Faster Exits Lead to More Funding at Higher Valuations in Early Rounds
Since last year, SPACs (special purpose acquisition companies) have accounted for the majority of IPOs on the stock market. This SPAC craze is now transforming angel and venture capital investing, making it easier for early stage startups to raise money at higher valuations.
To start, it’s important to keep in mind a unique condition of startup investing — whether by SAFE, convertible note, or equity, an investment in a startup can’t be sold, redeemed, or traded until the company is either acquired or makes its stock publicly traded stock through an IPO.
Unlike investing in the stock market, real estate, artwork, or NFTs, until the acquisition or IPO, the investor’s money is locked up, with no way to cash in. The acquisition or IPO is referred to as the “exit”, because this is the only way investors can leave the company.
Startups typically require 5–10 years to reach an exit. That’s a long time for an investors to hold their wealth in an investment that earns no interest or dividends. A lot can happen over those 5–10 years, making early-stage investing extremely risky. The gain has to be large to make the investment worthwhile.
The main reason for the long gestation period is the size required to be a publicly listed company. Although there is no legal requirement, $1 billion in revenue is considered the smallest size for a mature company to be publicly traded. High growth unicorns can consider listing after they reach $100M if their trajectory shows them reaching $1B quickly.
The process of becoming a public company with stock listing on NASDAQ or NYSE is arduous and expensive, requiring a team of investment bankers flying around the world with the company’s executives to meet fund managers to convince them to buy the stock. If they can’t drum up sufficient interest, the prospective IPO gets pulled.
In contrast, acquisitions are relatively simple. However, only large public companies have the cash (or tradeable stock) that make significant acquisitions possible. And large public companies don’t want to acquire startups until they’ve reached a level of maturity where they can be integrated into a big company, which typically means revenues of $25M to $50M.
In summary, startups have had 2 ways to achieve success for investors:
- Reach $100M+ in revenue and become a publicly traded company
- Reach $25M+ in revenue and get acquired
Reaching these milestones usually takes 5–10 years, and for niche products with a small market, may be impossible. The SPAC add a third option, and that changes the equation for early stage investors.
What is a SPAC?
While going public is an expensive and time consuming process, an acquisition is far simpler and straight-forward. The SPAC is designed to offer the best of both worlds — a public listing done as a merger.
The magic is to create a new public company with the sole purpose of acquiring a startup. This is called a SPAC.
Prior to acquiring another business, the SPAC has no operating business of its own; it’s just a pile of cash. With no history, the listing documents are simple and almost entirely boilerplate.
The goal of the SPAC is to use its cash to acquire a private company, turning the target into a public company. The SPAC has 2 years to find and acquire a business or the SPAC is dissolved and the cash returned to the original investors.
The SPAC Craze
Since mid-2020, SPACs have exploded, rising from an obscure financial implement to the majority of IPOs.
In 2014, there was $1.8 billion in 12 SPACS. This increased over the years to 59 SPACs in 2019. Then suddenly in 2020, $83 billion went into listing 248 SPACs.
To put this into perspective, there have been an average of only 167 IPOs per year since 2001. In 2020, there were 407 IPOs, meaning the majority of IPOs last year were not operating businesses but pools of money looking for a company to acquire.
Currently, there are 578 SPACs listed on the market holding $177 billion to acquire private companies. 154 of those SPACs are in the process of consummating an announced merger. 424 SPACs are searching for a partner. Then add another 284 SPACs that have filed for a listing.
Compared to around 150 operating businesses going public on their own each year, there will soon be around 800 SPACs looking for a private company to take public within 2 years or less.
Some of those 800 SPACs might give up and dissolve, but since the sponsors of the SPAC gets paid only if the SPAC consummates a merger, it’s a good bet that the vast majority of those 800 SPACs will find a company to acquire.
SPACs Transform Early Stage Investing
An investor’s willingness to invest in a startup comes down to 3 fundamental factors:
- probability that the company will reach an exit
- expected valuation on exit
- amount of time required to reach the exit
While it’s impossible to quantify the above factors with any accuracy before the company even has its first customer, early-stage investors have to assess them qualitatively in deciding whether to invest and at what valuation.
Adding SPACs to the mix changes all three of these factors for the better. As an acquisition rather than an IPO, SPACs make it possible for a company to go public much earlier and with lower revenues. The WSJ reports that the average revenues of SPAC companies is $48 million. Some, especially those in the biotech sector, don’t have any revenues at all. (https://www.wsj.com/articles/spac-frenzy-emboldens-silicon-valley-startups-to-forgo-venture-funding-11614344154)
The probability of reaching an exit is therefore greatly enhanced while the amount of time to get required to reach investor heaven can be sped up by years.
Further, with 800 SPACs out battling each other for a private company to acquire, it’s a seller’s market for startups, raising valuations.
This creates a virtuous cycle. With startups exiting quicker at higher valuations, early stage investors can recycle the capital tied up in previous investment to apply to the next round of startups. And the high returns and lower risk of the earlier exits attracts new investors to join in early stage investing.
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