Somebody’s got to Say It: SPACs are Ultimately Bad for the Software & Tech Sector
I wish it wasn’t true, but sadly it is. The noble idea of under-appreciated companies being found by brilliant investors willing to take a chance on them and connect them with tons of capital seems so great…until you dig in.
Upfront, a question worth asking is if VCs are struggling to find good deals today with relatively fewer startups starting and more competing sources of even cheaper money, why is it that SPAC (Special Purpose Acquisition Company) candidate companies are having trouble finding capital? The simple reason is that they are generally shitty businesses. As SPACs are beginning to show, the only people that make money with them are the people who set them up who can walk away quickly with 20% of the value by flogging crap to the general public before the cat is out of the bag.
Having been in the middle of the preparation for an IPO, the due diligence is mind-numbing. I will never ever forget sitting around a giant round table with around 25 lawyers and bankers noodling through almost every word in an S1. And that is just part of the due diligence that is performed which includes calling customers and partners, reviewing every contract, and dissecting financials down to the last dollar. It is this scrutiny that protects the general public and yet some stinkers still make it through this thorough process.
Let’s break down how a SPAC works. An investor with time on his or her hands pitches forming a SPAC to investors, celebrities, and sports heroes with a value prop of assured success. The savviest provide the seed money and as a reward for the their “entrepreneurial gumption” they get 20% of the stock of the company they ultimately take public for free. The SPAC sells these shares at typically $10 a share along with the dream that they will go after a deeply undervalued and under-appreciated company in a given sector. The SPAC goes public and then has a limited amount of time to find a target, generally 24 months, to incorporate into its public entity through various financial manipulations. Once the target company is identified, the initial investors have the right to turn in their shares for their original investment if they don’t like the chosen company. The savviest then seem to do so if and only if it isn’t a good asset OR they don’t think the company can be hyped enough to offload the whole thing to the general public. Once flogged to the public, those who formed the SPAC can get out with their automatic 20% winnings and other investors can cash out before the bubble bursts. The whole process partially avoids the rigorous due diligence of the IPO process due to the ultra-compressed timeframe and method, allowing the unscrupulous and greedy to hype less-than-ideal investments. In the end, it is not exactly a Ponzi scheme, but the impact is similar. Smart money that pushed the concept gets out quickly by attracting dumb money to take its place…and as they say “a fool and his money are soon parted” as the value of the shares then plummet for the those now public companies unworthy of actually being public. To learn more, here is a very detailed primer on SPACs from PwC.
Let’s now look at a real example. Virgin Galactic is a pet project of Richard Branson. First of all, let me say I love Richard Branson. Here is a guy who started his career working on women’s health issues, became a music mogul, an airline mogul, and arguably more mogul titles in more industries than anyone in history, through a smart, inclusive approach to management and seemingly a great moral compass. But Virgin Galactic was a tough sell. When the self-designed SPAC King, Chamath Palihapitiya, targeted Virgin Galactic with his SPAC, the company had recently had two fatal accidents and only a few months of cash left according to Bloomberg-Newsweek, who’s excellent article is shining some well needed daylight on SPACs. Palihapitiya had no problem hyping the dream of space tourism. I would argue this whole pursuit of space tourism is almost pure fantasy at the moment and very far away from being a worthy investment category for a retail investor. The type of people ready to spend money on space tourism are people like Lance Bass who seems to be worth between 22 and 25 million dollars, according to multiple dubious sources, and 300–400 million dollars, according to Russian Space Agency analysts circa 2002 around the time he tried to board one of their rockets to the International Space Station. Even he, who is certainly worth at least $10 million from all of his boy-band success, was only willing to foot a tiny fraction of the $20 million ticket price himself and was focused on getting virtually all the cash from sponsors.
Certainly, prices will come down for the relatively low suborbital flights that Virgin Galactic and Blue Origin plan to offer, if they ever get off the ground. How low remains a question. Will they drop to $100,000 any time soon and if so, how many rich people are willing to foot the bill themselves? The hope is that people will recognize that there are much more worthwhile investments, like averting a climate crisis that is already upon us with signs of drought threatening to displace humanity in multiple locations on the rock we all call home. If so, perhaps humanity hasn’t yet jumped the shark and the line to throw away $100,000 for a few minutes of Instagram glory will be very short. Other sane people seem to share my sentiment as the SPACers exited Virgin Galactic with their winnings and the stock price has quickly returned to earth. And this was a well-intentioned business with a successful and smart founder, real science, a real space plane, and what seemed initially like real promise. You don’t have to look far for far more dubious SPAC buys.
I do, however, see one possible bright spot for SPACs that I haven’t seen them used for yet in rolling up a space. There are tons of companies, especially in Silicon Valley, that are built as a feature that really should be in search of a suite of technology and a real business problem. VCs only seem to roll up failing assets in their portfolio with similar assets and only in rare cases. Rollup typically only happens today with more fully formed companies that have been acquired by private equity. Here the companies have more overlap and the combination can be fairly wrenching and ruthless. A SPAC could be a vehicle to roll up companies at a much earlier stage, combining multiple feature companies into a unified solution in a 1+1+1+1=7 kind of way. Where this gets dicey, is most SPACs have just 24 months to complete their acquisition(s), so you’d really have to have industry experts in the mix with a very strong game plan. This approach would be a gamechanger for early tech outcomes, but unfortunately, I think the vast majority of investors will view this as just too hard.
Again, sadly I wish SPACs were some great catalyzing vehicle for our industry, finding hidden gems and getting them the capital they need to succeed. They aren’t. They let companies that VCs have grown tired of, given up on, or refuse to invest in achieve a shaky second life. In the process, wealthy sharks get wealthier and the general public ends up holding the bag of mostly C & D grade companies hemorrhaging cash. Where it gets bad for the whole of the tech and software sectors is where these sharks flog junk to the general public, it fails, and then the whole sector gets a bad name. If SPAC companies continue to attract more sharks to sponsor them, large investors with piles of money lying around continue to fund them, and the companies they acquire or merge with continue to underperform, I believe we will see a chilling effect on legitimate, well vetted IPOs and company valuations. There will always be people so greedy that they happily feed off the froth of the market, but SPACs make this all too easy, packaging this greed into a sure thing for the SPAC sponsors and a near sure loser for many retail SPAC investors.
In the end, the IPO process is a well-defined process for a reason. It attempts to ensure that no snake oil makes it all the way to retail investors. Again, while junk does occasionally make it through this rigorous gauntlet, it is much reduced. SPACs pervert the IPO process by design, and I believe, some of the most infamous & felonious failures they will produce will make insider-trading look like a minor misdemeanor.
There, I’ve said it. Caveat Emptor and wealthy sharks be damned, but I know society benefits far more from building quality technology with intelligent money that provides lasting value, vs. funding more G700s for a few wealthy, slick-haired hucksters willing to lie on Squawk Box.
Ken Pulverman is a five time marketing & product leader whose work has driven two acquisitions, one IPO, and a promising D series work in progress. Ken consults on the topics of strategy, marketing, and product to primarily tech companies under his brand SageCMO.