Don’t worry, the bunny had a full recovery! Will we say the same about insurance SPACs?

SPACs have invaded the insurance space of late with Hagerty being the latest to join the fray, both on the startup side (Hippo, MetroMile, Doma, Kin) and with established companies (CCC & Hagerty).

I will cut straight to the chase. This is a bad development for all parties – the corporates, the private investors, and the public investors. There isn’t necessarily anything inherently wrong with SPACs, but the way they are being used of late is worrisome.

In short, they have misinterpreted the Lesson of the Hare and are no longer able to run.

I am not going to focus on any one company, but, suffice it to say, the recent run of SPAC listings has been rather disappointing. Several stocks are down more than 50% and several others have raised far less capital than anticipated due to investor redemptions. To state the obvious, this is not a good outcome.

Recall, the idea of the Hare is to use a cheap cost of capital to grow your business. It is a house of cards approach and can collapse at any time if not approached thoughtfully.

The goal is to be able to continuously raise capital cheaply by continuing the charade. The easiest way to do this is to not get piggish. Unfortunately, as we will discuss shortly, these SPACs were done at piggish terms and brought a stop to the music.

Brief SPAC Structure Review

I’m not going to do this justice but I’ll try to get everyone on the same page before we proceed. There are a few key elements to a SPAC.

First, it allows a company to go public (through an “acquisition” rather than a traditional IPO listing). Second, it raises capital from both the investors already in the SPAC, as well as new investors through what’s called a PIPE offering. More on this in a minute, but think of this as a private fundraise separate, but parallel, to the SPAC.

When a SPAC announces an acquisition target, the shareholders can either hold their shares and participate in the upside created by the deal (this is the goal!) or redeem their shares and effectively get back their original investment. If the SPAC negotiated fair terms, this should rarely happen.

However, as there are now far too many SPACs relative to the amount of companies who need to list, investors are increasingly voting with their feet against transactions and demanding their money back.

Back to the PIPEs briefly…if the transaction target is at too high a valuation to be bought fully by the SPAC shareholders, then the sponsor will raise additional money through a PIPE. You can think of this like an additional private equity round, but at the same (sort of) price as the SPAC investors.

There are two main differences between investing through the SPAC shares and the PIPE. One, the PIPE doesn’t have redemption rights. Two, the PIPE does tend to get other favorable terms that the public investors don’t get, like warrants, a convertible note structure, or a discount to the offer price.

How The Hare Breaks Its Leg

Remember, the alternative to going public through a SPAC is pursuing an IPO. We will come back to this idea later. Also remember, that a Hare only remains a Hare as long as it can convince people that it’s valuation will keep going up forever.

Additionally recall, two prior themes I have written about. One, it is easier to be a Hare in private markets where nobody can short your valuation and you only have to convince one person to pay a higher price. Public markets aren’t as forgiving which leads to the second point which is financial startups shouldn’t go public until they have a path to being self funding.

The companies who went public through SPACs forgot all these lessons. In fact, they did exactly the opposite!

Mistake #1: Mixing Public and Private Valuations

The first major mistake was letting private investors set the valuation for public markets through the PIPE. When you set the valuation too high, the SPAC investors all redeem and your capital raise essentially functions like a private round anyway, at least in regards to the $ of capital raised.

Unless you are sure public markets will accept the private valuation created by the PIPEs, you are setting yourself up for failure doing a SPAC.

Your public valuation goes down from the private round which ruins the illusion you are a Hare. Second, you force your private investors to realize immediate losses which means they won’t fund you again in the future. You have tied yourself in quite a knot!

The lesson is, if you want to be greedy about valuation, stay private longer. All these recent SPACs pushed the boundary of logical valuations which is a foolish thing to do when it is so easy for people to vote against you (both the SPAC holders who can redeem and the pending ability of uninvolved investors to begin shorting your stock).

Given the size of the redemptions in some of these deals, the companies barely raised any more money than if they had done another private round.

If, instead, the goal was to create a public currency, then the targeted valuation should have been set more in line with a typical IPO so that the SPAC holders would have held on to their shares and there wouldn’t be a line around the block to short the float on the first day possible.

Mistake #2: Leaving a Welcome Mat For the Shorts

To build on the last point, whichever bank is advising companies to top tick valuation through a SPAC should be fired yesterday. As mentioned, you don’t raise any more capital with a greedy SPAC valuation than a greedy additional private round because the SPAC holders all redeem and you end up in the same place…except for one thing.

The aforementioned line to short your stock. Let’s do a quick thought experiment. The “Fair” price for my IPO is $30 and the “greedy” price is $50.

