Special Purpose Acquisition Companies.

• Author: Brannon, Ike

* "A Sober Look at SPACS," by Michael Klausner, Michael Ohlrogge, and Emily Ruan. SSRN Working Paper no. 3720919, January 2021.

Investors have complained for some time that the mechanism behind initial public offerings (IPOs) does not appear to achieve an optimal outcome. It usually begins with an investment bank canvassing big investors to get a rough sense of what they might pay for the new company's stock, to establish a price range. The bank then attempts to steer the company to select an offer price at the lower end of that range.

The investment bank's intent is to create a scenario in which the price "pops" as soon as it hits the market. The initial jump in price helps the investment bank's reputation with investors and it also makes the bank some money, as the bank typically receives some of the stock as payment, and garners attention for the firm. However, the steep initial jump in price comes at a cost: if the original price had been set at the higher price, the company would have received more capital.

What's more, the cost of doing an IPO is not cheap: underwriting fees can be as much as 7% of the value of the company.

Alternatives to the standard IPO process have been tried. Google famously did a reverse auction for its initial offering, but it was widely viewed as having been a disappointment because it raised less money than the company hoped. Some attributed the outcome to its investment banks, none of which wanted the status quo upended. Few reverse-auction IPOs have been attempted since then.

More recently, the music app Spotify did a direct listing, whereby it simply listed its outstanding shares on the market without an underwritten offering. The perceived drawback of this is that existing shareholders are not required to hold onto their shares for a certain period--unlike in most IPOs--so the fear is that without that backstop the shares could tank. That, in turn, dampens demand and the new shares raise less money. While investors watched Spotify's direct listing carefully, it failed to spur many imitators.

Another alternative to the IPO gained popularity in 2020: the Special Purpose Acquisition Company (SPAC).

A SPAC is a "blank check" shell company created specifically to obtain a private firm and take it public. Investors buy shares in the shell company at a price fixed at $10, and the principals park the money raised while they search for a promising firm to acquire. Once the principals have identified a target, they...