Tag Archives: spacs

What SPACS Mean for R&W Exposure

The rapid rise to fame of special purpose acquisition companies (SPACs) brings with it a host of uncertainty and risks along with the promise of fortune. In the U.S., 274 SPACs were launched in 2020, and so far in 2021 about $100 billion has been raised, according to the Wall Street Journal. Such is the growing appeal of SPACs that the Securities and Exchange Commission took the unusual step in March of warning that it is “never a good idea to invest in a SPAC just because someone famous sponsors or invests in it or says it is a good investment.”

In addition to warning against basing investments solely on celebrity endorsements, the SEC recently issued further guidance on the booming SPAC market, and many believe that increased scrutiny will continue, with further regulation coming. From an insurance perspective, much of the focus has been on the risk exposures of executives and directors involved in the deals, resulting in an explosion of D&O insurance demand. Although many of the risk exposures remain the same as those in traditional M&A deals, lack of historical data has fueled uncertainty over future litigation possibilities. Perhaps the biggest difference in SPAC risk exposure is the speed with which deals must be completed. As with other areas of the mergers and acquisitions market, the use of representations and warranties (R&W) insurance can offer real benefits to both buyers and sellers to help manage these risks.

Managing the risks

The use of R&W insurance has become a standard feature and a valued tool to facilitate deals in the private equity (PE) space over the last several years, with myriad benefits for both sides of the transaction. Participants in SPAC transactions should also consider R&W insurance once a target has been identified and work is underway to complete the de-SPAC merger. 

The risks to be insured on a SPAC transaction are not radically different from a PE deal – for the buyers, the exposures are largely the same.  However, there is one significant difference in SPAC transactions that may drive risky behaviors: deals are being done against the clock. 

One of the key attributes of SPACs is that deals must be completed within a two-year time frame, which imposes considerable pressure on the founders to find the target and close the merger. In a typical PE deal, despite months – sometimes years – of due diligence and the seemingly good intentions of both parties, it’s not uncommon for M&A issues to arise under sales contracts—often after the ink has dried. The aggressive timeline of a SPAC transaction only heightens these risks. Some parties may be tempted to cut corners in the due diligence process and SPAC sponsors are well aware that discovering bad news might derail the deal. 

This time pressure can also mean that SPAC sponsors may make concessions during the negotiation of the purchase agreement, because they have an incentive to close the business combination and don’t have a fiduciary duty to the investors. In most cases, sponsors are able to sell their shares soon after the deal is done, so they are less interested than other investors in the target’s long-term performance. This last issue can, and in some cases has, been resolved by making sponsors hold shares in the SPAC longer so that their interests are more aligned with other investors.  The more interest the sponsor has post-deal, the deeper they may dig to understand the target, and the more invested they may be in the due diligence process.

How R&W can make it happen

In simple terms, R&W insurance hedges risk for both buyer and seller. When evaluating coverage options, working with a team of underwriters experienced in executing deals under tight time constraints can give SPAC acquirers certainty that they will have insurance in place when they sign a deal. 

Equally important is choosing an insurer  that has a deep bench of underwriters with depth and breadth of experience across sectors, as they will be able to highlight any soft spots in the diligence that need to be addressed to ensure meaningful coverage.

See also: Startups Must Look at Compensation Plans

There is also competitive pressure for targets. Having R&W insurance can be an advantage to the targets in an auction process, making them attractive to investors. Should there be any misrepresentations or breaches post-closing, the seller is liable for losses for the period of time set out in the agreement. To cover any legacy liabilities, a portion of the proceeds from the sale are typically held up in escrow, handcuffing sellers from using those funds. When a target has R&W insurance, it removes the requirement to have an escrow and the sellers can realize the entire proceeds of the deal on closing. For a purchase in the hundreds of millions of dollars, the ability to liberate a 10% escrow with an insurance policy is very attractive. 

While the risk profile for a SPAC target is not critically different from that of any other business requiring R&W insurance, the abbreviated timelines involved on SPAC deals and their shorter track record makes it harder to predict outcomes. Just as a celebrity relies on their reputation to secure endorsements, so too must an SPAC sponsor seeking investor and target company trust. R&W insurance serves as an important tool to facilitate these fast acquisitions, transferring risk to the insurance company and keeping reputations intact.

Startups Must Look at Compensation Plans

Traditional IPOs give private firms months (if not years) to prepare for the governance requirements of being a public company — including adjusting compensation plans, hiring independent directors and establishing charters and bylaws, for example. The explosion of special purchase acquisition companies (popularly known as SPACs) in the market highlights one of the things “reverse merger” deals don’t have — time. There are often just weeks between when an investor approaches a target company with a letter of intent and when a contract is signed, formally taking the firm public.

This accelerated timetable to go public is what makes SPACs attractive to many investors and founders. But a short timeframe also forces the target company to act quickly, ensuring compensation plans meet the evolving needs of the firm and that governance processes are addressed following the acquisition.  

