Investing in pre-IPO SPAC

I have an opportunity to invest in a pre-IPO SPAC at sponsor terms. The sponsors have strong backgrounds relevant to the type of targets they're looking for. I haven't invested in SPACs before, but while I understand how they work, I could use some guidance on how to think of payoffs and probabilities. My understanding is that the key risk is that they don't do a merger - is that right? Or are there other KEY risks I ought to be factoring in? Their focus is several verticals within tech, which is a competitive space where everybody is essentially looking. 

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Comments (20)

  • Associate 3 in HF - EquityHedge
Aug 29, 2021 - 1:09pm

When you say sponsor terms, you mean same as the sponsor promote? I.e. shares purchased for like $0.01?

Absurdly great proposition if they do literally any deal. Free shares, almost. Ur right main risk is no deal. Not something to ignore given 350+ pre deal SPACs looking/competing for deals, but the sponsors are sure incentivized to try their best

Aug 29, 2021 - 3:52pm

I'm sorry I should have clarified - perhaps a better way to describe is insider terms. I'm being offered these shares at $2/share, but I think they will resemble sponsor terms more so than classic shareholder terms because I've been told if there's no merger, I lose it all. 

Aug 31, 2021 - 11:41am

Ok, I got some clarification. These would in fact be sponsor shares, except that the actual sponsor pays a nominal fee for theirs whereas I'd be paying $2/share+warrant to buy in. If we assume the shares settle at $10 (if not lower) post-lockup, and say my money is locked up for 2 years (while they look to acquire) + 1 year lock-up (to be safe), is this a worthy proposition? Am I speculating here or investing? And if I'm really speculating, am I better off speculating on bitcoin and having the liquidity to go in and out any time?

Would be helpful to hear it from an HF professional's viewpoint.

Sep 1, 2021 - 2:50am

Aside from a HF professional which I'd want to hear, if SPAC units are being offered at 10/unit (including the common share + whatever fractional warrant), are you being offered a discount on the entire unit? Put another way an 80% discount to unit? All of what I'm asking applies to pre-IPO for avoidance of doubt

  • 1
  • Associate 2 in PE - Other
Aug 29, 2021 - 1:26pm

Do the sponsors have a track record with SPACs before or is this the first SPAC? The biggest thing here is to ensure you are aligned with the sponsors. Are you truly pari passu with the sponsors on the terms you are investing at? Or are they promoting you? Is your investment being utilized to fund traditional SPAC working capital - i.e., underwriting, legal, accounting fees - or is it specifically to fund trust overcollateralization? Will your share of sponsor economics be subject to future dilution? What are the terms of the SPAC units? Just FYI - a first time SPAC sponsor is highly, highly unlikely to price anything with less than $10.10 in trust, 1/2 warrant coverage, 18 month tenor, and +$0.10 for each extension. There are a zillion tech SPACs out there so I would probably think $10.20 in trust is what you should expect. Also, if you haven't thought of this already, be prepared to dilute your sponsor economics on the front end in order to lock in IPO anchor orders and then again on the back end in order to jam a PIPE through. 

You are right that the key risk is there is no merger. SPAC sponsors have traditionally had a great risk/reward profile. If you dont find a deal you get a 0 and if you do find a deal you are looking at = > 5-6x MOIC minimum. However, the right tail has greatly come in over the last four to six months as more and more sponsors have to give up economics for IPO anchor orders. The space your management team is focusing is highly competitive, especially with SPACs. 

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Aug 31, 2021 - 11:46am

I would be investing in the sponsor itself, except with a buy-in price of $2 per share + warrant. If they do no merger, it's a $0. If they do some form of merger, the return depends on where the shares are trading post-lock up. I think the sponsors have a 65% chance of doing a deal. Does this make sense with my money locked up ~3 years?

  • Associate 2 in PE - Other
Aug 31, 2021 - 1:12pm

Will your risk capital contribution be proportional of your sponsor share ownership? I.e., if you are funding 20% of risk capital you should expect to own at least 20% of the sponsor. Don't do any deal where risk capital contribution > sponsor share ownership. At ~$2 create and share range between $0 to $10 with a 65% probability of getting a deal done, I think you are creating your investment at an expected high teens to low twenties IRR over three years. I wouldn't do this, but YMMV. FYI, there is a current trend in the SPAC market with sponsors targeting non-SPAC or novice SPAC investors because the main guys have either pulled out of the market or will only invest on vulture terms, so you need to make sure you're not being taken advantage of by the sponsor. Highbirdge will still do a SPAC deal and quickly close if they can rip eyes out, for example. 

Aug 31, 2021 - 1:41pm

Very helpful, thanks. I would be owning shares in the sponsor, not directly owning the sponsor shares in the SPAC if you will. I think by virtue of making me pay $2/share+warrant versus the nominal price at which the actual sponsor is getting the SPAC shares for, it probably means that my risk capital contribution will be lower than my sponsor share ownership. To be fair though, it's only like a small amount ($50K). When you say you wouldn't do this, is it because a high teens-low 20s IRR is just not attractive enough for a speculative investment? In absolute dollar terms it obviously won't make me a lot of money, so I concede that, but I'm curious to just understand why that kind of IRR seems unattractive to you. 

Most Helpful
Sep 1, 2021 - 4:18pm

I don't necessarily disagree with most of the things Associate 2 in PE said on this, but thought I'd add in my $0.02 as someone who has been a 4x member of SPAC sponsors in the past couple years (two acquisitions closed, one announced, one recent IPO), and who has advised a number of sponsor clients/underwritten multiple SPACs from an IB perspective:

1. $2.00 is, based what I've heard from other prolific institutional risk capital investors, maybe a little bit pricy for founder's shares in a first-time sponsor's SPAC, but it's a somewhat better deal with the warrant included (figure a pre-IPO value of maybe $0.25 per? Hard to say without knowing if it's a 1/4, 1/2, or full warrant). Typically for people of this level (i.e. first-time sponsors), institutional investors are coming in more at the $1.00 - 1.50 range per founder's share, but to be honest would not surprise me if it's actually lower now given the glut of low quality SPACs out there. 

