Why startups should explore blank-cheque firms for raising capital

From only a handful of startups at one point, the ecosystem has exploded to occupy a chunk of the Indian corporate landscape. Proliferation of private equity capital and availability of financing have been fuelling this growth. At the same time, it is interesting to note that the number of deals has been reducing over the last couple of years.

Having deployed their dry powder, many funds are sitting on their investments or planning to cash out. At the same time, many startups have not delivered as well as investors expected at the time of investment. As an alternative to private markets, startups could look at the public markets for fundraising.

Public listing 

IPOs give the investor direct access to liquid capital markets, better negotiating power with financial institutions as adoption of international accounting standards lead to higher transparency and lower information asymmetry, and more operational flexibility to founders compared to startups controlled by venture capital and private equity firms where ownership gets diluted. 

However, many startups cannot opt for an IPO. Most of them are not large enough in terms of scale. Also, high cash burn rates and lack of profitability make them less attractive to public market investors.

Some experts argue that investor risk aversion is inversely correlated with their income and education. Investors in developed markets are, thus, less risk averse compared to their Indian counterparts. 

Further, many of the business models that are unproven in India have already been proven in these developed countries. One such proven model is the Special Purpose Acquisition Vehicle (SPAC), which provides an opportunity for Indian startups to raise money from offshore investors.

What is a SPAC?

SPACs are essentially blank cheque companies that are listed on an exchange to raise capital and acquire another company through a reverse merger. They came into existence in 1993 after the US Securities Exchange Commission adopted Rule 419 introducing ‘blank check companies’. 

SPAC units include a common share and a fraction of a warrant. SPACs are sponsored by highly connected and reputed professionals, such as former fund managers or investment bankers. They typically own about 20% of the SPAC post an IPO. This called promote. 

A sizeable promote can create agency problems as the founders would always get the promote, irrespective of whether the investment goes bad. To counter this, a lock-in period of three years is in effect in the US. 

Warrants lead to dilution of new shareholders and over the years, warrants per unit have come down while its strike price has gone up (more out-of-money warrants). 

Over 98% of the SPAC proceeds are deposited in escrow and the interest earned is used to run the SPAC’s operations. In case of an exit, the investor is paid from the escrow facility. The founders take a nominal salary. For investors, a SPAC unit is essentially a risk-free note with a call option.

SPAC listing requires specialised underwriters that take higher risk. They are therefore better compensated compared to normal investment banks, although the deferred part of their fee has gone up over the years.

If an acquisition is completed within a pre-defined timeframe (18 to 24 months), a proxy vote is conducted. The current threshold to vote down acquisition proposals is approximately 90%. This has been done to protect normal shareholders against large investors such as hedge funds. An alternative to proxy votes is a tender offer, through which each shareholder gets an effective say in voting on the acquisition.

If investors vote down the proposal, sponsors get until the deal deadline to complete the acquisition. If they are unable to do so, the SPAC is liquidated and the proceeds from escrow are distributed to the shareholders. If the acquisition is approved, the SPAC acquires the target through a reverse merger after which it becomes a regular publicly traded stock. 

However, the lack of separate listing considerations for SPACs is the biggest roadblock against its implementation in India. According to a paper by Brij Bhushan Garg, Soubhik Chatterjee and VK Unni, the lack of both tangible assets as well as an operational record pose challenges for SPACs.

SPAC exchanges

Backdoor entries to NASDAQ through reverse mergers gained notoriety in 2011 and 2012 when some Chinese companies entered the US. markets through a reverse merger and were found to be committing accounting fraud. The situation has improved since then and SPACs' credibility has improved.

Other than the NASDAQ, LSE, ASX (Australia), HKEx (Hong Kong), TSX (Toronto) and OMX (Stockholm) are alternate locations for SPAC listing. 

All of them have widely different regulations. LSE requires the listed entity to delist and then reapply, while ASX and HKEx require prior intimation and consultation. NASDAQ Stockholm has less stringent criteria than the above three. TSX has separate guidelines on SPACs and wants to actively participate in SPAC listing.

Way forward

SPACs provide an opportunity to startups with business potential to unlock some value and enhance their reputation. Typical SPAC sizes fall between $50 million and $200 million. This is also the typical size of an asset-light Indian startup that has proven its worth. Thus, SPACs fits well with their fundraising strategy.

Enhanced lock-in period, lack of voting rights, and requirement of escrow are some of the effective fail-safe measures. They protect investor’s wealth, avoid capital misuse and increase the attractiveness of SPAC units as a constant return security with potential upside. 

While SPACs are quicker and easier to list compared to an IPO, the proxy voting requirement can lengthen the time it takes before investors realise their returns.

Concerns regarding backdoor entry have receded lately and regulators globally are opening up to the idea of SPACs as a way to enhance market returns and ensure better participation from retail investors. New rules have been introduced to avoid fraud. For example, norms around minimum holding period have been tightened, both for investors and founders. 

Traditionally, SPACs were linked to companies with low quality and small size, which typically find it difficult to raise capital through regular IPOs. However, even this perception is changing. The SPAC listing of Yatra and Videocon DTH along with the recent listing of an India-focussed SPAC on NASDAQ have been encouraging signs. As India’s startup population swells, this is the right time for such new-age firms to unlock value in a truly globalised capital market.

Tuhin Harit is a senior associate at KPMG Corporate Finance. Ramabhadran S Thirumalai is clinical assistant professor-finance at Indian School of Business. Views expressed are personal.

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