Discover Venture Capital SPAC Magic for Finance 3.0

Zero to One

On January 27th, 1880, legendary Thomas Edison patented the lightbulb. Ever since that patent, the evolution of manipulating electricity has been the driving force behind the technological revolution. Elon Musk is currently spearheading the path to a world with self-driving sustainable electric cars and a net zero emission future. With visionaries such as Musk, the world now seems to move from Zero to One in some sort of none-linear leaps. The expression “Zero to One” is derived directly from Peter Theil’s book about entrepreneurship. In Zero to One, Theil details that creating value is not enough if the creator is unable to reap some of the company profits. That is why the global economy must allow entrepreneurs to benefit by creating effective monopolies. Being a rent seeker is not an object of effective monopolies, as this implies a static world where nothing changes and where the goal for founders is to corner markets. Instead of being traditional monopolies, effective monopolies must be incentivized to continuously come up with new products that lacks competition and opens up unopened doors. This line of thinking explains the logic behind time limits on patents, which was for example given to Thomas Edison by the US government to incentivize other inventors such as Musk to execute on important ideas in the future. For entrepreneurs to succeed in creating a Zero to One idea, they need to start companies and this is where venture capital investors enter the story.

Peter Thiel

Venture Capital

After idea generation comes execution, which is achieved by forming a company. Today, creating companies is relatively inexpensive, but access to capital is still important and somewhat more difficult to attract. Certain products including software is less capital intensive, as there is no upfront investment other than time, while other types such as cars require investments in expensive machinery. That is why technology companies such as Apple, Spotify, Facebook and Amazon are “garage” stories, meaning that these tech giants needed less funding than a more traditional business of equal size. Nevertheless, even tech companies need start-up capital, which must be sourced from somewhere. If family and friends lack funds, then entrepreneurs are likely to pitch their product to venture capitalists (VCs). However, becoming a VC also requires access to large pools of money. That money is usually sourced with private capital or from other investors. If the money is sourced from other investors, then the typical venture capital fund charges fees similar to a hedge fund. Generally, that means an annual 2% management fee and a 20% performance fee. The fees are charged based on total assets under management (AUM).

Figure 1

Figure 1 represents the famous J-curve for a startup. The beginning is all about survival and Venture Captialists help entrepreneurs navigate these tough beginnings in return for a potential huge payoff in the future.

VC Example

For example, say that VC Lars runs a fund investing in technology startups. Lars is currently looking for new investment opportunities and it so happens that recently the up and coming entrepreneur, Lisa, pitched a really cool app idea in front of Lars. Lisa requires a 10 MUSD investment from Lars to market her idea so that it can spread on social media. Lars currently have 5 MUSD in free investment capital so he must find another investor willing to invest 5 MUSD in his VC fund. After making some calls to his network, Lars sets up a meeting with Henrik who is a CIO for a large pension fund. Henrik has an investment mandate to diversify a small portion of the pension’s portfolio to technology companies, but he believes that all technology companies in the public market are overvalued, which is why he agrees to the meeting with Lars. After the meeting, Henrik believes in Lars superior ability to invest in technology companies and invests 5 MUSD in the VC fund. In turn, Lars invests 10 MUSD in Lisa’s company at a 100 MUSD valuation. Lars now holds a 10% equity stake in Lisa’s company so if Lisa sells the company for 200 MUSD in 3 years, Lars would make 10 MUSD (100%) in total profit from that sale. However, Lars revenue share would be less than the 10 MUSD in total profit. That is because Henrik deserves his portion of that revenue. Henrik’s profit would be around 3.8 MUSD because he paid 2% in management fee over 3 years plus the 20% performance fee from the final sale. Lars final revenue is therefore 5 MUSD from capital appreciation and an additional 1.2 MUSD in fees from Henrik.