2. Assuming this is a pre-IPO investment, the specific use of proceeds is sort of irrelevant - that money is usually raised concurrently with the IPO, and is all contributed to a single pot that is then disbursed as necessary for working capital needs and other transaction expenses. I have not encountered anything like "your money will go to xyz expense" in a pre-IPO setting, and does it really matter anyway? I assume that you would receive the same equity as any other individuals regardless of the purpose of your investment. Extensions wouldn't happen until the SPAC is on the verge of expiring anyway, so I wouldn't necessarily come in with the expectation that it'll happen (although I similarly wouldn't peg it as an unlikely outcome). 

3. The extent to which you are exposed to further potential risks to your investment are largely defined by the sort of purchase agreement that you're entering into with the sponsor entity. There may or may not be particular rights or protections around your shares (registration rights, transfer rights, protections against forfeitures, etc.) that are hard to evaluate without reading the subscription agreement itself.

4. Considering that the sponsor equity is generally fixed in quantity (20% of the post-IPO shares outstanding), I don't think dilution from IPO investors is a concern (same for PIPE investors on the back-end). Assuming that you are purchasing a fixed number of securities (as opposed to a percentage ownership of the sponsor entity), the main sponsor group should assume responsibility for forking over otherwise unencumbered sponsor equity. Once again, this depends on the specific terms of your investment, however, and is difficult to evaluate blindly. The real issue that I would be anxious about is that recent SPAC transactions have been a bloodbath on the back end for the sponsors. Sponsors are frequently forfeiting/deferring as much as 50% of their equity on mediocre transactions just because it's so competitive to complete transactions right now. This may seem like a very semantic distinction from dilution but the reality is that a true purchase of securities (rather than a percentage ownership in the sponsor corp.) could be relatively insulated from these potential issues.

5. A potentially undiscussed point here that I would like to raise is that the idea of syndicating your risk capital investment to the point of accepting $50k investments from individuals at $2.00/share is a bit of a red flag to me. I've dealt with a sponsor that syndicated out a $2.5M risk capital fundraise to >40 individual HNW investors (!!!) and that was an incredible shitshow for a variety of reasons. First, it's alarming because you want the actual SPAC operators to be highly motivated to get a good deal done, and the fact that an individual such as yourself was approached with the opportunity to invest a relatively small amount of capital in my mind implies that they're casting a wide net in terms of raising money for the front-end. If this is the case, then they are likely going to end up putting in relatively little of their own money, and this is, frankly, a terrible situation for an investor. In this market, with this much competition, having a highly motivated operator is critical, and when they have nothing at risk, it can become extremely problematic. Secondly, it can create enormous logistical issues on the back-end, as sponsor economics are very frequently subject to a number of negotiations around lockups, forfeitures, deferrals, support agreement terms, etc., and it can make deal execution very challenging if you need to approach a huge syndicate of investors to sign off on every little thing. 

Overall, in my personal opinion it's relatively unlikely that you will end up *losing* money on this, but the risk/reward for sponsor economics has really taken a huge hit of late. Additionally, private/HNW investors will probably end up bearing the brunt of any forfeitures/losses on the back end, as funds tend to do a better job of protecting themselves, and will occasionally hold deals hostage to protect their investments. If you could get them to sell you the shares directly, as opposed to being a part owner of the sponsor entity, that would go a long way toward protecting your investment - I'd try to see if this is possible. 

Sep 1, 2021 - 12:36pm

I think one thing you should first ask yourself is why are you being offered this seemingly sweet deal. Why you. Do you bring some sort of expertise to the table? Connections?

If this management team is such a hot deal, why would they need to offer discounted terms for people like you. Maybe because they can't find anyone to chip in and they are desperate for the money? I would definitely ask who else is buying in at these terms and see whether they're reputable.

Sorry to be this cynical and this not personal against you, but every time a deal like this hits your desk you should ask yourself what the seller's motivations are.

Sep 2, 2021 - 2:08pm

To be fair, the CEO is my friend (from school but not close) and I'm the one who asked if they were offering to friends and family after I saw the S-1 filed. He said they have made a small allocation available for those interested. He was very clear that there's no pressure on me to invest and that he's intentionally not blasting it to everyone because he wouldn't want friendships to sour if the money is lost. 

  • Research Associate in HF - Event
Sep 1, 2021 - 10:57pm

A SPAC typically has to fund transaction expenses that come out to low teens % of the promote (i.e. a $200m SPAC has a $50m promote and sponsor needs 11% or $5.5m to fund the formation of the SPAC). Otherwise meaning a sponsor has to fund $1.10 to get $10 + partial warrants out if a deal closes with no forfeitures/earnouts and it trades at "deal value". So that's a 9x+ return if deal goes as planned (again, with no earnout).

They are offering it to you at $2 to juice their return (you pay $2 and $2-1.1=$0.90 difference likely reduces their cost basis i.e. hugely juices IRR/MOIC). That's all there is to it: you're paying up a little bit for opportunity of -100% / +500% while sponsor moves their risk reward on tail to much higher % return.

They're doing all the work to find the target and close a deal, why should you get same ups as them for sponsor economics? It's also not easy to just go out and raise for first time sponsor and the partners of the sponsor may not have $5.5m cash laying around to fund themselves.

Besides crypto, not many opportunities to five bag in short time frame so I'd do it. It's definitely riskier with first time sponsor though.

Sep 2, 2021 - 2:09pm

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