How SPACs work: Structure, Risk and Regulations

If you want to go public, but you consider the traditional IPO route inconvenient, here’s what you need to know about the legal framework of SPACs.

A Special Purpose Acquisition Company (SPAC) is a shell company formed to raise money through an initial public offering (IPO) so it can later purchase or merge with another company. SPACs are usually formed by investors with knowledge in a particular industry and they have no commercial activity. SPACs operate on promises and time constraints: they raise money through an IPO, place the money in a trust, and have between 18 and 24 months to identify and merge with a target company. If a target company is not found, the SPAC is liquidated and the investors receive their money back.

Simply, a SPAC allows you to go public without taking the traditional route, translating into higher valuations, increased speed to capital, less stringent regulatory framework and lower costs.

However, SPACs have a poor historical performance. In January 2021, out of 514 SPACs, 298 were liquidated. Usually they underperform and attract the attention of the SEC. They were in part the cause of the 2007-2009 Financial Crisis, their number rose again in the beginning of 2020 but quieted down towards the end of the same year.

Moreover, the AXS De-SPAC ETF (DSPC) that tracks de-SPAC merged companies had returns of negative 67% in 2023, and negative 60% in February 2024.

But if their historical performance has been so weak, how did they begin to experience growth in the summer of 2024, after two years of decline? What is the current landscape for the SPAC regulatory framework? Moreover, did you know about Donald’s Trump SPAC endeavour?

Let’s play a game to better understand why SPACs still exist and the reason for their current boom.

Imagine you are a wealthy individual, so you want to raise capital by taking an empty holding company public in an IPO.

The SPAC uses the cash proceeds from the IPO to acquire a private company and make it public.

Since the SPAC issues a lot of stock to close the deal, the private company controls the entire entity, a process known as “reverse merger”. The Sponsor, known as a “promote", gets a 20% stake with less regulatory measures than an IPO. So you, as the Sponsor, invest almost nothing for 20% stake.

In other words, the promoter actually obtains a very profitable call option: if the stock price rises significantly, the promoter benefits enormously; if, on the other hand, the stock collapses, the promoter loses little or nothing relative to the minimum initial investment, while still potentially exiting with a profit relative to the capital initially committed

Over the past two decades, there was a surge in these financial vehicles that peaked during 2021 in the US where there were 302 de-SPAC mergers accounting for US$622.9 billion invested, a year-on-year gain of 152%. Recently, in 2024 there was a resurgence, with 56 SPACs going public indicating new interest from investors.

John D. Morley, a Yale Law School legal scholar, noted that even if SPACs offer a faster route to public markets, they bypass some of the rigorous scrutiny associated with traditional IPOs, potentially leading to post-merger governing issues.

As a consequence, in January 2024, the SEC issued a final rule enhancing financial reporting and disclosures for SPACs and shell companies, in order to enhance transparency and protect investors.

The key provisions include:

1. Enhanced Disclosure Requirements: SPACs are to provide detailed information about sponsors, conflicts of interests, target companies and dilution risks

2. Projections Oversight: stricter guidelines that limit the safe harbor protections for SPACs forward looking financial statements

3. De-SPAC Transactions: the target company must be a co-registrant in fillings, making it liable for misstatements. A new rule treats business combinations involving SPACs as securities sales

4. Investment Company Act Consideration: it was clarified that SPACs focusing on business combinations and holding government securities are less likely to be classified as investment companies.

The provisions took effect on July 1st, 2024 and provide a stricter regulatory framework that aims to protect the financial markets.

Moving about 2500 km south-US, the Cayman Islands has emerged as a favoured jurisdictional territory for the SPACs climate, due to:

1. Reputation and Stability: the legal system is well-rounded, offering a stable off-shore solution

2. Legal Flexibility: the legislation is progressive, allowing for tailored corporate structures and bespoke government arrangements

3. Tax Neutrality: there are no capital gains, income, profits, corporation or withholding taxes

4. Efficient Incorporation Process: with necessary documentation, a day is enough to incorporate your business

5. Robust Merger Framework : the regime accommodates efficient business deals

These attributes have made the Cayman Islands a particularly attractive area for SPAC activities.

What about Donald’s Trump SPAC Endeavour?

In 2021, a merger between Digital World Acquisition Corp (DWAC) and Trump Media & Technology Group (TMTG), the parent company of Truth Social was announced. It underwent extensive delays due to regulatory investigations and shareholder approvals. Ultimately, in 2024 the deal was approved, with the combined entity beginning trading under the ticker symbol “DJT” and achieving a valuation of approximately $6.8 billion.

However, financial challenges post-merger appeared, such that one-month post merger, TMTG reported a net loss of over $58 million, with revenues of only $4 million from advertising on Truth Social, without mentioning the scrutiny over its choice of auditor, leading to the termination of its accounting firm in May 2024.As for 2025, TMTG experiences significant volatility, and trouble in navigating the complex landscape of SPACs. Without diversification, future prospects are not positive.

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What now?

While the U.S. has dominated the SPAC activity, as regulatory clarity improves we might see an extension of the SPACs in emerging markets.

It is commonly believed that 2025 is poised for a resurgence, characterized by strategic adaptations, regulatory shifts and a favourable climate in the innovative specific green industries. However, stakeholders are advised to carefully balance optimism with due diligence as the SPAC landscape still remains a maze with moving walls.

CC: Alessandra Albescu