Estate Planning for Special Purpose Acquisition Company Founders
“Estate Planning for Special Purpose Acquisition Company Founders,” that’s the subject today’s ACTEC Trust and Estate Talk.
This is Toni Ann Kruse, ACTEC Fellow from New York City. Special Purpose Acquisition Companies, or SPAC, present unique estate planning opportunity for their founders. To educate us on this topic, you will be hearing today from ACTEC Fellows, Marc Bloostein and Kimberley Cohen, both of Boston, Massachusetts. Welcome Kim and Marc.
What is a Special Purpose Acquisition Company – SPAC?
Thanks. Let’s start with what a SPAC is. A Special Purpose Acquisition Company is a corporation formed to raise capital from the public to be used to acquire a business. Sometimes this is referred to as a blank check company. Investors believe in the founders and their ability to put capital to work, often having little idea of what they will end up owning. SPACs have become hugely popular in the last couple of years. While they’ve been around for a while, only recently are we seeing them in great numbers. So, there were 46 SPAC IPOs in 2018, 59 in 2019, and in 2020, there were 248. This year, so far, we’ve seen 331. Now, a SPAC is formed like pretty much any other startup with the founders getting founder shares for next to nothing. Typically, the founders pay $25,000 for all the founder shares, but unlike with a typical startup, there is usually a pretty tight timeframe between formation of the SPAC and an initial public offering in which units in the SPAC are sold to the public.
There might be as little as 10 to 15 weeks between formation and IPO. Now, once the SPAC holds cash after the IPO, it’s got a set amount of time in which to complete a business combination. Typically, the time limit is two years. In the meantime, the cash in the SPAC has to be held in a trust and invested in short-term government securities. If the SPAC fails to enter into a business combination in two years, the public shareholders get their money back, plus interest. Also, even if the SPAC enters into a business combination, the public shareholders have an opportunity to redeem their shares at the time of that combination, getting their money back, plus interest.
What’s in it for the SPAC Founders?
So, what’s in it for the SPAC founders? Well, making a ton of money if the SPAC succeeds. In contrast to a private equity fund, a SPAC is pretty much a one-shot deal that will succeed or fail over a two-year period. If it succeeds, its success can be magnificent, and if it fails, there’s nothing left for the founders. Now, let me hand it over to Kim who will talk a little bit about the capital structure of a SPAC.
Capital Structure of a SPAC
Thanks Marc. The SPAC is generally organized as either a Delaware or Cayman corporation. The sponsors or founders, or their entities, create the SPAC, and as Marc mentioned, in return for a nominal investment, receive founder’s shares. In addition to these shares, the sponsors usually also agree to purchase private placement warrants at the time of the initial public offering. Often, founders use an LLC or similar vehicle to pool their assets, and it is this vehicle that purchases the founder shares and the private placement warrants.
The founder shares, as Marc mentioned, are issued for only $25,000, but they entitle the founders to a whopping 20% of the capitalization of the company. These shares are essentially the same as the common shares offered during the IPO, except they are subject to a one-year lockup after a business combination and are not redeemable upon the business combination. At the time of the IPO, units in the SPAC are then offered for sale to the public, usually for $10 per unit. A unit generally consists of one common share and a public warrant, or a fraction of a warrant, meaning you may receive a quarter of a warrant such that for each four shares you purchase, you’ll have a single warrant that you may exercise in the future.
Common shares are subject to dilution by the conversion of the founder’s shares following the business combination, as well as by the exercise of both the public and private warrants, which I’ll discuss momentarily. The SPAC then goes out in search for an appropriate business combination. In some cases, the public shareholders first ever right to vote on whether to proceed with a proposed business combination. Otherwise, as Marc mentioned, the public shares can be redeemed upon a business combination such as if the public purchasers or the shares are unhappy with the transaction, they can get their money back and essentially walk away unharmed.
Turning to the warrants, the sponsor is generally obligated to purchase private placement warrants at the time of the IPO for a cost of between 50 cents and $1.50 per warrant. The proceeds from the warrants are then used to cover the upfront underwriting commissions and the operating expenses, and they’re really the funds that are at risk for the sponsor. These private placement warrants are typically subject to a lockup that expires 30 days after the business combination and gives the holder the right to acquire common shares for a fixed price. Generally, on the same terms as the public warrant, if no business combination occurs, then these warrants are worthless.
