Transactions involving SPACs, or special purpose acquisition companies, have become increasingly popular but also come with several risks. A SPAC is an entity with limited business operations that goes public through a SPAC initial public offering (IPO). Following the SPAC IPO, the SPAC must consummate a merger with a private operating company. If the SPAC fails to identify a merger target within the required timeframe, typically 18-24 months, it must liquidate.

The process of a publicly listed SPAC merging with a private target company is referred to as the de-SPAC transaction. Following the completion of a de-SPAC transaction, the private target company becomes a publicly traded company. For many private companies, the de-SPAC process is an attractive alternative to a traditional IPO.

Once the parties sign a business combination agreement, the SPAC will file a Form S-4 registration statement with the Securities and Exchange Commission (SEC). The Form S-4 contains extensive disclosures about both the SPAC entity and the target operating company. The Form S-4 serves as both a prospectus and proxy statement. It contains information about the shareholder meeting that will be held shortly before consummation of the merger transaction.

The public shareholders of the SPAC entity typically have redemption rights, meaning they may request that the SPAC redeem their shares for cash if a business combination is consummated. Public shareholders may prefer to redeem their shares for cash rather than hold equity in the new public company following the merger closing.

A common risk encountered in many de-SPAC transactions is that the public shareholders will exercise their redemption rights. These redemptions often occur just days before the shareholder meeting is held to vote on approval of the merger and certain related proposals. The redemption rate in recent de-SPAC transactions has been relatively high, in many cases exceeding 90%. When shareholders request to redeem their shares, cash is paid out of the SPAC’s trust account. A high number of redemption requests can potentially jeopardize the closing of the merger because the SPAC is required to have a minimum cash balance to ensure the post-merger company has sufficient cash to meet its operating needs. The minimum cash condition is a negotiated threshold that is usually set forth in the business combination agreement.

Concurrently with the execution of the business combination agreement, the SPAC sponsor and company directors often enter into support agreements. Pursuant to the terms of these support agreements, the SPAC sponsor and company directors agree to waive their redemption rights.

In order to further reduce redemption risk, the SPAC may enter into non-redemption agreements with certain existing shareholders or potential shareholders. Pursuant to the non-redemption agreements, the shareholders will agree not to exercise their redemption rights with respect to the shares they own.

Another way to offset the risk of high redemptions is to enter into securities purchase agreements with certain institutional and accredited investors at the time of signing the business combination agreement. This private placement in public equity (PIPE) financing provides another method of raising funds for the post-merger business. It also can bridge funding gaps in case the redemption rate is higher than expected.