Potential upside for founder and VC is huge

Entrepreneur vs Investor

Few doubts the importance of founding entrepreneurs including Daniel Ek, Stewart Butterfield and Mark Zuckerberg when creating unicorns such as Spotify, Slack and Facebook. However, behind every successful entrepreneur is an investor with capital. Usually, this investor is a VC who took risk by investing in the talented entrepreneur. Sadly, the VC is often forgotten. So, if the entrepreneur is the star basketball player like Jordan or Kobe, the VC is more similar to a Popovich (head coach). Just like Popovich motivates players and creates the optimal basketball team, the VC is a compass navigating the entrepreneur through the business landscape. Another similarity is that both a coach and a VC have often been a star player/entrepreneur in the past. My favorite example is Chamath Palihapitiya (Cham). At the age of six, Cham’s family moved from Sri Lanka to Canada to improve their life situation. According to Cham’s biography on Wikipedia, he used to sleep on a mattress in his family’s living room while attending Lisgar Collegiate Institute and at the same time working to support his family. I believe that these hardships taught Cham to work smart and value time, which made him the successful VC he is today. Although Cham never founded a company prior to becoming rich, he has been on the ground floor for multiple businesses. After graduating university, he started his career as a derivatives trader where he learned practical risk management skills. After leaving the job as a trader, he worked for AOL and then later for Facebook in 2005. While working at Facebook, Cham made venture capital style investments on the side in now huge companies such as Peter Theil’s Palantir.

Chamath Palihapitiya

VC Finance 3.0 Style - SPAC

In 2015, Cham and his ex-wife founded Social Capital, which I believe is a finance 3.0 approach to VC investing. Social Capital targets technology companies on an opportunistic basis. The end goal of a VC such as Social Capital is to exit with a massive profit to compensate for all the risks involved when investing in startups. The exit takes place when a VC’s portfolio company sells shares either privately or publicly. Historically, exiting has been limited to traditional approaches like an IPO, but Social Capital has figured out a new way to create more value for entrepreneurs through creating special purpose acquisition companies (SPACs). What I find most intriguing is the structuring of the investments that Cham and Social Capital has completed.

Chamath Palihapitiya with Sir Richard Branson (founder of Virgin Galactic)

Stages in Venture Capital

Before exiting, Lisa’s company undergoes the traditional venture capital timeline (VCT). The stages of the VCT often blends together. Generally, the first stage of the VCT is the seeding stage. The financier at this stage is usually an angel investor, which is most likely to be family and friends or an accredited individual investor. The financier could also be a VC such as Lars who believes strongly in Lisa’s app idea. The financing at the seeding stage supports salaries, market research and business establishment. The following stage in the VCT is the startup stage. At this point, Lisa’s firm is likely to earn revenue. The startup stage financing is usually provided by VCs that prefer more information about the product prior to investment. These startup stage VCs will hopefully know if Lisa’s idea has the potential to generate lots of revenue in the future. Lisa in return will need more funds for product development and more marketing. Worth noting is that VCs entering at this stage generally does so at a higher valuation in return for receiving more information. A negative impact to Lisa and other early investors at this stage is that a VC could dilute ownership percentages and add another decision maker. Before accepting new capital, the value of the VC investment must therefore be weighed against ownership dilution. After these early stages in the VCT, Lisa’s company will enter the final financing stages. These second and third round financing stages supports Lisa’s company when the app is already generating revenue and provides capital needed for major company expansion. If Lisa is successful with the expansion, she should start preparing for her exit strategy. This strategy hopefully involves mezzanine financing, which is used to capitalize an initial public offering (IPO).

Figure 2

Figure 2 depicts the Venture Capital Timeline (VCT). All VCTs are not created equal for companies.

4 Ways to Sell a Firm

Not counting bankruptcy, entrepreneurs can usually pursue four exit strategies to liquidate ownership. These exits include merger and acquisition with and by another company, management buyout or IPO. The first three exits are likely if the firm is unable to IPO or if the owner of the firm is reluctant to fully let go of managing the company. For example, in a management buyout, the main principal might need liquidity to invest in other opportunities with the goal of maintaining control of the company. As a result, the principal sells part of the company to a familiar management team. However, an IPO is considered the holy grail, as an IPO involves honor and the highest profit for investors spanning the VCT. Traditionally, IPO’s are expensive, as they involve experts. These experts help setting up process and procedures dealing with SEC rules plus other responsibilities necessary to attract capital from public investors. Generally, the experts are investment banks and they also assist the IPO company by sourcing demand and setting IPO price and date. The IPO process is without a doubt a lengthy and costly ordeal, which is why Cham focused on the genius idea of starting holding companies or so-called special purpose acquisition corporations (SPAC) to short-cut the IPO process and provide more value for founders. These holding companies are created for direct listings rather than an IPO, but the end result is still a huge payout for the founder and all other investors in the firm.

