The once obscure, derided financial product that just might transform deep tech venture capital
By Peter Hébert
Unless you’ve been hiding under a rock over the past year or perhaps docked at the International Space Station, it’s been impossible to miss the Special Purpose Acquisition Company (SPAC) craze that has overtaken Wall Street.
This year alone, as of October 30, 169 SPAC IPOs have raised a total of $59.5B, compared to $13.5B raised by 59 SPAC IPOs in all of 2019. For perspective, the 169 SPACs raised in the first 10 months of the year nearly match the 172 raised from 2015–2019.
Typical late inning behavior amid a massive asset bubble, right? Well, not exactly. A product whose sullied reputation decades ago would have made even a stockbroker in a Long Island strip mall blush is evolving…and improving, rapidly.
Financial innovation can sometimes come from the unlikeliest of places. In the 1960s and 1970s, low-grade bonds, also known colloquially as “junk bonds,” existed in the underbelly of Wall Street, far from the elite white shoe banks and trading firms pushing Nifty Fifty blue-chip stocks to ultimately unsustainable levels. But during this time, a recent MBA graduate and later financial market pioneer named Michael Milken recognized value in these overlooked financial securities, compiling research that counterintuitively proved they could be better risk-adjusted investments than traditional investment grade bonds. In short order, “junk” euphemistically became “high-yield,” and an emerging alternative asset class was born, unlocking access to the debt markets for a legion of companies and imaginative dealmakers that were once spurned by Wall Street.
The financial and capital markets innovations that Milken and his contemporaries pioneered were not contained just to the world of fixed income securities. Like any valuable idea, it spread, lighting the bonfire on an immense boom in leveraged buyout (LBO) activity, which has continued to this day under the moniker of “private equity,” as the LBO kingpins rebranded and refined their craft. It is not hyperbole to claim that without the evangelism and eventual popularization of a once-disdained financial security — the unloved junk bond — the multi-trillion dollar private equity asset class as we know it would not exist.
Junk → High Yield → Private Equity :: SPACs → Venture Capital?
The ingenuity of the SPAC is to synthetically combine a credit instrument with equity upside. In plain English: consider a poker game, where the participants ante up to play the hand, but have the right to redeem in full if they don’t like the cards they later draw. That is, in essence, the SPAC. The SPAC structure provides investors with full capital protection alongside the ability to catch lightning in a bottle through equity and warrants in a business combination. In a zero-interest-rate world, for investors in SPACs at issuance, there is little downside to waiting out the 24-month duration of the product to see if a compelling deal can be found. SPAC IPOs, historically supported mostly by the “SPAC mafia” (usually a set of hedge funds employing an active credit strategy), are now seeing a welcome influx of fundamental shareholders from more patient mutual funds and long-only managers whose main interest is the underlying investment.
So let’s get some things out the way. Based on our actual experience, and thorough market research, Lux is now an enthusiastic supporter of the SPAC.
There, I said it! This means we have encouraged the founders and management teams of some of our most promising portfolio companies to investigate whether this path meets their needs and long-term objectives. And our latest fund is also now a SPAC sponsor, having launched and closed the $345M Lux Health Tech Acquisition Corp. (LUXAU) last month on the Nasdaq, to partner with a leading company at the intersection of healthcare and technology.
Today, many of my VC compatriots in Silicon Valley still sneer at the SPAC, and several I know actively encourage their portfolio companies to avoid SPAC sponsors.
“A product for also-rans who can’t go public the normal route.”
“Frankenstein financial engineering for speculators and amateurs.”
To which I say, BALDERDASH!
Despite being an industry that funds and births world-changing technological innovation, on the whole, the reflexive response to financial innovation among venture capitalists (with Bill Gurley among the notable exceptions) is often No! Non! Nyet! Sometimes the disinclination to embrace change is due to lack of public market sophistication but more often than not, it is rooted in a historical (and potentially outdated) understanding or mythology that has been spread by those motivated to maintain the status quo. As Bill has covered, the barometer of success in Silicon Valley is an IPO led by Goldman Sachs or Morgan Stanley that pops at open, regardless of whether that wealth transfer to hand-selected public market investors is in the company’s long-term interest (debatable) or to the benefit of existing shareholders (spoiler alert: it’s not).
While I started my career at Lehman Brothers, I had not the faintest expectation that my current world of technology venture capital would ultimately collide with SPAC. That is until one of Lux’s most remarkable and sophisticated entrepreneurs (Desktop Metal co-founder and chief executive Ric Fulop) called me during the summer to share that he had been approached by several SPACs, had methodically spoken to as many bankers, sponsors, and market participants as he could, and concluded this financing path made sense for Desktop Metal.
