The SEC issued accounting guidelines that pumped the breaks on the white-hot SPAC market and caused many SPACs restate their financials.

A SPAC, also known as blank-check company, is a stock created by sponsors that raises money in an initial public offering with no underlying business. Investors entrust their money to one of these sponsors, instead of to an operating company.

Typically, the SPAC must use its cash within two years to buy a private company (in a de-SPAC transaction), or refund the money to investors. Generally, investors don’t know what the acquisition target will be until the announcement.

Reserve now, buy later

A SPAC IPO is usually structured to offer investors a unit of securities consisting of (1) shares of common stock and (2) warrants. A warrant is a contract that gives the holder the right to purchase in the future a certain number of additional shares of common stock at a certain price.

The terms of warrants vary greatly across different SPACs. In general, sponsors receive the more advantageous private placement warrants and outside shareholders receive less-desirable public warrants. A SPAC itself can redeem warrants pursuant to their terms. Warrants are often exercised when the merger target is announced.

A liability, not an asset

Recently, the SEC issued accounting guidelines stating that SPACS must consider warrants, often previously classified as equities of the entity, to be liabilities. This is because an outside third party could make a cash tender offer, and the SPAC would be obliged to give all warrant holders cash for their warrants. The classification of warrants also depends on their value on redemption; the value can vary greatly according to the terms of the SPAC’s IPO.

Many people consider this an unnecessary burden. “In reality, the company will never pay cash because the warrant holder will exercise [the warrant] and get the equity. That’s more valuable to them.” said Harris Antoniades, managing director of global investment bank and advisory firm Stout.

Workarounds

In June, Smith and Tomov delineated many of the convoluted provisions necessary to classify warrants as derivatives, a form of equity. “In many of the deals, the warrants don’t meet an exception in FASB’s accounting standards for derivatives. As a result, they’re misclassified as equity”.

Recently, legal (Laura Anthony, Esq. and Joel Rubenstein et al. of White and Case, LLC.), and financial (Noam Hirschberger, CFA and Eric Gelb, CPA of PKF O’Connor Davies) groups also addressed the fine points of the SEC statement. They came up with several suggestions on how current SPAC agreements might be amended, or how future SPAC contracts might be worded, so that warrants could indeed be classified as equities of the entity rather than liabilities.

One solution would require the sponsors to give up some of the considerable financial advantages they enjoy in holding private placement warrants. It remains to be seen if the sponsors would be willing to do so.

Another approach is to simply not include warrants in the SPAC’s IPO. That’s how flamboyant SPAC proponent Chamath Palihapitiya handled his latest series of biotech SPAC IPOs in June. Alternatively, new contracts might include rights agreements, commonly used in Europe, rather than warrants, but rights agreements are considered riskier for the investor.

Demanding a recount

Meanwhile, the SEC ruling has caused a flurry of new filings, as almost three-quarters of existing SPACs scrambled to amend their statements to conform to the new guidelines. The new standards are forcing companies to redo the initial IPO valuation and analyze the value of the warrants each quarter, rather than just at the start of the SPAC. They will also have to use more complex valuation models, said Antoniades.

At the same time, the ruling has caused a huge drop in the number of SPACs created (from 298 January-March 2021 to just 32 in April and May 2021), and fueled speculation both that such was the SEC’s intent, and that the IPO market may shift away from SPACs and back to traditional IPOs. However, after an initial tumble, the market appears to have shrugged off the reclassification, and value of existing SPACs has not plunged.

Conclusion

The SEC has issued new guidelines requiring SPACs to classify or reclassify warrants as liabilities. This means they have to appear on balance sheets quarterly rather than only once, and to undergo a more complex valuation process. This and other recent guidance from the SEC has put the brakes on a previously red-hot SPAC market.