Inside Silicon Valley’s SPAC psychology

The SPAC (special purpose acquisition company) hype is the latest financial engineering offering to quickly hit both mainstream media and the backrooms of Silicon Valley.

Wall Street is now “printing” 15 new SPAC IPOs each week while mainstream media prints 15 articles a week on the subject. Perhaps it’s time to explore the psychological motivations driving SPAC-mania.

I’m not going to cover the architecture or the mechanics of SPACs. The concept is the more familiar “reverse merger” where a public company acquires a more valuable private company to increase the public company’s valuation. With SPACs, the public company is literally a blank-check IPO company and the sole goal is for the acquired private company to become the operating public company.

SPAC IPO investors of the blank-check company also intend to include a PIPE (a third legal/financial structuring of a private investment in a public entity) to ensure that the resulting public company is fully funded for at least the next five years.

The psychology of how such hype develops and the pattern-matching that determines how it is likely to play out can be discovered through private conversations inside Sand Hill Road VC offices, in Silicon Valley boardrooms and on Wall Street. Here are the three investment themes I’m predominantly hearing:

• New market creation and market-timing psychological forces.
• Fear versus greed and risk rationalization psychology.
• The FOMO flywheel effect.

Theme 1:  Wall Street and Silicon Valley created a new product for Main Street

Money, like water, finds the lowest ground and follows the path of least resistance.

Wall Street is currently awash in cash seeking a return. Effective 0% interest rates have stimulated new financial engineering ideas with relatively low risk, reviving a decades-old “financing vehicle”  known as the SPAC “blank check” IPO company. Wall Street has linked up with private markets to allow for a faster path to liquidity and higher value exits to create a tasty new investment product. Frost with a classic VC fund-like structure (2+2+20) to reduce risk for SPAC sponsors and initial investors, and the product sells like hotcakes!

Finally, put a for limited time only clock on the whole structure and the resulting rush to jump through a new IPO window before it closes creates a new investment race where there will be clear winners, laggards and losers.

As with most great new investment products, the idea is to sell this product to Main Street at a much higher valuation while creating a classic win-win-win mindset and a “buyer beware” undertone.

Notes:

• (2+2+20) consists of a typical 2% management underwriting fee + $2 million of management operating expenses to fund the SPAC sponsors’ private company search, plus a 20% negotiated discount of the private company’s shares the SPAC is acquiring in return for taking them public at a higher valuation.
• SPAC IPO companies are required by the SEC to find an acquisition target typically within 24 months or the structure is delisted and all remaining cash is returned to the original investors.

Theme 2:  Fear versus greed and risk rationalization psychology

As with any other new markets being created, we are witnessing a bit of irrational exuberance as SPACs are touted as the holy grail of future financings. What began as COVID-19 fear in March 2020 — causing private company operations and new private company equity funding rounds to slow down — has now turned to SPAC greed as we enter Q4 2020.

These same coronavirus-wary investors now see a very real path to faster liquidity and higher valuations with a new gold SPAC rush. Resulting backroom conversations range from “you too can SPAC” to “I’m now seeing CY 2028 valuations being defended,” to “we should combine a few of our portfolio companies to help make them SPACable,” to finally “why wouldn’t we SPAC?”

Some of the larger VCs and private equity firms are even getting in on this opportunity by creating their own SPACs (e.g., Reid Hoffman/Marc Pincus, Lux Capital, Apollo Global, TPG Capital, Ribbit, SoftBank Vision Fund, etc.).

Theme 3:  The FOMO flywheel effect

The fear of missing out (FOMO) is the final theme driving investment cycles like this.

Leveraging the psychological factors associated with FOMO begins with turning otherwise skeptical/conservative investors into believers. We’ve witnessed this already with investment professionals and even Goldman Sachs touting SPACs as a fad to fully jumping into the pool and even creating their own SPAC desk (Goldman’s version of an “IPO desk”) to assist broker SPAC IPO sponsors with potential private companies.

As with all historical FOMO mindsets (e.g., Dutch tulips, California gold rush) the storytelling of riches is a powerful emotional force.

Almost everything you need to know about SPACs

SPAC roadmap

SPAC Research found that the number of SPAC IPOs created in 2020 is on track to go over 200, a 20x increase from a decade ago. Meanwhile, the amount of SPAC capital being raised is predicted to top $75 billion in 2020, more than double the $35 million average that U.S. VC firms raise from limited partners in any given year.

Here are clear action steps I highly recommend you consider in the coming weeks:

Establish your own clear POV of the benefits and risks of SPACing.

• Update your valuation roadmap.
• Be a chess player; think three moves ahead of your competition and develop a reasonable game theory of SPACing or being SPAC’d.
• Call a meeting with your board to create a shared set of SPAC assumptions for your company’s future.

Initial questions for investors, your board or SPAC sponsors courting your company

• How much capital is required to fully fund our business plan through CY 2025?
• What does an objective analysis of your valuation roadmap/forecast look like?
  • Create scenarios including being SPAC’d/public and missing your public guidance quarters (30%-70% price impact)
  • Are you staying private and growing your valuation and raising capital every two years at private market valuation benchmarks?
  • Include key metrics milestones along your roadmap (revenue, gross margin, EBITDA) for you or your board/investors to fill in with a resulting valuation calculator.
• Is there a rollup strategy in your industry for which a public company valuation and cheaper public currency could accelerate?
• Are we really willing as a board and executive team to operate and govern a public company, or do we need to actively start shoring up our gaps?
• Should we really enter SPAC sponsor conversations now instead of focusing on value creation?

What the SPAC sponsor market is currently seeking

• Companies that can legitimately defend revenue of $50 million in CY 2021.
• Revenue growth rates of at least 50% annually and ideally +80%.
• Ability to defend a revenue forecast of +$150 million by CY 2025.
• Industry enterprise valuation multiples (revenue, gross margin %, EBITDA) that can defend a minimum of $1 billion by CY 2025.
• Ability to maintain revenue growth rates for the next several years and can defend very large total addressable market (TAM).
• Companies in high-profile industries that need to either SPAC or be SPAC’d (acquired by a competitor who SPAC’d).

SPAC risk factors

• Companies cannot reasonably achieve the above financial metrics.
• No real shot of being IPO-ready within the next 12 months due to:
  • SOX compliance and board governance
  • internal and external financial controls
  • financial forecasting capability
  • audited financials or significant issues with recent audit reports
• The SPAC sponsor/structuring discussion does not enable enough cash to fully fund your business plan for at least the next five years. Thus, the probability of “missing” your quarterly or annual investor guidance as a public company and being relegated to the “pink sheets” is a very real concern.

The only thing I’m nearly 100% certain of regarding the latest investor psychology of Sand Hill Road and Silicon Valley is that a SPAC discussion is coming to your email inbox, Zoom or board meeting soon.

Be prepared, as a CEO or CFO, to lead this SPAC discussion with your board or with investors. But before you do so, develop an objective point of view, drive toward a shared set of benefits and risk assumptions with your board.

Is the 2020 SPAC boom an echo of the 2017 ICO craze?