If I do an IPO at $30 and the stock goes to $50, investors will probably be afraid to short it because of the momentum and fear of getting squeezed up to $60 or even $75.

However, if I do the SPAC at $50 and the SPAC holders mostly redeem, I can short this thing all day long because I know there is no pent up demand coming to the rescue. It’s an easy short to $30 and maybe even to $25 or $20 because things get carried away and nobody wants to be a hero and try to call the bottom.

This is basic investor psychology. It’s one thing for a management team that has never been public to not realize this, but that is the banker’s job and it’s an egregious failure on their part not to understand this setup and advise against this approach.

Mistake #3: Not Thinking About Future Capital Raises

Now, you could say I overlooked one thing. In the SPAC scenario the company raised money through the PIPE at $50 vs. in the IPO they only raised at $30, so the issuer is better off.

And that’s true…in the short term. If you listened to my advice and waited to go public until you were self funding, then, yes, maybe it is worthwhile to have gone the SPAC route. However, that is not the situation for most of these companies involved.

They will need to return to the capital markets multiple times. How are they going to do that?

The private investors are done. You burned them. The idea that you could play the Hare, stay private, and ask them for another round at a higher valuation in a year or two is over. That’s an unforced error.

But now you have access to the public markets! OK, but tell me how many people like to buy into busted deals? If your stock is down 50% from the IPO, good luck building a book for that next deal. It’s not happening.

In fact, as I discussed before, the shorts will only be emboldened by your perceived weakness. They know you need more capital and will drive the stock down to painful levels where it is not really feasible to issue. That’s how you end up in a death spiral.

So, congratulations, you raised this round at a better valuation…but you greatly increased your company’s risk of future ruin! You have broken the Hare’s leg!

The Busted PIPE Investors

I’ve mostly discussed how these SPACs are bad for the corporates. And they are. But let’s not leave out the PIPE buyers. As mentioned, they don’t get the chance to redeem their shares once they catch wind the market doesn’t like the terms.

They are stuck. They have bought the absolute top. They are the opposite of the Hare. And I don’t mean the Tortoise sort of opposite. More like Wile E Coyote. They ran themselves off a cliff.

Sure, they got some protections in their deal that ease the pain a bit, but those favorable warrants they got? They’ll never be worth a dime. The price break they got on the valuation? Buying something at 95 cents on the dollar that’s now on the 50% off sales rack isn’t really a deal.

The private money also needs to remember the flaws of trying to play hot potato on valuation when the next holder isn’t another private firm that doesn’t need to mark to market, but rather public holders who can bet in two directions.

The IPO Alternative

At the end of the day, water finds its level. Eventually, the stock will trade where it should. It may take years for that to happen, but eventually it will.

The whole point of being the Hare is to try to stay above that level for as long as possible and take advantage of the cheap capital. You do this by creating an illusion of prosperity that is painful for a skeptic to challenge.

When you get greedy and poke the market in its figurative eye, the illusion disappears because nobody likes to feel disrespected. People (especially investors) are willing to be suckers, but they don’t want to be told that you think they’re a sucker.

If you’re a more mature company and this is your last fundraise, you can try to top tick a SPAC if you like and accept the tradeoff of higher offering proceeds vs. the perception that comes with your stock languishing for the next year or two (or three?).

The risk there is that your long term valuation may suffer if investors consider you a “disappointment”, not necessarily because of your operations, but because “oh, that stock never works. Can’t own it”. It is not uncommon for two companies with similar fundamentals to have a valuation difference largely due to investor perception.

However, if you’re running a company that is still in growth mode and needs to continue raising capital, the wise play is to go the IPO route. Sure, you give up some near term proceeds, but you have much better odds of keeping control of the narrative.

Owning your narrative is a big part of being a successful Hare. It creates urgency for investors to buy in now, lest they miss out! A successful IPO “pop” followed by a future capital raise at a higher price is a great way to build that narrative.

Or Stay Private

Yes, I will beat this drum one more time. Don’t come public if you will continue to need more capital. If you have private investors willing to fund your PIPE, then tell those investors “look, it is risky if we go public at the same time. We open ourselves up to short pressure and volatility. Why don’t we do this as another private round”?

You avoid all the near term headaches of being public and you buy time to grow into the valuation and be able to have a successful IPO in a year or two.

If this is about wanting a public market to be able to cash out some of your personal holdings, then, let’s be honest, you’re not running the company in the best interest of all shareholders. Furthermore, you’re hurting your ability to maximize the price you sell the rest of your shares at in the future.

The best thing you can do is address your cash burn so you can accelerate the timeline for when it makes sense to be a public company.