Checklist for SPAC Investors -- Investment Companies and Individuals

Ever since the SEC’s statement relating to warrants issued by special purpose acquisition companies (“SPACs”) was published on April 12, 2021, conversations have revolved mostly around the impact on SPACs themselves. However, other questions have arisen on the sideline, such as: “Are there any implications on investors in SPACs?” “What else do investors need to know about SPACs and SPAC warrants?” “Are there any key factors that investors should consider before investing in SPACs?”

If you observe the timeline of events below, there has actually been a consistent focus by the SEC on educating investors on SPACs. This has culminated in the most recent updated investor bulletin issued on May 25, 2021 by SEC’s Office of Investor Education and Advocacy (“OICEA”) to educate SPAC investors, and the testimony by SEC Chairman Gary Gensler before the U.S. House Appropriations Committee on May 26, 2021 to discuss SPACs, among some other topics.

SPAC investors may include investment companies (e.g., hedge funds and private equity funds, collectively, the “fund investors”) and individuals (the “individual investors”) (collectively, the “investors”). They invest in the SPACs and hold various financial instruments such as units, common stock, warrants, private investments in public equity (“PIPE”) commitments, backstop commitments and forward purchase agreements.

Investors should be aware of what goes on during the lifecycle of a SPAC, namely the 1) SPAC IPO; 2) pre-merger; and 3) de-SPAC (merger between a SPAC and its target company). We included a simple checklist below for investors at each phase of a SPAC lifecycle, highlighting certain key considerations. This checklist is not exhaustive. Each SPAC transaction has unique aspects and may vary from the descriptions below. Prior to making any decisions, all investors should consult with their advisors to discuss the specific facts and circumstances.

Phase 1 (SPAC IPO)

First phase of a SPAC lifecycle includes a SPAC’s formation and IPO. This may take about eight weeks. This process involves the selection of underwriters, finalization of legal documents, filing of a registration statement to initiate the IPO, roadshows and the undertaking of the IPO itself.

Here is the investor checklist during Phase 1. Investors should note the following while reviewing the SPAC’s prospectus and reports filed with the SEC (list is not exhaustive):

• Sponsor and SPAC management. The sponsor can be a private equity or venture capital firm, or made up of experienced individuals with prior private equity, mergers and acquisitions or operating experience. The sponsor will raise money from the public market investors through the IPO of the SPAC. It pays for the offering expenses and receives founders’ shares in return. The sponsor may also form part of the SPAC management team who is made up of three-to-four experienced individuals. Sponsors may also purchase warrants issued by the SPAC through a private placement. Investors should evaluate the capabilities of the sponsor carefully as it will be the one who is ultimately bringing the SPAC through a successful merger with a target company.
• IPO proceeds and the interest, if any, earned on these proceeds. The IPO proceeds are placed in a trust and generally invested in conservative interest-bearing instruments. However, this may not necessarily be required by the prospectus.
• Difference in distribution of trust proceeds between investors who invested during the IPO and those purchased from the open market after the IPO. Distribution will be made on each investor’s pro rata share of the trust account. It is to be noted that if the investor had purchased shares in the SPAC in the open market, the price paid in the open market (e.g., $14) may be different from the pro-rata share this investor will get in the trust account (e.g., $10).
• Period given to consummate the de-SPAC. This usually takes place between 18-24 months of the SPAC’s IPO.
• IPO price. It is typically priced at $10 per unit; however, it should be noted that this is generally not based on the valuation of the existing business.
• Industry of the target company. This may be indicated on the prospectus, but the industry of the target company ultimately selected may not necessarily be the same as in the prospectus.
• Accounting for the public and private placement warrants by the SPAC. With regulatory focus on SPAC warrants, investors should inquire with the SPAC and/or discuss with their consultants regarding certain provisions of the warrant agreements (e.g., features that may differ based on holder characteristics), and how these impact the accounting conclusion on whether the warrants should be classified as equity or liability.
• Impact of jurisdictions of SPACs on your tax exposure. U.S. shareholders may often invest in a SPAC that is formed in other jurisdictions, such as Cayman Islands. Certain tax implications relating to passive foreign investment companies (“PFICs”), qualified electing funds (“QEFs”) and mark-to-market elections are complex and should carefully be evaluated by the investors.

Phase 2 (Pre-Merger)

Second phase of a SPAC lifecycle consists of target search and periodic filings of Forms 10-K and 10-Q. It can take between 18 and 24 months from a SPAC’s IPO through the closing of the de-SPAC transaction. Stemming from SEC’s recent statement on SPAC warrants, SPACs also have to revisit their existing accounting for warrants. If the SPAC needs additional capital to pursue the business combination or pay its other expenses, the SPAC will often arrange committed debt or equity financing, such as a PIPE commitment, to finance a portion of the purchase price for the business combination.

