SPACtacular Assumptions
SPACs or Special Purpose Acquisition Companies have been around since the 1990s and every decade since has seen them rise and fall in popularity. However the 2010s (and 2020) saw an explosive resurgence with mind-boggling amounts invested via these vehicles (as can be seen below[1]).
2014: $1.8bn across 12 SPAC IPOs
2015: $3.9bn across 20 SPAC IPOs
2016: $3.5bn across 13 SPAC IPOs
2017: $10.1bn across 34 SPAC IPOs
2018: $10.7bn across 46 SPAC IPOs
2019: $13.6bn across 59 SPAC IPOs
2020: $83.3bn across 248 SPAC IPOs
The popularity is driven by the fact that SPACs allows companies that are relatively early in their journey to go public and skip the onerous IPO procedures. The process is quite simple to understand, but considering most readers would be familiar with it, we’ll skip the explanation (but see this footnote in case you’re not as familiar[2]). The process has bought (or will bring) several fascinating companies to the public markets. These are companies with high-ambitions, some of which are literally aiming for the stars. Companies in genomics, electric vehicles, and space exploration are all being taken public via SPACs.
The hype behind some of these companies may be real as they try to push the envelope of what’s possible in their respective fields, and some might go onto become the large and megacaps of the future. The market seemingly agreed (at least before the recent corrections), bidding up SPACs to huge premiums over their book values even before they announced an acquisition deal. As happens when there is a lot of attention and money being made in a certain area, the SPAC ‘craze’ has attracted a number of celebrity sponsors, sponsors of spurious character, sponsors who list multiple SPACs and then hype them up on Twitter, along with a few seasoned and reputable investors/sponsors. Given all of this, we chose to stay away from the space, as we typically wait until the hype has died down before taking a look to see if there is something worth investing in and within our circle of competence.
However, given all the attention, we were requested by some of our clients to take a look at a few names to give them our high-level thoughts. While going through the presentations about the acquisition targets, we noticed a number of egregious trends within the presentations and thought it would be worth pointing out a few of them. None of this means that those companies won’t be successful but as investors, we are underwriting the future. To do so we have to make certain claims and assumptions, but we find some of these projections so difficult to stomach that the old adage comes to mind that when you assume you make an “ass” out of “u” and “me”.
The 5-Year Plan:
Did any of you see the movie Big Daddy starring Adam Sandler? In our opinion it was a hilarious movie (or at least it was to our 11-year old selves) and the peak of Sandler’s career. In the movie, the protagonist (played by Sandler) gets dumped by his girlfriend as he doesn’t have an ambitious “5-Year Plan” and leaves him for a much older man who has such a plan. As the movie winds up we find out that the older man’s plans have fallen apart and is working as a fry-cook to which the protagonist quips, “Maybe it’s a 10 year plan.”
We couldn’t help but recall those scenes when going through the investor decks of the SPAC acquisition targets. Each one seemed to have a wonderful 5-year plan laid out that shows phenomenal and unceasing growth. The growth numbers are then used to justify the fact that if you look a few years forward, the valuations the company is seeking are really not all that crazy.
SoFi’s 5 year projections – predominantly based on growth in products that have only just launched.
Furthermore – many of these companies are basing their revenues on nascent products, or in some cases, pre-revenue products. For example, as you can see in the table above, SoFi saw its growth decelerate significantly in 2020 but because of a slew of new products, is confident that higher levels of growth are just on the horizon. Now there’s nothing wrong with thinking big, but when was the last time you saw a 5-year plan go right? This could be in public markets, private markets, or even in your own life (I’ve never had a personal 5-year plan go as expected!). There are a number of factors outside the companies’ control that will determine future growth including competition, macro conditions (for example no company predicted the trade wars in 2018 or the covid outbreak in 2020), and just plain dumb luck. Given that public companies regularly get their quarterly and annual guidance wrong, it’s shocking that the market, at least for a time, fully believed that these 5 year projections were going to be spot on. Now granted a few of these companies might beat the odds, but we’re almost sure, most will not, and instead, will need a “10-year plan.”
The Carl Sagan Number:
When I was in business school, we studied under an entrepreneurship professor, who in a few words was, a force of nature. She was unfiltered in her criticisms of business plans and presentations. However nothing got her more worked up than when fledgling companies used what she referred to as the “Carl Sagan number” to express their potential. Sagan’s number, named after the famous astronomer, is the number of stars in the observable universe (Currently estimated at 70 sextillion) and is now used humorously to describe any very large number.
Companies bastardise this concept often by projecting a very large TAM for their industry (their Sagan number) and then state that if they get just 1% of this market, their revenue potential is huge. In the eye of a casual investor, that actually seems reasonable – by golly, why can’t they get just 1% of the market share? But to our professor, this was like stepping on her foot and then asking her to apologise. She would go ballistic, and demand to know exactly how the founders planned to capture this 1%, as they made it seem that it was almost guaranteed to them.
One of the companies we looked into was an excellent example of misusing this concept. Matterport, a leader in 3D visualization technology for real-estate, presented their Sagan number as part of their investor deck. We actually think Matterport’s business is fascinating and our checks revealed a real product-market fit. But nonetheless, this slide gave us PTSD from our days in business school, standing in front of our professor and trying to explain why that 1% would be bestowed upon us. In this example, a 1% penetration for Matterport would give them a $2.4bn revenue. Now that seems reasonable, until you stop and realize that their current revenue is just $86MM and they would have to grow this number by 30x to hit their 1%! One must also realize that Matterport is a B2B business so in order to hit this number they’re either going to have increase their salesforce drastically (which is no guarantee of success and no easy task in the first place) or make their current salespeople 30x more efficient.
The Base Rate irRationality:
A few years ago, we were watching an interview of a seasoned investor, and the interviewer asked him what was something he wished he knew earlier in his career. He mentioned that one of the biggest mistakes he used to make was being overly aggressive in his assumptions and that he would base his growth rates off of Amazon’s growth rates in its early history. However, he realized later on that there are few companies like Amazon, and to set your base rates based on the one of the world’s fastest growing companies is probably a mistake. Now over the last few years we have started to see several companies reach similar if not slightly better growth rates, but SPAC projections are on another level.
The electric vehicle space is a particularly strong proponent of using ridiculously high growth rates. The Wall Street Journal pointed this out using the below infographic, which poignantly shows that five EV companies getting listed via SPACs were projecting growth rates higher than those of Google, the fastest company to reach $10 billion in revenue.
Source: WSJ
In fact, as can be seen, some of these projections are so aggressive that some of these companies think they will make $10 billion in revenue less than two years after they make their first dollar. Perhaps they will defy the odds and succeed, but just in case, we would suggest you take a more conservative approach to your assumptions when deciding to jump onto the SPAC hype-train.
Again, we are generally optimists, and are excited for the future of technology, but when it comes to investing, forgive us if we are a bit skeptical of these SPACtacular projections.
Thanks for reading all – happy investing!
[1] Source: https://en.wikipedia.org/wiki/Special-purpose_acquisition_company
[2] Essentially the SPAC (which is just an empty vehicle with cash) gets listed, funded by issuing shares, units, and warrants to sponsors and initial investors and then searches for an acquisition target. When the sponsors of the SPAC identify the target, they merge with it, effectively taking the target public. If the sponsor does do not find a target over (typically within 18-24 months), investors can sell the units back to the SPAC at the listing price (typically $10).