Social Capital’s Backdoor Unicorn IPO

We have recently discussed the changing dynamics of the IPO market and startups’ shifting perspectives in regards to going public.  Public offerings haven’t all gone wrong this year, but latest rounds of unicorn IPO flops appear to have dampened some investors’ outlook on the traditional IPO route.  Nevertheless, unicorn investors still need liquidity and are turning to creative ways to get the IPO pipeline flowing again.

Recent IPO Case Study

Venture capital firm Social Capital has made headlines recently with its latest IPO endeavor, and not just for its unusual name.  The IPO for Social Capital Hedosophia Holdings raised $600 million, but it isn’t associated with any operating company – at least not yet.  The firm plans to use the holding company, which is structured as a special purpose acquisition company (SPAC), to find and acquire a technology unicorn.  By using the SPAC structure, Holdings could potentially take the company public within a few months.  Let’s take a look at some of the basics of a SPAC:

• Unit sales, not shares.  Investors in SPACs typically purchase a unit of the company, which includes a share and a warrant exercisable for additional shares.  Pitchbook notes that unlike older vintages of SPACs that issued one in-the-money warrant per Unit, the newer generation of SPACs targeting Unicorns increasingly issue Units with partial, out-of-the-money warrants that may not be transferred or exercised prior to the acquisition.  Presumably, this feature attracts investors who are focused on the long-term operating success of the venture.
• Investor protections. Although investors are essentially writing a blank check when they make their initial investments in a SPAC, redemption rights allow for monetary recuperation if the entity doesn’t find an investment within the given time frame.  However, even once a target has been identified, investors aren’t beholden to the chosen startup.  Investors can opt for capital redemption in the event that the investor doesn’t agree with the SPAC’s choice.
• Trust formation. Funds from the SPAC’s IPO are deposited in a trust that protects the investment solely for use in making the acquisition.
• Time constraint. SPACs may speed up the process of taking a company public in several ways.  First, the bulk of the legwork associated with the IPO is done before the acquisition target is even identified.  Secondly, most SPACs have an imposed time constraint to identify and acquire a target.
• Deal Structure. Taking a company public through an acquisition allows for additional flexibility, as well.  Typical acquisition deal terms such as earnouts and escrows can be utilized and the structure can be designed so that the seller retains a portion of control after the deal closes.

SPAC Cost Structure Considerations

The cost structure of a SPAC brings up its own questions.  The sponsor of the acquisition vehicle (Social Capital in this case) receives a “finder’s fee” from the investment, typically 20% of the amount raised for the special purpose company.  Compared to an IPO underwriting fee –which is approximately 5-7% of the amount raised through the offering –this seems like a hefty price to potentially speed up the process of going public.

With the money already in hand, investors seek out IPO potentials rather than allowing the companies to court them.  This supply and demand structure is likely to drive target company valuations upwards, further steepening the price investors must pay to gain access to this exposure.

Conclusion

The SPAC is not a new investment vehicle, but it has been relatively absent from the venture capital space.  Considering the low public investor sentiment surrounding other recent unicorn IPOs, it may seem surprising that investors are willing to bet on a company that hasn’t even been selected.  One common analogy is that investors in a SPAC are betting on a jockey, rather than a horse.  In other words, they are trusting Social Capital’s judgment to find an investment.  With the protections afforded by the special purpose vehicle structure and few other ways to buy into large exits by venture-backed companies, some investors appear willing to take that bet.

Related Links

• IPO Supply and Demand
• How to Value a Company Planning to IPO
• Accountability, Rights, and Discipline in Early-Stage Companies