In this article, we’ll explore the biggest compensation and governance issues private firms should address and then plan for when approached by a SPAC investor.

Adjust Compensation Plans Before a Deal Is Signed

When a firm is approached by a SPAC investor, the business should ensure its compensation plans are in order and make any necessary adjustments before signing a letter of intent for a deal. Once the letter is signed, the investor will need to be involved in approving changes, which can complicate the process.

In a traditional IPO planning scenario, we recommend leaders establish or review their guiding compensation philosophy, what they can afford on cash and equity programs, internal pay equity and pay for performance alignment. There’s little time for that kind of deeper analysis on a SPAC deal, however. The target company needs to be pragmatic and look at what changes to executive compensation and equity incentive plans can be done immediately.

Here is a checklist of items to tackle first and quickly to ensure your compensation programs are ready for when the acquisition is complete, and the firm is public:

  • Update broad-based and executive peer groups. Peer groups will shift from pre-IPO and private companies to public firms of similar size and industry or to where the firm is competing for talent. Keep in mind that the COVID-19 pandemic has accelerated the number of employees working remotely, effectively widening talent pools. Smaller, private firms are more likely to hire from local talent pools but that will likely change as a business grows — therefore, new peer groups may need to include businesses outside of the local market or industry.
  • Revisit current and future change-in-control provisions. Many incentive plans include CIC provisions for more traditional transactions and don’t apply to SPAC deals. First, determine whether your incentive plans need to specify SPAC deals more explicitly. Then, update CIC plans for when the company is public. It’s in stakeholders’ interests that key executives have reasonable employment protections that allow them to focus on executing strategy and driving performance.
  • Update parameters for equity incentive plans. Determine the ideal number of shares to authorize given what’s already outstanding and the company’s future headcount growth needs. We typically recommend a plan include an annual evergreen feature because they allow for an automatic, formulaic increase in plan reserves, typically at the start of each new plan year. Absent such a provision, increases in plan reserves after an IPO require shareholder approval via a proxy vote. Firms will also need to consider whether outstanding equity will be converted, cashed out or canceled upon completion of the acquisition.
  • Retain key talent through the close of the deal. Cash compensation and unvested shares should be market competitive to retain key talent through the transaction. The uncertainty surrounding SPAC deals can present a flight risk for employees.
  • Decide whether to introduce an employee stock purchase plan (ESPP). ESPPs can add a lot of employee value with minimal cost and are more widespread depending on company industry and size. To learn more abouot ESPPs, please see our article on plan prevalence here and plan design here.

Integrating the Board and Setting Up Director Pay

A SPAC acquisition is complicated and requires effective communication between the business leaders and the boards of both the SPAC and the target acquisition. Furthermore, the founders and board members of the target firm often stay at least for a certain period after the acquisition is complete. Therefore, it’s important for the combined team to build a positive relationship from the start.

Board members won’t typically receive compensation until the deal is complete and the company goes public. Instead of receiving cash compensation, SPAC board members receive pre-IPO founder shares of the SPAC. The founder shares for the SPAC investors are converted into common shares on the first public day of trading in a ratio of 1:4.

See also: How Startups Will Save Insurance

Once the SPAC is taken public, we advise the board to meet with external advisers to determine the market rate for board compensation based on the firm size and industry. As with many governance issues, director compensation has received extra scrutiny from investors in recent years and newly public companies need to establish fair pay plans that aren’t deemed excessive by proxy advisory firms and institutional investors. The largest proxy advisory firm, Institutional Shareholder Services (ISS), deems director pay excessive if it is within the top 2% to 3% of companies in the same sector and index.

Addressing Governance Processes Once Public

With investors increasingly scrutinizing the governance policies of public companies, including those that are newly public, going through a SPAC means your company will need to act quickly on governance issues.

Consider that, a few years ago, ISS began recommending investors vote against or withhold votes from the entire board of a newly public company (except new nominees to be considered on a case-by-case basis) if the board adopts bylaws or charter provisions that allow for what ISS deems egregious governance policies. These include supermajority vote requirements, a classified board structure and a multi-class capital structure.

There are numerous actions that pre-IPO firms should take early on. SPAC investors typically don’t have a lot of experience with public company governance requirements, so business leaders will rely heavily on the expertise of external advisers and the newly formed board of directors.

The first steps should include recruiting independent board members from diverse backgrounds (e.g., gender, race, ethnicity, work experience). From there, establishing independent committees and charters and then developing an annual independent board evaluation process to provide insight into performance are key. Once those processes are established, companies need to develop a plan of disclosing their governance policies to stakeholders. While certain public disclosure is required (e.g., director bios, their independence, committees and charters), the level of detail can vary, and many institutional investors are expecting more robust disclosure than has been standard. As part of this, showcasing an awareness of environmental, social and governance issues (ESG) in public disclosures can also help to position a newly public company favorably relative to investors, customers and employees.