform well. But it seems that people ignore the data, sometimes.
This is the number of SPACs in the US since 2009. That bar in 2021 is as of March 2021, we still have 9 months ahead of us.
People have been pouring money into these things like never before.
Bill Ackman did a so-called Super-SPAC called Pershing Square Tontine Holdings (PSTHU)- which raised $4 billion, and became the largest SPAC offering of all time- and that of course happened last year.
308 SPACs have raised $99.7 billion so far this year, according to SPAC Analytics.
These are blank companies that are not producing anything, and their value drives up just based on the hype of what they might buy. It’s inevitable to compare them to the dot com bubble, but got a lot of shade for doing that a couple of weeks back.
Remember, these are companies that will need to merge/acquire something. That's 1,000 mergers expected this year, from SPACs that haven’t done it yet.
Remembering 1999, there were 489 IPOs, right before the bubble burst. Since then, that number has never been matched.
Some reasoning seems to have hit the market, and a lot of SPACs saw heavy crashes since February.
The SEC started an inquiry, and the number of New SPACs expected for April went down to 0. These news are probably going to change as we finish editing and producing this: it’s April 26th today.