Social Capital Hedosophia Holdings Corporation (SCHH) listed its shares on the NYSE, raising $600 million for its special purpose acquisition company. Such vehicles aren’t necessarily new, but SCHH is planning to use its capital to buy stakes in VC-backed tech unicorns, either minority investments or full ownership. This unconventional approach could pave a new path to liquidity for companies moving forward.

Our latest VC Analyst Note breaks down special purpose acquisition companies and the risks associated, as well as takes a look inside Social Capital Hedosophia, its managers, strategy and potential benefits for VC in the long run.

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Key takeaways:

  • Special Purpose Acquisition Companies (SPACs) have been utilized for many years and typically have little media coverage, but Social Capital and Hedosophia’s new SPAC (“Social Capital Hedosophia Holdings” or “SCHH”) is garnering attention due to its size ($600 million) and stated intention of acquiring a technology company valued over $1 billion.
  • Being acquired by SCHH would provide the targeted company with an avenue to go public without many of the hurdles posed by the traditional IPO process. This is the latest in a series of recent innovations and alternatives to traditional exit options as hold times for VC-backed companies have risen.
  • While being acquired by a SPAC can reduce the costs related to an IPO for the company, it doesn't solve any of the reporting, transparency or other problems of operating as a publicly traded firm. The SPAC management also retains a 20% finder’s fee.
  • Several risks are inherent in SPAC structure, most notably investors’ redemption rights if they do not approve of the proposed acquisition—essentially giving investors a money-back guarantee

The venture capital industry continues to search for alternative exit routes to meet the liquidity needs of the employees and investors. Even as the route to a traditional IPO has become less costly in recent years thanks to developments such as the enactment of the JOBS Act, we have yet to see a sustained increase in new listings. Venture-backed offerings have been especially tepid since the spike in IPO activity observed in 2014. One driver of this development is that VC fundraising has been robust and dry powder has surpassed pre-crisis levels, so VCs have greater latitude to complete follow-on financings to help companies operate and expand without accessing public markets. This phenomenon has permitted venture-backed firms that would historically have been IPO candidates to avoid the scrutiny, transparency and costs of being a publicly-traded firm.

VC SPAC

The recent dearth of IPOs may have been further exacerbated by poor performance of high-profile technology unicorn IPOs in 2017, such as Snap and Blue Apron. However, on average, US technology IPOs from 2015, 2016 and 2017 YTD have all recorded considerable returns in the market after IPO, and 2017 IPO counts are on the rise. In other words, the IPO route is still a viable exit option but certain headwinds persist, mainly for unicorns. Given some of the challenges inherent in executing an IPO, venture capitalists have been exploring other ways to ease the process of introducing companies to public markets. A special purpose acquisition company is the most recent idea that has been floated as a way to provide an expedited and alternative path to the public markets for venturebacked companies.

Special purpose acquisition company definition

The blank check company is an entity formed by financial sponsors for the sole purpose of purchasing one or multiple companies. A SPAC within the context of the venture capital industry would focus on acquiring a controlling stake in a private company as a method to take the target company public. The SPAC first follows the traditional IPO process, registering with the SEC, filing prospectuses and running investor roadshows. This entity then prices the IPO and raises the funds that will subsequently be deployed to acquire the target business. At this point, the SPAC is a publicly traded shell company and has assumed much of the costs and time commitments usually borne by the target company. The IPOs of SPACs are structured as sales of units that include one share and either a full or partial warrant. Warrants, similar to options but issued by the company itself, give the holder the right—but not the obligation—to buy one share at a set strike price.

The SPAC management, which usually retains 20% of the equity in the SPAC, has enjoyed more favorable terms in recent years when compared to their predecessors, especially relating to the warrants offered. SPACs formed prior to the financial crisis typically included one in-the-money warrant per share purchased, while most SPACs are now offered with either one-half or one-third of an out-of-the-money warrant with each share. This recent change in terms is substantial because partial warrants cannot be exercised or sold. Furthermore, now that the warrants are issued with a strike price higher than the offering price, there is added incentive on both sides for the acquisition to be accretive. The change to units with out-of-the-money warrants should also serve to encourage investment by long-term focused shareholders, as the warrants may take time to become valuable.

All the proceeds from the IPO are then deposited in a trust to be used only for the potential acquisition; the SPAC management team has a specified amount of time (usually 24 months) from the IPO to source and close an acquisition. If no deal is completed within the timeframe, the SPAC is dissolved and the money from the trust is returned pro rata to the investors, with the SPAC management forfeiting their original investment. When an acquisition is identified, the SPAC management team only needs shareholder approval if that stipulation is explicitly guaranteed in the SPAC’s S-1, or when it is required under applicable law or stock exchange rules. However, shareholders are given a tender offer that affords them the right to redeem their investment if they are displeased with the acquisition target. After receipt of the tender offer, investors in the SPAC have a 20-day window during which they may redeem their shares for their pro rata share of the trust account. The risk the SPAC management bears is that a significant percentage of investors redeem and leave the proposed deal with a large financing gap that must be bridged via further investment by the sponsor or outside financing. This has the potential to distract the SPAC management and could result in the transaction being withdrawn if a large enough portion of shareholders choose to redeem.

Once all of this is settled, the acquisition can be closed and the target business becomes a publicly traded entity. The acquired company would then be afforded all the benefits of being publicly traded: increased company/brand awareness, easier access to capital, and more liquid equity to allow for employee exits and executing acquisitions. Conversely, companies must also grapple with the normal requirements of being public, such as more robust quarterly reporting, increased transparency and

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