Here is the investor checklist during Phase 2 (list is not exhaustive):

• Timing of shareholders’ vote to redeem shares or approve of the de-SPAC event. Once a target company has been identified, investors will be given a redemption offer, and in most cases be able to vote on the de-SPAC transaction. Approval of the initial business combination typically requires the approval of the owners of a majority of the outstanding public shares (often Class A) and privately placed sponsor shares (often Class B) voting together as a single class. The investors can either stay as a shareholder in the new combined company after the de-SPAC or redeem and receive their pro rata share of the trust account balance.
• Proxy statement or information statement. If shareholder approval is required for a de-SPAC, a proxy statement will be provided prior to the vote to approve of the business combination. If certain investors (e.g., sponsors) hold enough votes to approve the de-SPAC transaction whereby a shareholder vote may not be required, an information statement may be provided. Both the proxy and information statements consist of key information relating to the target company, financial information, interests of sponsors and other parties, and capital structure of the new combined entity, etc. It is to be noted that a SPAC may not be required to provide either of the above, and investors will receive a tender offer statement containing information on the target company and their redemption rights.
• Considerations when voting to approve the business combination. Investors should understand the background of the proposed target company and the level of public-company readiness in terms of accounting, internal controls and reporting. The qualifications of management at the target company should also be evaluated as they are often part of the management for the new combined entity.
• Reevaluation of the accounting for warrants by the SPAC. Investors should understand how the SPAC is currently accounting for the warrants issued, if they are classified as equity or liability, whether the warrant agreements consist of certain provisions highlighted in the SEC’s statement, and the current steps taken by the SPAC in reevaluating its accounting position. This may have reporting implications (restating financial statements if deemed a material misstatement), valuation and tax implications.

Here are some additional considerations for the fund investors during Phase 2 (list is not exhaustive):

• PIPE commitment. The topic of PIPE commitments was discussed during AICPA Investment Companies Expert Panel (the “Expert Panel”) in November 2020 and January 2021. The PIPE commitment is a common financial instrument that may be used by SPACs to fund future business combinations or pay for expenses. It relates to the commitment by the fund investor to acquire shares of the common stock of a merged entity at a fixed price, subject to certain contingencies such as shareholder approval and capital raise. The fund investor would then fund the commitment upon the merger and when the contingencies are met.
• Initial recognition of PIPE commitments. The Expert Panel suggests that they should be recognized when the commitment is legally binding. Therefore, fund investors should discuss with the legal team on certain aspects of agreements and understand PIPE commitments, if any. Contingencies would not impact when the PIPE commitments would be recognized (but may impact valuation as discussed below).
• Measurement of PIPE commitments. PIPE commitments may meet the definition of a financial instrument, derivative or other investment. When recognized (e.g., if the PIPE commitment is deemed to be a derivative), the unfunded commitment should be fair valued on the balance sheet and re-measured every reporting period with change going through the income statement.
• Valuation consideration for PIPE commitments. The valuation process involves significant judgment pertaining to the inputs used for the valuation model. Examples of inputs to be considered include the share price of the SPAC, expected timing of the merger event and certain contingencies.
• Unit of account for the PIPE commitments and equity shares in the SPAC (if applicable). The PIPE commitments may be issued with equity shares in the SPAC, and the fund investors would need to determine the unit of account and whether the commitment should be measured separately from the equity shares as two units of account, or as one unit of account.
• Accounting treatment for PIPE commitments whose contingencies have been resolved (i.e., it now becomes an “obligation to fund the SPAC”). The Expert Panel considered whether there could be a point where it is appropriate for a fund investing in a PIPE commitment to fund a SPAC to record a gross asset and gross liability prior to closing date. The Expert Panel discussed two alternatives to consider when accounting for PIPE commitments when the contingencies have been resolved (i.e., when there is an obligation to fund the SPAC by the fund investors):
  
  • Record a gross asset (debit investment) and gross liability (credit payable for investment purchased) on the fund investor’s balance sheet on any date prior to the closing date (i.e., the date when funding occurred); or
  • Continue to follow a derivative accounting model or a model similar to derivative accounting (if the PIPE commitment is not a derivative) until the closing date whereby the gross investment would then be recognized (debit investment) and the cash payment be recorded (credit cash). As such, there will be no recognition of a gross asset and liability prior to the closing.

Phase 3 (De-SPAC)

Phase 3 of the SPAC lifecycle is when the business combination takes place between the SPAC and the target company upon the approval by the shareholders (if approval is required). This is when the target company prepares to be public company ready and is getting its financial statements audited by an independent accounting firm under the PCAOB standards.

Here is the investor checklist during Phase 3 (list is not exhaustive):

• Differences between being an investor in a trust account as compared to an operating company. Investors need to understand that once the de-SPAC is completed, they are investors in the new combined company going forward, as opposed to a pro-rata share in a trust account prior to merger.
• Evaluation by the SPAC and target company on who the accounting acquirer is during the de-SPAC. It is a critical step to determine who the accounting acquirer is under ASC 805 which involves a high level of judgement. The conclusion in turn drives the presentation of financial statements and whose financial statements that are required to be reported at fair value. For example, if the target operating company is determined to be the accounting acquirer (often the case even though it is the legal acquiree), this is considered a reverse merger and typically accounted for as a reverse recapitalization if the only pre-merger asset of the SPAC is cash. The target company will account for this as a capital transaction and any seller transaction costs would be recorded against the equity proceeds. However, if the SPAC is the accounting acquirer, it would apply pushdown accounting by recognizing the assets and liabilities of the target company at fair value under ASC 805. Any buyer transaction costs would be expensed.
• Difference between the sponsor’s rights and yours as an investor. Investors should understand that sponsors generally purchase equity in the SPAC at more favorable terms than the investors themselves. Even though the SPAC’s capital have been primarily provided by investors, the sponsors and founders will benefit more than investors from the SPAC’s completion of an initial business combination. Sponsors may provide additional financing to fund the merger, and securities may be issued to the sponsors with preferential rights as compared to other investors.

Our Current Issue: Q3 2021

• Checklist for SPAC Investors -- Investment Companies and Individuals
• The Drivers and Challenges of ESG for Private Equity
• Family Offices and Regulatory Scrutiny Following Archegos Capital Management Implosion
• Investing in a Venture Capital Fund: Tax, Regulatory, and Finance Implications