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Irrational Exuberance

April 05, 2021  /  Steffen Bartschat

A year ago, our planet was plunging into the big unknown of the pandemic. Today, we have largely recovered from the second major COVID wave in the Bay Area and as restaurants and gyms are reopening, there is hope the relaxed restrictions will stick this time – after all, over 25% of our population has already received its first dose of the vaccine.

On the stock market, there was a giant plunge a year ago but it quickly recovered. The feared black-swan, nuclear-winter investment pause for startups never happened. We are now back in record territory and everyone is dreaming about either forming a SPAC (Special Purpose Acquisition Company) or getting acquired by one. The ludicrous valuations driven by SPAC acquisitions remind me of the IPO froth at the beginning of the new millennium. Rumor has it that in those days, VCs were trolling the hallways of Stanford Business School, desperately writing checks to any MBA student with a draft business plan.

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Is it 2000 all over again, when we were all busy ignoring Alan Greenspan's infamous advice? Before answering that question, here's a one-paragraph primer on SPACs: SPACs essentially flip the IPO process on its head. Traditionally, a company is founded, builds a cool product, scales up sales, then goes public. A SPAC starts the process by going public - as a "shell" company with no product, no sales, no office building. After its shares begin trading on the public market, it goes on the hunt to acquire one or more startup companies. When it has found one, the SPAC issues a press release, announcing a merger or acquisition - and watches the resulting fireworks on its stock price.

It is interesting to think about the winners and losers in the typical SPAC deal:

The Winners:

  • SPAC founders – yes, they have to put some small initial capital at risk to cover the IPO expenses, but they will get a big share of the company when they make a successful acquisition.

  • SPAC institutional investors – this group buys the initial shares of the SPAC (usually valued at $10/share) during the IPO process and it sounds like a no-lose proposition. Their money goes into a trust fund that can only be spent on an acquisition (not on SPAC expenses). Further, when an acquisition is announced, if they don’t like it, they can take their money out of the trust without penalty. Further, they get warrants that allow them to buy additional shares, later, at a significant discount.

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  • Startups - the startups considered for acquisition can negotiate a firm valuation with the acquiring SPAC principals as opposed to going through the rigmarole of the traditional IPO process that includes lengthy road shows, disclosures, and quiet periods and the attendant risk that a change in market conditions during this process can change the expected share price or even sink the IPO altogether.

  • Startup investors – SPACs tend to drive the startups to an IPO sooner than it would be possible under normal circumstances, and currently, with so many SPACs looking for companies to acquire, valuations are quite favorable. Startup investors see a good exit sooner.

  • Startup employees – Startup employees normally would have had to wait for years before they could exercise their options after an IPO. If they decided to leave the company before the IPO, they would need to decide whether to put their own capital at risk to exercise their options at the time of departure. Now, their options are exercisable without risk to capital within a short time after the merger is completed.

The Losers:

  • The momentum investor that buys into the SPAC after its IPO, and especially after the acquisition target is announced – that’s usually when the big price spike occurs, but in many cases it doesn't very last long.

  • The SPAC founders could be losers if they don’t find a suitable acquisition target. The SPAC's institutional investors get their money back if an acquisition is not made within a certain time frame (typically two years), but the founders’ money is burned during the IPO process and while looking for a suitable acquisition target.

  • VCs that specialize in late stage (Series B+) deals. These VCs were capable of putting up the large amount of capital required of late stage companies looking to scale globally - and in return they could extract a lot of onerous anti-dilution “ratchets” and liquidation preferences. No one wants to deal with them now – the smart VCs are forming their own SPACs.

So does 2021 resemble the 2000 dot com froth? There are definitely similarities when looking at momentum investors – they were the first to buy IPO shares on the open market back in 2000, and they are the first to buy in now post-IPO and post-deal-announcement.

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And what would compare today with the desperate VCs roaming the halls of Stanford Business School in 2000, looking for deal flow? Well, you might see some desperate SPAC sponsors in 2022, nervously looking for an acquisition deal before their SPAC expires.

But one thing is different now - you won’t find those target startups in the imagination of an MBA student – remember, the SPAC institutional investors with their money in the trust fund need to approve the deal or they will sink the acquisition. So the acquired startup needs to have a rational story that includes big profits in the future. But, judging by projections made by companies involved in a some recent SPAC deals, I am starting to wonder how “rational” these stories really need to be…

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