The Start-up Empire Strikes SPAC

By: Akshay Pai From (SCMHRD) and Ritu Menon From NMIMS Mumbai

Special Purpose Acquisition Companies (SPACs) along with Bitcoin and $GME have been the most talked about keyword among financial enthusiasts in 2020 for good and bad reasons alike. Like all revolutionary (but not perfect) financial instruments and innovations before it, SPACs have divided Wall Street exactly down the middle with an equal number of backers and opponents. Most unicorn start-ups think of SPACs as a deliverer from their IPO woes and the best idea since sliced bread, but most analysts and value investors have panned them citing unfavourable returns and hidden costs (most target companies overprice shares to offset the 20% of total float which is issued to the SPAC as a part of the deal).

A SPAC is in essence a shell company set up with a big-name investor or group of investors at the helm with the aim of raising money through IPOs to eventually acquire other companies. This makes a SPAC an evolved hybrid of IPOs and reverse mergers, that offers a faster (not necessarily more secure) route for a private entity to go public. A textbook example of a SPAC is the Diamond Eagle Acquisition Corp. which went public as a SPAC in December 2019 with no pre-set targets.in April 2020 it announced a reverse merger with DraftKings which then began trading as a public company.

The main advantage of a SPAC for the target company is the acceleration of the process of going public, shaving off almost 4 crucial months that would be required in the conventional IPO method per a white paper on SPACs. For the SPAC retail investors, the advantage is bottom floor entry into unicorn start-ups that maytake off exponentially once they receive the funding from going public. The SPAC owners gain about 20% of the shares of the merged entity as their reward. The SPAC exists for the sole purpose of acquisition and has no operational history or commercial operations – the capital raised from its IPO is locked in a trust account to be returned to investors with interest if no suitable acquisition is made within a set time limit – typically 2 years. 

This sped up process is not without its risks. In finance trade-offs are the norm and not the exception – for every instrument that offers a higher return, the investors must also bear a higher degree of risk. The speed of the SPAC process comes with due diligence and propriety as casualties of the trade-off norm. The investors are also headed blindly into the investment since they have no knowledge of which company the SPAC will acquireand need to trust the promoter’s judgement. Transparency also takes a hit as the SPAC process is not as rigorous as traditional IPOs, this combined with the fact that SPAC managers are incentivized to find a target company to acquire within the time limit can limit their consideration for value accretive acquisitions. These factors can combine to provide a worst-case scenario where retail investors may be left holding the bag if an acquisition goes sour.

Can two wrongs combine to make a right?

So, if SPACs have been described on Wall Street as ‘a business model that incentivizes promoters to do something – literally anything – with other people’s money is bound to lead to significant value destruction on occasion’ why are we touting the SPAC route as a likely saviour for start-ups in India, perhaps as the missing link catalyst that Atmanirbhar Bharat has been missing?

The answer comes down to two simple, interlinked elements that are causing great consternation to almost all Indian start-ups, time and money. In a survey by NASSCOM 90% of the start-ups surveyed admitted they were stressed on funds and 70% admitted they would run out of funds over the next accounting period with the current rate of burn – unless additional funding could be raised with haste. In case these start-ups are forced to shut down, apart from the usual suspects like employment numbers, a bear run in the market and a small dent to economic indicators – the impact on India’s MSME sector and Atmanirbhar Bharat program would be catastrophic. Many of these start-ups by necessity operate in segments and areas which are not tapped by the bigger multinationals – from the hyperlocal delivery apps like Delhivery and Dunzo to the female sanitation mavericks like PeeSafe, a vast variety of start-ups cater to markets not serviced by global players and help generate revenue which stays in India, and boosts employment and other indicators in India.

While most start-ups find it easy to find Series A investment, the lack of a proper ecosystem to develop and nurture start-ups ensures most start-ups don’t make it to Series B and C funding. Of the few that do make it, fewer still get funded over tedious and time-consuming rounds with dilution of equity and control. IPOs are out of the question for enterprises which haven’t seen profit since their inception, though they have the potential to merit an investment by well aware retail investors. This has a negative impact on the Atmanirbhar Bharat mission which has always seen start-ups as an important driver present in all 5 pillars of demography, balance of supply demand, technology system, economic upheaval and infrastructure upgrades. 

While the research indicates that most start-ups have forced this fate on themselves by opting to go for VC funded expansions with ideas copied from the west and not optimized for Indian markets with deep discounts as a substitute for actual demand – instead of bootstrapped expansion within means with original ideas. The fact remains that a cascading failure in the start-up ecosystem would have disproportional negative impact on the fledgeling Atmanirbhar Bharat mission. Fortunately, the get rich quick expansion of the start-ups and their need for funding may be met with the meet acquisition targets quick mentality of SPACs if they are allowed to operate in India. 

Indian start-ups are projected to require over ₹ 100 crores in funding in 2021, and SPACs across USA have shown the potential in raising upto $75 billion of war-chest with stable mergers like Nikola, Opendoor, Virgin Galactic and DraftKings acting as proof of concept. The Indian start-up story may just continue on its upward trajectory with two wrongs (the cash burning orientation of Indian start-ups and the acquisition KPIs targeted mentality of SPAC managers) combining – under healthy amounts of supervision and regulation – to provide an ingenious Indian solution to an Indian problem to keep the flag of Atmanirbhar Bharat flying high.