A special purpose acquisition company (SPAC) is a shell company formed solely to raise capital through an initial public offering (IPO). The purpose is to acquire or merge with an existing private company, taking it public. Some market participants view SPAC transactions as providing private companies with greater certainty in pricing and control over deal terms, compared to a traditional IPO.
In April 2021, the Securities and Exchange Commission (SEC) issued staff statements on how SPACs were handling their warrants. It pointed out that many SPACs were incorrectly categorizing their warrants as stock. But, according to the SEC, these warrants should be considered liabilities in certain circumstances. Such increased regulatory scrutiny led to a decrease in SPAC issuances.
The article aims to demystify SPAC warrants by answering common questions, such as: What is a SPAC warrant? How do warrants work in a SPAC? How to exercise warrants? And how to trade SPAC warrants?
SPAC warrants explained
Investors in SPACs typically buy what are known as SPAC units. A SPAC unit consists of shares and warrants, or even fractional warrants, such as a quarter of a whole warrant (per unit).
Therefore, SPAC warrants can be defined as financial instruments issued by SPACs during IPOs. These are contracts that give investors the right to purchase a predetermined number of common shares of the SPAC at a certain price (the strike price) in the future, often a premium to the stock price at the time the warrant is issued.
Typically, SPAC warrants have a specified exercise period (often several years), during which investors can choose to exercise their warrants. If exercised, investors pay the strike price to the SPAC and receive the corresponding common shares.
Warrants can be traded separately from the SPAC’s common stock, allowing investors to speculate on the future performance of the SPAC or hedge their investment risk.
There are public and private placement warrants, each with its peculiarities.
Public warrants:
- Issued alongside SPAC shares during the IPO.
- Typically have a strike price of $11.50 or higher (such price is chosen to encourage investors to buy the warrants by offering potential profit above the $10 initial offering price).
- Subject to a lock-up period, often one year after issuance or after a merger or acquisition.
Private warrants:
- Offered to SPAC sponsors or founders before the IPO (known as the “promote”).
- Can have a purchase price significantly below the original SPAC share price.
- May have cash and cashless exercise options or have no SPAC warrant redemption terms.
- Redemption prices may fluctuate based on warrant terms and market conditions.
Additional reading: Explore reverse triangular mergers to learn how to utilize financial and legal mechanisms for efficient corporate acquisitions.
How do SPAC warrants work?
Overall, the SPAC lifecycle involves the formation of the SPAC, the IPO and capital raising process, the search for and acquisition of a target company, and the completion of the merger or acquisition.
Warrants are typically issued during the IPO stage of the SPAC lifecycle. Investors who participate in the IPO by purchasing SPAC units receive a combination of common stock and warrants. These warrants entitle holders to purchase additional shares of the SPAC at a predetermined price in the future.
Warrants can be a large contributor to total returns, as they often carry value beyond the share price alone. In a standard SPAC, where investors typically receive half a warrant with each purchased unit, the value of warrants is influenced by factors like current share price, volatility, and time to maturity. As share prices increase, so does the value of warrants, adding substantial percentage points to total returns.
To understand how SPAC warrants work, let’s use the example of the Cyxtera merger, with insights from Matt Frankel, a financial professional, who, in response to Cyxtera investor question, explains how and when to exercise the warrants:
- Warrant terms. Warrants typically grant investors the right to purchase shares of the company at a fixed price within a specified timeframe, often five years. In the case of Cyxtera, one warrant allows the holder to buy one share at $11.50 within the next five years.
- Forced exercise circumstances. There are circumstances where warrants can be forced to be exercised early. If the stock trades at $18 or more for 30 consecutive days, the company can redeem the warrants essentially for nothing.
- Staying informed. Investors need to closely monitor news alerts for any announcements regarding warrant redemption. This allows investors to stay informed and make timely decisions regarding whether to exercise, sell, or hold onto their warrants.
- Risk assessment in SPACs. If investors are uncomfortable with tracking news or potential warrant redemptions, they may choose to sell their warrants or focus solely on owning the stock. This ensures investors can mitigate the risk of being caught off guard by warrant redemptions.
Note: When a SPAC completes its initial business combination, the ticker symbols for the combined entity’s stocks and warrants change. Investors wishing to exercise their warrants should keep this in mind.
How to get started
Here’s what to do to start investing in SPAC warrants:
- Choose the right broker. Select a reputable broker like Webull, Robinhood, Fidelity, or Interactive Brokers that offers warrants on their platform. Consider factors such as trading features, fees, and customer support to ensure a smooth trading experience.
- Research and select SPAC warrants. Conduct thorough research on SPAC warrants available on a chosen broker’s platform. Look for warrants from trusted SPACs run by experienced professionals, and be cautious of cheap options.
- Calculate the theoretical valuation of a warrant. Use online price calculators that allow you to input various factors and valuation metrics, such as implied volatility and the pricing model. This can help identify the fair value of a warrant. You might also be interested in reading our business valuation tutorial.
Characteristics of SPAC warrants
SPAC warrants have certain features that differentiate them from other financial instruments. Here are some key characteristics:
- Warrant exercise price
Warrants have a predetermined exercise price, which is the price at which the warrant holder can purchase the underlying common shares. This exercise price is set at the time of issuance and is typically at a premium to the SPAC’s IPO price. The exercise price is fixed and doesn’t change over the life of the warrant.
