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What is a SPAC?

  • January 07, 2021
  • Noah Weidner

In our post about initial public offerings (IPOs) and whether you should buy them or not, we mentioned a “new,” trendy alternative to IPOs called SPACs. SPACs, which stands for special purpose acquisition companies, have gained great fervor among investors in 2020.

To the average passerby, a SPAC is theoretically no different than an IPO. However, though investing in a SPAC has the same feel as investing in an IPO, they are fundamentally different. For that reason, we wanted to delve into how a SPAC works – and how seasoned investors can potentially leverage them in a portfolio.

How does a SPAC work?

In our post about initial public offerings (IPOs) and whether you should buy them, we break down the way an IPO works. In case you need a short refresh: a company going public seeks out a bank to help them sell their shares on a stock exchange. The bankers (underwriters) acquire shares of the private company, help the company price their IPO, and then sell the shares on markets to help the company raise money. 

SPACs are essentially an inversion of the IPO model. Rather than a private company seeking a bank to go public, the company will actually generally be sought out by a publicly-traded company with no designated purpose. This is a prevailing reason why SPACs are sometimes called ‘blank check companies’ – they can be formed by anybody with enough money, raise money from investors, and then use that money to entice a company to merge with the SPAC. 

You’re probably familiar with mergers because, when they’re big enough, they get a lot of media attention. However, there’s a special name for the merger that is undertaken when a private company replaces a publicly-traded SPAC. It’s called a reverse merger, and in the case of SPACs, it’s an event where a private company essentially “eats” a public company – replacing it on public markets. 

It is worth underscoring that investors in the SPAC’s IPO have no idea what company the SPAC’s managers will ultimately acquire with the money they give them. They might receive some guidance as to what industry or market it will be in, but ultimately the money raised could then be utilized to acquire any company. This can be attractive to some investors because of the opportunity. However, this also means that SPACs can be risky or speculative.

So, should I buy a SPAC?

In order to buy the best SPACs, many investors would be expected to do a lot of research and due diligence that frankly is not ideal for the average person. For that reason, buying a SPAC might not be the best use of money for some investors. After all, there are safer and less risky investments that might be able to make you money now.

An alternative to investing in SPACs frivolously before knowing what company they intend to merge with is waiting until the SPAC announces what it’s acquiring. Knowing what company will replace the SPAC might allow you to make a more informed investment decision. Oftentimes, the announcement of a SPAC finding a company to merge with is prominently announced on markets. But, beware, it becomes an event where investors might either rush into a stock or run for the door. 

However, if you have an interest in a specific field or SPAC manager, investing in that SPAC might make sense. In fact, you might know someSPAC managers and chairmen – either from business news, politics, or sports. SPAC managers you might know include: Shaquille O’Neal, former U.S. house speaker Paul Ryan, and Chamath Palihapitiya, who, arguably, kicked off the modern SPAC mania. But, since the average investor likely doesn’t have intimate knowledge about a SPAC at his or her disposal, proceed with caution. The most crucial takeaway is to do your research on the SPAC, its managers, and the industry they intend to make an incursion into.

Whatever type of investment you’re considering making, equipping yourself with the right information is critical to making the best decision possible. This is often the most daunting part of the process, since information is literally everywhere and, if your goal is to thoroughly understand what you’re getting yourself into, then you could be researching forever (hello, Google rabbit holes). That’s why Front built smart FISCO technology, to make it simple for novice and experienced investors alike to quickly assess the risk of a particular stock. Front’s AI-driven algorithm automatically looks at company financials, stock performance, recent news, and more, serving up the stock’s risk rating in a single, easy to understand number. If you’re investing (or considering investing) in the stock market, arm yourself with one of the most powerful, free tools out there, and make smarter investment decisions with Front. 

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