How Spacs Work

Shell companies have become a popular way for startups to get on the trading floor. But they are not always the right path for startups.

A Special Purpose Acquisition Company (Spac) can be a good shortcut for start-ups to go public. Hundreds of Spacs around the world are looking for startups suitable for this. The air taxi manufacturer Lilium from Weßling near Munich, for example, recently went public via a Spac.

Most Spacs are based in the USA, but there are now also a few of these shell companies in Germany. But an IPO organized in this way can also go wrong. An overview of how Spacs work and when founders should perhaps rather go for a classic IPO.

What exactly is a Spac?

A Spac is a company that was founded with the aim of acquiring another company and thus taking it public. This company has no business of its own. In order to finance the takeover, the Spac raises money from venture capital investors, hedge funds or other companies. Private investors can also take a stake in the shell companies.

In the USA, Spacs raise between 50 million and two billion US dollars to either merge with one company or take over several at once. To find a suitable takeover target, the manager of the Spac has 24 months. If, for example, he does not find a suitable start-up, the investors get their money back. If the manager has found a takeover candidate, investors can still walk away from the deal and ask for their money back.

What are the advantages and disadvantages of Spacs for investors?

Put simply, Spac investors make a profit if the share price of the acquired company improves after the IPO. But behind this lies the problem: if the share price of the acquired company does not rise or even falls, they make a loss. Investors often have no choice but to trust the space manager. He has to have a good sense of whether a takeover is really worthwhile. The longer it takes him to take over a suitable company, the worse the deal he closes is likely to be. Critics worry that he is more likely to pull off a bad takeover than pay back the money.

There are currently hundreds of Spacs looking for suitable candidates, that they will all find one whose share price subsequently goes through the roof is considered highly unlikely. That's why criticism of Spacs keeps coming up. In an interview with Startbase, founder Nils Seelbach states that for him Spacs are the sign of a completely overheated market. He would rather ban Spacs altogether.

When are Spacs worthwhile for start-ups?

Shell companies are a shortcut to the stock market for young companies. Through them, it sometimes takes only a few months to jump onto the trading floor. This is because the start-up that wants to go public only has to negotiate with the Spac. Normally, an IPO takes up to 18 months of preparation. In a roadshow, the management normally has to search for several investors.

A Spac theoretically allows start-ups to go public that are actually not yet mature enough for this step. Either because they do not yet have significant sales or, in case of doubt, the business model does not even really stand up. Start-ups could also convince a Spac investor with future planned sales. This usually doesn't work with a classic IPO, because in that case investors are usually not willing to take on such a risk.

When should start-ups do without a Spac?

Founders should keep in mind that when they merge with a Spac, they have to give up a good portion of their shares directly to the Spac owners. That could be as much as 20 percent. Incidentally, if the shareholders of the newly merged company sell their shares directly afterwards, the share price may fall.

The first Spac in Germany was set up in July 2008 by ex-Arcandor boss Thomas Middelhoff, management consultant Roland Berger and ex-banker Florian Lahnstein. After reportedly looking at around 140 companies, they merged with AEG Power Solutions. But the power supply manufacturer went bust the next year.

Such cases can cast a bad light on Spacs, as well as startups that rely on a shell company. At worst, they damage the reputation of the startup industry as a whole, critics fear. Young companies should therefore carefully consider whether they want to go public early on via a Spac, or perhaps wait until they are mature enough for a traditional IPO.