- Limited investor rights
Warrant holders typically don’t have voting or dividend rights. This distinguishes them from common shareholders who have these privileges.
- Correlation with the underlying stock
SPAC warrants’ prices generally move in tandem with the underlying stock prices. This makes warrants highly sensitive to market volatility.
- Dependency on merger success
The value of SPAC warrants after the merger heavily relies on the merger’s success. In cases where a SPAC merger fails, warrant values may drop, sometimes to near-zero levels.
- Dilution impact
When warrants are exercised, SPACs must issue new shares, resulting in dilution for existing shareholders. This dilution can impact earnings per share and share price.
- Warrant expiry date
Just like in options trading, warrants have an expiration date, which is the deadline by which the warrant must be exercised. If the warrant isn’t exercised before the expiry date, it becomes worthless, and the holder loses the right to purchase the underlying shares. The expiry date is set at the time of issuance and is often up to five years after the acquisition or merger.
- Early redemption features
Even though SPAC warrants theoretically have an expiration date of up to five years, the majority include early warrant redemption deal terms. For example, some may have conditions under which warrants must be redeemed within 30 days if the stock price remains above a certain level for a certain period.
Additional reading: Discover how to expand a business globally by reading our comprehensive article on the topic.
Value and risks of investing in SPAC warrants
Let’s take a look at the key advantages and disadvantages of investing in warrants.
Value
- Potential for high returns
SPAC warrants offer unlimited profit potential if the performance of the underlying stock is strong.
- Liquidity considerations
The warrant market is generally very liquid, allowing investors to easily buy and sell warrants on the stock exchange, providing flexibility in their investment strategies.
- Diversification
Warrants can facilitate diversification as they often have a lower entry cost compared to buying the underlying asset outright, allowing investors to spread their investment across multiple assets.
- Leverage
SPAC warrants can strengthen returns as they provide investors with the ability to control a larger position in the underlying stock with a smaller investment, potentially maximizing profits in a given period.
- Smaller initial investment
Warrants typically require a smaller initial investment compared to buying common shares.
Risks
- Complexity
Warrants are complex financial instruments and due to their complexity they may not be suitable for inexperienced investors.
- Lack of standardization
Warrants often lack standardization across offerings, requiring investors to carefully analyze the terms and conditions of each warrant, which can increase the complexity of investing.
- Bigger risks
While warrants offer leverage and potential for higher returns, they also come with bigger risks.
- Discounted pricing
Warrants may trade at a discount relative to their equivalent common stock due to the risk of merger failure or other uncertainties, which could lead to losses if the warrant becomes worthless.
- Regulatory risks
Regulatory changes, including those issued by agencies like the Securities and Exchange Commission, affect SPAC warrants and can change their value and how they trade.
Strategic considerations for investors
Strategic considerations for exercising warrants involve assessing various factors, including:
- Due diligence. When investing in a SPAC through an IPO, investors should conduct due diligence and ensure the SPAC is managed by experienced professionals. The success of the investment largely depends on whether a merger occurs, so trust in the SPAC’s management team is very important.
- Expiry date. Exercising warrants before the expiry date ensures that investors don’t lose the opportunity to convert SPAC warrants into underlying shares. However, exercising too early may not be optimal if the stock price has not yet reached a favorable level. Therefore, investors should wait for the optimal time.
- Specific terms. Understanding the terms and conditions of warrants is essential for building effective trading strategies. Investors should thoroughly review these terms before exercising warrants. For example, warrants may include clauses specifying conditions under which they must be redeemed early.
- Tax implications. Depending on the jurisdiction and individual circumstances, exercising warrants may trigger capital gains taxes or other tax liabilities. Investors should consult with tax advisors to understand the tax implications of exercising warrants and plan accordingly.
- Portfolio diversification. Investors should consider how exercising warrants fits into their overall investment strategy and portfolio diversification goals. For example, exercising warrants to acquire additional shares of a particular company may concentrate portfolio risk if the investor is already heavily invested in that company or sector.
Long-term vs short-term investment
Determining whether to treat SPAC warrants as a long-term growth potential investment or a short-term speculative opportunity requires careful consideration of various factors.
Key takeaways
- Special purpose acquisition companies (SPACs) are companies with no commercial operations. They are created only to raise capital through initial public offerings to acquire or merge with an existing company.
- SPAC warrants are financial instruments issued during IPOs that give investors the right to purchase common shares at a predetermined price, typically at a premium to the IPO price, offering the potential for high returns.
- Investors should carefully review the terms and conditions of SPAC warrants, considering factors such as early redemption features, expiration dates, and dilution impact, to mitigate risks and optimize their investment outcomes.
- Strategic considerations for investors include conducting thorough due diligence on SPAC management teams, evaluating market trends, understanding warrant terms, assessing tax implications, and aligning warrant exercise decisions with overall portfolio diversification goals.
- The regulatory environment surrounding SPAC warrants is constantly changing, so staying informed about updates and developments is crucial for investors to navigate potential risks effectively.