IPO is the holy grail!

SPAC

As an entrepreneur and founder of Pay Pal, Thiel wants to maximize profit for his stakeholders by creating efficient monopolies. However, for a founder to actually earn money after creating an efficient monopoly someone else needs to buy shares of the founder’s company. According to Cham, merging with a SPAC and directly listing the company on a public stock exchange is the optimal way for a founder to capture the largest risk adjusted slice of the company’s revenue pie. SPAC’s have existed for a long time, but have exponentially increased in popularity after Cham’s Social Capital successfully merged with Richard Branson’s Virgin Galactic in 2019. A SPAC is formed through an IPO to buy another company. The first line of investors in a SPAC is generally the sponsor. For example, Cham always invests a minimum of 100 MUSD in all of his SPACs so that he has skin in the game. After the sponsor comes investment banks and other institutional investors and finally private investors. A SPAC is essentially a blank check company meaning that the company itself does not pursue any commercial operations. Instead, the SPAC is formed by sponsors with industry specific expertise for the purpose of raising capital to purchase a company in an industry of their expertise. Generally, the sponsors have an idea of which company to target prior to creating a SPAC, but they do not disclose the target company to investors for the purpose of avoiding extensive disclosures during the IPO process. After raising enough capital, the money is first placed in an interest-bearing trust account. That money is then used to purchase the target company or is returned to investors if the SPAC is unsuccessful. Merging with a SPAC has gained popularity among founders of large firms including Spotify and DraftKings. The reason for SPAC popularity is founder optionality. A SPAC is essentially a combination between a direct listing and a private round so everything is set and done after the SPAC and the target company agrees to amount raised, valuation and percent dilution. For example, in 2019, Social Capital agreed to purchase 49% of Virgin Galactic for 800 MUSD. As of September 30, 2020, Social Capital’s 49% slice is worth around 2 BUSD, which is a 150% increase in valuation since directly listing on the stock exchange. In return for merging with Social Capital, the owners of Virgin Galactic ensured an 800 MUSD payout while keeping the upside of a direct listing. With a normal merger or management buyout the founder is likely to receive less profit and with an IPO the profit outcome is uncertain although the upside might be higher than directly listing through a SPAC.

Figure 3

Figure 3 is a light rundown of the SPAC timeline

Conclusion

Before Edison and Musk was able to create groundbreaking products, humanity learned how to harvest electricity. The exact moment when electricity was manipulated equates to a singularity, as electricity continuously shapes our society precisely like the big bang still shapes our universe. The future of venture capital resides with successful entrepreneurs within the cross-space of technology and other sectors such as finance, health care and energy. The goal of a motivated technology entrepreneur is to create an efficient monopoly so that it is possible to extract some of the surplus generated by the company. To create motivation, VC investors must both provide capital and come up with creative ideas for the entrepreneur to capture the value being created. As a former employee of start-up companies, Chamath is spearheading the way a founder captures value from his company through the creation of SPAC for the purpose of entering the public markets. In finance 3.0, the SPAC is a great option for an entrepreneur to go public, as the set-up combines a final private round with a direct listing. The future is bright for VC.

Cheers!

Stay Adaptive!

1.https://www.investopedia.com/terms/s/spac.asp#:~:text=A%20special%20purpose%20acquisition%20company%20(SPAC)%20is%20a%20company%20with,have%20been%20around%20for%20decades.

2. https://seekingalpha.com/article/4376539-chamath-palihapitiya-strikes-while-iron-is-hot-social-capital-iv-v-and-vi

3. CFA curriculum