Navigating SPAC Market Challenges For Microcap Issuers

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Apr 30, 2024

Securities

Navigating SPAC Market Challenges For Microcap Issuers

By: Lucosky Brookman

Law360 (April 30, 2024, 5:35 PM EDT) --

With the recent high-profile closing of the merger between Digital World Acquisition Corp. and Trump Media & Technology Group Corp., a special-purpose acquisition company, or SPAC, which saw over $300 million from SPAC trust proceeds stay in the deal, some might believe that SPACs are back and thriving.

However, a closer look at the SPAC market, especially as it relates to microcap issuers — companies having a market cap of under $300 million — tells a cautionary tale whereby very few targets looking for the advantages that SPACs can provide actually attain them.

A SPAC is a shell company without commercial operations that is formed for the purpose of raising capital through an initial public offering to then acquire or merge with an existing operating company.

In late 2020 and early 2021, the SPAC market saw enormous growth and accounted for the majority of new U.S. public listings, more so than traditional IPOs.

Advantages of SPACs are supposed to include (1) speed, (2) the ability to negotiate the target's valuation up front and (3) a pool of capital to fund operations and fuel growth.

In reality, as the regulatory landscape continued to change and the U.S. Securities and Exchange Commission started to promulgate new rules in an attempt to slow SPAC transactions, the time needed to complete a de-SPAC transaction — the process by which the SPAC merger with its operating target transitions to a publicly traded entity — has continued to increase.

In 2021, the average time between signing a business combination agreement and closing a de-SPAC transaction was 5.2 months. The average time between signing and closing was about 7.2 months in 2022, with some taking as long as 18 months to complete.[1]

This is particularly true of target companies that are microcap issuers.

These companies often do not have the infrastructure and expertise to navigate the process that has become more onerous with the SEC creating roadblocks by changing the accounting treatment of warrants, challenging pro forma financial information and valuations, as well as requiring lengthier and more detailed disclosures.

The ability for a target company to negotiate its valuation upfront is an advantage for the target that would otherwise have to rely on investor sentiment after a registration statement is filed.

Especially for microcap issuers, however, the valuations negotiated upfront are of little to no consequence when redemption rates remain so high.

The average redemption rate has increased significantly since the bull market of 2021, with now over 90% of investors voting "No" on proposed deals, according to SPAC Research.[2]

Source: S&P Capital IQ; SPAC Insider

So even if a target company is able to negotiate a high valuation at the outset of a SPAC transaction, it only generally affects the sponsor equity percentage in the deal as little to no cash from the trust is staying in deals, outside of the rare SPACs backed by private equity, with most of those deals being reserved for companies with a valuation north of $1 billion.

In fact, in January 2023, the average enterprise value of the target companies in de-SPAC transactions was approximately $185 million. In contrast, in January 2022, the average enterprise value of target companies was $1.06 billion, and in January 2021, the average was $2.22 billion.[3]

Smaller deals create more scrutiny on the valuations and viabilities of the targets as redemption rates continue to climb.

Once most SPACs are redeemed, in order to meet listing requirements, SPAC deals become reliant on alternative methods of financings such as convertible notes or private investment in public equity that are typically variable in nature and could cause the stuck to plummet within weeks of closing.

Accordingly, the idea that a microcap issuer will access a pool of capital for operations or growth through the closing of a SPAC merger is no longer viable.

Even the transactions that do close are typically inheriting the burden of the SPAC's costs and expenses that include, but are not limited to, large deferred underwriting compensation fees due on capital that has since been redeemed, legal and professional fees, and high directors and officers premiums.

In of one our firm's recent deals, which has been terminated, the target company would have acquired $13 million in fees and paid the sponsor 15% of the company for the privilege of listing on Nasdaq with debts that it would struggle to service and no corresponding operating capital from the SPAC trust. Hardly an enviable position and ultimately one too costly to recommend to shareholders.

Understanding the Microcap Issuer Re-IPO

While SPACs usually involve a merger with a private target company, there are several circumstances whereby a SPAC may merge with an already existing public company.

During the recent SPAC boom, smaller public reporting companies trading on the over-the-counter Markets began to look at SPACs as a potential way to re-IPO and list their securities on a national securities exchange.

Reasons for pursuing a merger in order to list vary for such companies, but include: illiquidity, volatile trading, lack of capital, and low-priced securities that precluded such companies from pursuing their own listing in favor of a longer, more expensive, route as a means to an end.

Any merger with a SPAC requires that the target company comply with the initial listing qualifications of the exchange. Most of the microcap listings occur on Nasdaq and for most of the OTC companies seeking listing they would not have net income of $750,000 over the prior two-year period using the equity or market value of listed securities standard.

Both such standards require, among other things:

300 round lot shareholders
Public, nonaffiliate float of $15 million;
Positive shareholder equity of $5 million; and
Stock price of $4, with a few exceptions.

It is important to note that decades of SPAC practice included the use of valuation reports for private companies in order to establish the value of the private target in any merger.

Upon establishing the valuation, stock of the target would be exchanged with stock of the SPAC, generally trading at the original SPAC IPO price of $10, with the surviving entity capitalization structure reflecting the agreed-upon valuation based on the SPAC's stock trading price.

Until recently, this method of valuing the target was also expected for any public company seeking a merger with a SPAC, especially over-the-counter companies whose trading may have not reflected their true value for numerous reasons.

However, in June 2023, the Nasdaq changed its long-standing practice of allowing targets to exchange stock with the SPAC at the SPAC's trading price.

In July 2023, the Nasdaq then released a FAQ that held that a SPAC acquiring 100% of a publicly traded target company or is acquired by a publicly traded target company, Nasdaq will now rely on the trading price of the publicly traded target company — adjusted for any applicable exchange ratio and for the additional cash provided by the SPAC — to determine compliance with the price-based listing requirements.

Several over-the-counter companies that have come close to listing on Nasdaq were unaware of this policy only to be denied listing just prior to closing with one application denial now the subject of a lawsuit with the exchange.[4]

Any publicly traded company seeking a merger with a SPAC must understand these rules and to do a proper initial listing analysis to understand if recent hurdles can be overcome by restructuring or perhaps doing a simultaneous capital raise to meet certain of the listing criteria.

While the New York Stock Exchange and the Chicago Board Options Exchange have not completely adopted Nasdaq's rigid stance on pricing, they will consider the public company's trading price, along with valuation reports and the pricing of any public investment in private equity transaction, among other things.

With the SPAC boom of 2021 over, it is important for all issuers and especially microcap issuers, to understand that not all SPACs are created equal. Issuers need to understand and, in most instances, negotiate the costs and expenses of a SPAC transaction upfront — underwriting and professional fees — so you are not saddled with a pile of debt out of the gate.

In addition, targets should find SPACs that have high-quality sponsors with the ability to backstop capital needs in order to mitigate the possibly high likelihood of redemptions and avoid variable priced private investment in public equity transactions as a financing of last resort.

Read more at: https://www.law360.com/articles/1827704/navigating-spac-market-challenges-for-microcap-issuers?copied=1

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