What are Search Funds,SPAC(special purpose acquisition company) and SPE?

"Entrepreneurship through Acquisition" (ETA) is a model where entrepreneurs buy businesses that already have a proven product, a good market fit, and are generating revenue.

Why would someone sell a business like that?

There are many possible reasons. The business owner may be getting older, and no one in the family wants to continue the business. The owner could be a serial entrepreneur who wants to move on to a new venture. Or the owner may feel the market is right to cash out and enjoy a financially stress-free retirement.

Whatever the reason, the ETA model is a win-win for both the entrepreneur and the business owner.

Now let's look at some of the "vehicles" used for these transactions and understand their differences.

Search Funds

Let's start with "Search Funds." This model was popularized by Stanford Business School. Students at top business schools will likely have heard this term.

Search funds are for entrepreneurs who have a business degree (or are about to graduate) and want to become CEO of a company. Here is how it works.

An individual or a small team creates a "search fund" and gets early investors. These investors provide funding during the "discovery phase." This is when the entrepreneur searches for a business that is already making money.

Once a good company is found, the investors put in their share of the investment to help close the deal. This model reduces the risk for young entrepreneurs who have not yet run a company. They acquire a business that is already profitable.

Search funds usually target small to mid-size companies. It is a great way for budding entrepreneurs to take over a company and become CEO at a young age.

SPAC

Now let's look at SPACs (Special Purpose Acquisition Companies). Think of a SPAC as an extension of the search fund model, but aimed at larger companies instead of small or mid-size ones.

In the SPAC model, the "entrepreneurs" are industry veterans with extensive experience running large companies. Here is the key difference: a "shell company" is first created and taken public through an IPO to raise the required capital.

The entrepreneurs then spend the next one to two years finding a company that matches their investment thesis. They go through the acquisition process and, after the deal closes, start managing the company.

This model is similar to a Private Equity LBO (Leveraged Buyout), except the cash is raised through an IPO instead of private investors.

Advantages of SPAC

Less time: A traditional IPO can take six months to a year. With the SPAC model, the process can take as little as a couple of months.

Fair Valuation: With a SPAC, the seller can negotiate a fair price directly with the SPAC sponsor. In a traditional IPO, the valuation depends on market demand.

Strategic Partnership: SPAC sponsors bring industry expertise. The company can use this knowledge after going public.

Easy acquisition process: SPACs are shell companies with lots of cash already raised from the IPO. This makes the acquisition of the target company smoother compared to being acquired by an existing large corporation.

Disadvantages of SPAC

Rushed Judgment: SPAC sponsors must find a company within two years. If they don't, they have to return the money to investors. As the deadline approaches, sponsors may rush and make a poor purchase.

Quality of the target company: With the boom in SPACs, there may be more SPACs than good companies available. This limited supply of quality targets can lead to poor choices.

Quality of the Sponsor: Investors in a SPAC rely heavily on the sponsors, not just the company being acquired. Finding a good fit between the SPAC sponsor and the target company is key to getting a good return on investment.

Rise of SPAC

Recently, SPAC-based acquisitions have been on the rise.

"There were 194 traditional IPO deals raised $67 billion, the best year since 2014, according to Renaissance Capital. But it was an even better year for SPACs, which raised just about the same amount: 200 SPACs raised about $64 billion." - CNBC - 2020 SPAC and IPO figures

Some popular SPAC-based IPOs in 2020:
Virgin Galactic (NYSE: SPCE)
DraftKings (NASDAQ: DKNG)
Opendoor (NASDAQ: OPEN)
Nikola Motor Company (NASDAQ: NKLA)

Some fintech companies have also used the SPAC route for their IPOs.

SoFi, an online lending platform, was set to go public through a SPAC-based IPO that year. It was valued at $8.65 billion for its merger with the SPAC called "Social Capital Hedosophia Corp V."

SPACs have provided a safe way for companies to go public during the COVID pandemic. Many companies feared market volatility and worried they would not get a fair valuation through a traditional IPO. The cash-rich SPACs helped reduce this risk.

SPE

Lastly, let's look at SPEs (Special Purpose Entities). It is easy to confuse SPACs with SPEs, but they are different.

An SPE is a risk management tool used by companies. For example, say a company wants to start a new project and needs funding. It can create an SPE using its assets (like accounts receivable) and use those assets to get new loans.

SPEs are also used to structure complex transactions during mergers and acquisitions. The most famous -- or rather infamous -- use of SPEs was by Enron. Enron misused SPEs to get loans from banks.

In conclusion, entrepreneurs have many creative funding options available to them, such as VC, search funds, SPACs, and PE. In the end, starting a company comes down to the will and the dream of the entrepreneur.