What You Need to Know About SPACs Before You Invest

beautiful young woman dressed sweater hat sitting chair cafe table taking notes What You Need to Know About SPACs Before You Invest

It seems like the word “SPACs” is in every other headline these days. Odds are, if you turn on the news or browse a business website, you’re bound to run into this strange acronym.

So what does it mean? “SPAC” stands for “special purpose acquisition company,” and it’s a business entity that’s being used to take private companies public. Basically, companies that want to have an initial public offering (IPO) are using SPACs to make it happen. SPACs themselves are publicly traded, and some investors are buying SPAC shares in an effort to get in as early on companies.

But SPACs, like many investments, are not something you want to jump into without doing some homework first. Below, we’ll cover the basics of SPACs, how they work, and what investors should know before plunking down dollars to buy SPAC shares.

SPAC Recap

SPACs are legal business entities that don’t have any assets or conduct any sort of business activity. In effect, they’re empty husks. That’s why they’re often called “blank check companies.”

As for their purpose, SPACs are used more and more frequently these days to take companies public. So instead of going through the traditional IPO process, many companies are instead using SPACs to get themselves listed on the stock markets.

In fact, over the past two years, SPACs have been used to take more companies public than during the previous ten years combined. Recognizable brands are using SPACs to go public, including sports betting company DraftKings, spacecraft venture Virgin Galactic, food company Whole Earth Brands, and even SoFi — which is preparing to go public by merging with a SPAC sponsored by Chamath Palihapitiya.

SPACs and Acquisitions

As for how a SPAC takes a company public, the process is basically a reverse-merger, when a private business goes public by buying an already public company.

Here’s a step-by step: A SPAC goes public, selling shares and promising to use the proceeds to buy another business. The SPAC’s sponsors sets its sights on a company it wants to take public—an acquisition target. The SPAC often raises more money to acquire the target. Remember, SPACs are already publicly traded, so when it does acquire a target, the target is absorbed by the SPAC and then becomes public too.

Why would a company want to use a SPAC transaction to go public rather than go the traditional IPO route? The simple answer is that it can be much faster and easier. For instance, a merger between a SPAC and its target can take between four to six months, whereas the traditional IPO route can take 12 to 18 months.

How Do I Invest in SPACs?

SPACs are designed to raise money so that they can acquire their target. To raise money, they need investors, which is why they’re generally publicly traded. Since they’re publicly traded, it’s pretty easy to invest in SPACs—in most cases, a brokerage account is all that’s required.

Buying SPAC shares is pretty much the same as buying any other stock. Plug in the name of the SPAC, and put in a market order. SPACs tend to sell their shares for $10 each, making them more affordable to the average investor, who may not have the cash to buy another tech IPO or an already pricey mega-cap stock.

5 Things to Know Before Investing in SPACs

Before you plunk down your hard-earned dollars on what could be a risky investment, run through this list of considerations. Investing in SPACs may be relatively easy, but it’s important to keep in mind that they are often risky and unproven. Here are some things to take into account:

1. Failure to Find Target

SPACs really exist for one reason: To acquire a target company and take it public. But there’s a chance that some could fail to do so—something that prospective investors should take seriously. The clock is ticking, too. If a SPAC does not acquire a target within a specific time frame–typically two years–it could liquidate.

For investors, that means getting your money back, thankfully. But money that had been sitting in SPAC shares for two years likely would have been otherwise invested—possibly causing investors to miss out on gains.

2. Investor Dilution

SPAC investors also run the risk that their shares could be diluted, or lose value. Though an investor may buy into a SPAC at $10 per share, the SPACs sponsors—the folks running the SPAC—may throw in additional funding that can erode the value of those shares.

That dilution typically happens during the merger process. As the merger takes place, fees are paid, warrants are exercised, and the SPAC’s sponsor receives 20% ownership in the new entity. All this can take ownership from investors’ shares, diluting them.

3. Poor Performance

Many companies that go public via a SPAC transaction don’t do so well after the merger. Their stock values don’t perform as many investors have hoped. This is yet another very real risk that SPAC investors must contend with.

As SPAC targets are private companies, investors can be limited in the amount of research they can do on the targets. Their financials may be difficult to find. As a result, investors are basically relying on the due diligence of the SPAC sponsor. So there’s an element of trust at play.

But what investors should know is that many companies that have gone public through a SPAC underperform compared to the broader market at large.

4. Big Names Can Cloud Investor Judgment

It can be easy to get caught up in the hype around certain SPACs. Whether the SPAC itself is targeting a particularly noteworthy company to take public, or if it’s being managed by a big-name investor or famous person, the glitz and glamour may blind investors to certain risks.

It may be fun to think that you’re getting in on an investment with a celebrity. But that doesn’t mean that the investment they’re attached to is a good one, or the right one for you.

5. Uncertain Future

SPACs are the hottest thing on the market right now but that won’t last forever. And since there are some significant risks involved in investing in SPACs, it may only be a matter of time before regulators step in and make some changes.

Given the lack of transparency around SPACs, and the general fast-and-loose approach that the markets are taking to them, the government and other watch dogs are already calling for some reforms.

Among them: Tamping down on SPAC hype, like protecting investors from misleading information or expectations, enhancing disclosures, and being more forthcoming about the risks to investors.

The Takeaway

There’s a lot to consider about SPACs from an investor’s point of view. The important thing to remember is that SPACs are speculative, risky investments. Just because you’re hearing about them daily, and seeing celebrities get in on the frenzy doesn’t mean that they’re the right investment for your portfolio.

Investing in SPACs will likely require a high risk-tolerance for most investors, and it’s a good idea that you have your other financial ducks in a row before dedicating any money to it.

Whether you’re looking to invest in SPACs or bolster your portfolio with some blue-chip stocks, SoFi’s Active Investing platform allows you to get started. Sign up today and start trading with no commission.

*This story originally appeared on Sofi and was republished with permission