Nanalyze

An Intro to Blank Check Companies and SPACs

In a recent article we talked about a cannabis themed Initial Coin Offering (ICO) led by an ambitious young model and an influential musician that all but epitomizes today’s heated ICO market which throws valuations out the window and just “raises money” based on a white paper. Even the bright minds at CB Insights are analyzing this trend with some of their insights seen below:

An ICO is whereby an entrepreneur with a dream to change the world blasts his LinkedIn contacts and raises tens of millions of dollars because he figured out how to launch a coin on the blockchain.

That’s actually pretty accurate. If you’re not familiar with how an ICO works, it is similar to an Initial Public Offering (IPO) except everyone receives tokens instead of shares and there is no notion of valuation whatsoever because generally all you have is a business plan (also called white paper). To make matters worse, there is no market that these tokens can be traded on, and unless you can find a bigger fool someone who is willing to buy them from you, then your tokens are literally worthless.

In the case of an IPO, institutional investors determine what the shares ought to be worth because they have teams of MBAs doing boring valuation exercises that can actually be fairly accurate, but are prone to extremely volatile answers depending on what variables you are using to predict the future. They decide what they are willing to pay for the startup before it is unleashed on the public markets where retail investors can then participate. Venture capital firms can then cash out of their original investments and celebrate a rare success (1 in 10 venture capital backed startups will make it to a successful liquidation event).

The IPO route to becoming a publicly traded company serves to protect retail investors, most of whom can’t tell the difference between an over-the-counter (OTC) pump and dump and a legitimate technology stock like Illumina (NASDAQ:ILMN). When an IPO takes place on a major exchange, it has been vetted by institutional investors and can be considered to be “lower risk” than the “reverse merger” route that some companies take on the OTC market which largely ends up in disaster. If someone needs to promote a stock to get people to buy it, then it’s probably not worth buying.

So far we’ve talked about three routes that startups can use to raise funds from retail investors; IPO, ICO, or a reverse merger on the OTC market. There is also one lesser known way which is that of a “blank check company“. You may also hear this referred to as a “SPecial Acquisiton Company” or SPAC. Semantics are not important in this case, since the general idea of a blank check company or SPAC is for investors to literally sign over a blank check to someone who then decides what to invest the money in prior to the whole vetting process taking place. Essentially, investors are putting all their faith in the person running the shell. It’s kind of like a reverse merger on the OTC market except that the shell is traded on a major exchange. Here’s how the SEC describes a blank check company:

A blank check company is a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person. These companies typically involve speculative investments and often fall within the SEC’s definition of “penny stocks” or are considered “microcap stocks.”

Notice how that last sentence equates a blank check company to a penny stock when it comes to the extent of speculation taking place. Given that 99% of penny stocks fail, that’s not a good sign. As you can guess, blank check companies are best avoided by everyone except the most sophisticated investors. Yet over the past few days, we’ve seen articles on every major tech news site about a company that’s going to “turn Silicon Valley upside down” with a financing method that’s been around for ages – a blank check. That company is called Social Capital.

VC plans to be Warren Buffett of Silicon Valley with $500M IPO says the headline at Silicon Valley news, while CNBC announces “This former Facebook employee is trying to build the next great investing company like Warren Buffet“. Looks like the PR team is really pushing the “Warren Buffet” angle here and we’re having a hard time picking up what they’re putting down. Warren Buffet largely invests in value plays with a focus on income generating assets. Silicon Valley startups on the other hand generally burn through cash to pursue rapid growth. Not to mention, Warren Buffet has traditionally avoided tech companies.

Social Capital is actually a well-established Silicon Valley venture capital fund with about $1.2 billion in assets. The founder, Chamath Palihapitiya, has a successful track record as an entrepreneur and has partnered with another VC firm, Hedosophia, to create a new blank check company that wants to revolutionize the traditional IPO process. While Mr. Palihapitiya probably realizes that he’s closer to Masayoshi Son of Softbank than Warren Buffet, he can’t use the Masa reference because few retail investors know who that is. There’s also another big difference here. Social Capital is looking to raise $500 million while the Softbank fund is playing with over $100 billion and Warren Buffet’s Berkshire has a market cap of around $440 billion. Even with such a “small amount” to play with, Social Capital shouldn’t have any problems finding places to spend the money given their investment track record as of last month:

Source: CB Insights

Social Capital to help startups go public without an IPO” says an article 24 hours ago by Tech Crunch. That’s not exactly true. If Social Capital just uses this one shell for one startup, then that’s true. If however they intend to invest in multiple startups (as they say they will), then you have what more resembles a conglomerate as opposed to a single publicly traded company. In the Social Capital S-1 filing, it states that Social Capital has to have a majority stake in any startup they acquire (more than 50% of outstanding shares). With only $500 million to work with, that doesn’t give them lots of options for late-stage companies (we’re assuming that’s what they are investing in if this is an “alternative to an IPO”). As you can see in the below chart, Social Capital’s late stage deals are much larger (average is $118 million):

Source: CB Insights

What you might end up with then is a portfolio of about 5 companies that you need to keep track of individually in order to value the shell. While this looks super interesting and may provide a new sort of asset class for diversification, it doesn’t appear to be worthy of all the “Warren Buffet” analogies.

This form of financing has been around for a long time and is hardly anything new. A fire hose of outrage is spraying everything in sight these days, and Silicon Valley has not gone unscathed. People seem to be desperately seeking a way to circumvent the traditional startup capital raising process which is one of the reasons why ICOs have become so popular. The truth is that these venture capital firms have created the entire world of technology as it exists today. Given their track record of performance, they’re probably the best people to be deciding where investments should be made in technology.

Venture capital firms have been around for a lot longer than blank check companies have and they aren’t going anywhere. In the case of Social Capital, you have the opportunity to invest alongside a known VC in some late-stage startups. Let’s hope it performs better than others who have tried this type of business model in the past, like 180 Degree Capital Corp (NASDAQ:TURN). Social Capital plans to list their SPAC on the NYSE under the symbol IPOA.U.

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