Ric is a high-horsepower serial entrepreneur and has built a globally recognized innovator in metal 3D printing, originally spun off from MIT. But he had also previously witnessed the “conventional” IPO experience: in the mid-2000s his prior company, A123 Systems, was ahead of its time in energy storage, with Sequoia’s Mike Moritz as a board member, and Morgan Stanley and Goldman Sachs as lead bookrunners for what became the largest IPO of 2009. At Desktop Metal, with blue chip investors like NEA, Kleiner Perkins, and GV alongside Lux, why would Ric choose a SPAC?
For the same three reasons I came to appreciate the SPAC as a valuable and advantaged funding mechanism for ambitious companies who are in the midst of a growth phase-change.
Ability to provide forward guidance
Today’s traditional IPO and direct listing paths to exit work well for companies whose last 12 months are good indicators for what the future can bring. Software companies with reliable revenue growth rates allow analysts and buy-side investors to simply extrapolate forward and modulate the multiple for price expectations. In an alternative universe, but one which has developed its own rhyme and reason, the biotechnology IPO window has been wide open since 2012. The entire biotech ecosystem and conveyor belt of capital (from VCs to crossover investors to mutual and hedge funds — and the banks and strategic corporates that support the flow) have developed to nurture scientific innovation to public platform companies. But no such financing structure exists for companies with large ambitions and meaningful order books, but without robust trailing twelve-month revenue streams to extrapolate forward. The SEC currently prohibits companies going through an IPO to communicate forward guidance with prospective investors. Thus the only basis an investor has to evaluate a company with futuristic technology is what has occurred in the past, when nearly the entire value of the enterprise is based on what will occur in the future. It is within the context of this fundamental dissonance, especially in a low interest rate environment, that the most significant advantage of the SPAC becomes clear. In the SPAC process, companies that have large bookings yet to be ultimately realized as GAAP revenue, or major product introductions in the future, are able to conduct in-depth conversations with sophisticated investors in private. This means growth companies are able to partner with SPAC sponsors who have the freedom to conduct deep diligence and understand all of the nuances and growth prospects for their business, but in private, rather than through arms-length speed dating based upon publicly-posted, historical financial data.
Upfront private price discovery
Imagine you are an entrepreneur making probably the most significant decision of your career. By listing your company on the public markets via the traditional route, you learn the size of the capital raise and market valuation only upon the completion of the process. An investment banker’s incentives are similar to those of a real estate agent: win the listing by telling the client what they want to hear, and then float the trial balloons to see what the market will bear. Witness WeWork, where investment bankers painted notions of a $100B market cap, only to see the market resoundingly reject such a notion in a publicly painful and catastrophic way. In contrast, the SPAC process allows companies to have conversations with sophisticated sponsors, discussing price and terms of a potential business combination, all in complete privacy. If a deal happens, great. If not, life goes on.
Investor selection + syndicate curation
The most elite and fortunate venture-backed startups keep a velvet rope outside their cap table to ensure only the privileged join as shareholders. And yet, when it comes to their IPOs, they are guided by their investment bankers on how to allocate the order book. Often the select investors recommended by the banks are also the right shareholders for the respective companies. But incentives are such that the bank has an obvious interest to feather the nests of their most reliable customers, which often are not the right shareholders for those companies. The SPAC process has evolved to include a companion PIPE (Private investment in Public Equity), in which companies and their SPAC sponsors hand-select partners and determine allocations in the same fashion as what happens in late-stage venture capital rounds. Lux’s experience as a roll-over shareholder in publicly-announced SPACs (Desktop Metal and Aeva) has been a positive one, with founders retaining the ability to place shares with investors who share the same investment philosophy as — and are fully aligned with — the company’s existing, patient shareholders.
The SPAC market has evolved rapidly in the past 12 months, and it will continue to adapt as practitioners learn, experiment, and innovate. The quality of sponsors today is remarkably higher than it has been in the past. Hedge funds and private equity firms were some of the institutional pioneers, with Chamath Palihapitiya as a notable early believer from the technology sector. In addition to Lux, other VC and growth equity SPAC sponsors include Altimeter, Dragoneer, FirstMark, General Catalyst and Ribbit Capital. Sponsors are iterating on financial structures — from the embedded economics to warrants (e.g., Bill Ackman’s Tontine Holdings).
SPACs come with their own sets of tradeoffs and risks (more on that in a future post), but I firmly believe that for the right company — those with a high-quality executive team, financial controls and systems in place, a large addressable market, and winning product or service — these types of vehicles can be rocket fuel to enable companies to compound over years and grow meaningfully for public shareholders.