The public warrants allow the purchaser of the common shares to purchase one share of common stock at the later of 30 days after the initial business combination or one year from the IPO usually, at $11.50 cents per share. In some cases, if the value of the common shares exceeds a certain threshold, typically $18 per share, the SPAC may have the right to redeem the warrants for 1 cent each. I’m going to turn this back over to Marc to discuss some of the valuation issues that arise when planning with SPAC interests.
Valuation Issues that Arise when Planning with SPAC Interests
Thanks Kim. So, we’ve got these potentially very valuable interests, the question from an estate planning perspective is what are they worth upfront, when they can be given away or sold? Well, let’s talk about the two kinds of interests we generally see a founder holding: the founder shares and the private placement warrants.
With founder shares, the first thing to note on valuation is that there’s a likely conflict between the SPAC’s income tax position and a gift tax valuation, because generally the $25,000 paid for the founder shares on formation is treated as fair market value for income tax purposes. So, there is no income realized when those shares are purchased. There’s no authority for this, but that’s the industry practice.
Now, an appraisal, a fair market value appraisal, is likely to come up with a value higher than the $25,000 issue price. And generally, it’s going to be somewhere between that initial issue price and the IPO price, probably closer to the issue price than the IPO price. And generally, the IPO price in the SPACs is $10 a share. The key factors an appraiser is going to look at are things like the likelihood of a successful IPO, the likelihood of a successful business combination. There’ll be a discount for lack of marketability of the founder shares, and the founder shares will be discounted to present value, taking into account a number of factors, including the fact that post-business combination, these shares are going to be subject to an ongoing lockup; so, a number of factors.
Where we are in the very short pre-IPO lifespan of the fact can be important. The value on day one after formation is of course going to be less than the value the day before the IPO. But the bottom line here is you’re going to end up with a real number. So, for example, I recently had founder shares appraised at $1.50 a share. Now, a founder might have several million of these founder shares, so we’ve got a significant amount of value to deal with from an estate planning perspective, if we want to make a gift or a sale of these interests. So, the reality is that there’s a real chance that these things are going to be worth many times that gift tax value, but it’s a real value to deal with.
Now, turning to the warrants, valuing warrants, really, we’re valuing options. So, an appraiser will typically start out with a Black-Scholes analysis. And of course we reduce this, the appraiser reduces this value by a discount for the probability that a business combination won’t happen and further reduces the value to present value based on a number of factors. I’ve seen private placement warrants valued at less than their purchase price, which as Kim said, is typically between 50 cents and $1.50. The fair market value might be just a fraction of that number. But keep in mind that the purchase price for the private placement warrants is used to fund IPO expenses. And so, the amount paid probably relates more to those expenses than it does to the actual value of the interests themselves.
Now, let me turn it back over to Kim, who will talk about the potential application of section 2701.
The Application of Section 2701
Thanks Marc. When planning with SPAC interests, one issue that arises is whether Section 2701 needs to be addressed. Sponsors generally hold multiple classes of interest. One, they hold the founder shares, and two, they hold the private placement warrants. From a 2701 analysis, the warrants would likely represent an applicable retained interest in the form of an extraordinary payment right, which are problematic even if the transferor is not deemed to be in control of the entity.
That being said, if the subtraction method under section 2701 came into play, it’s not clear that the warrants would have substantial value, as Marc previously mentioned. Nevertheless, in order to avoid the risk, we would recommend that a transferor stay within the vertical slice exception, meaning that a proportionate number of the warrants also be transferred along with the common shares. Marc’s now going to speak briefly about planning options with the SPAC interest.
Planning Options with the SPAC Interest
With carrying a private equity fund, our go-to approach is a gift or sale of the carry to an intentionally defective grantor trust. A gift or sale of founder shares in a SPAC could be similarly powerful, but there are some very different considerations with founder shares and other interests in a SPAC.
So, first while carry typically has a low value, with founder shares, there could be a real value attached to those shares. And as I said, I’ve seen a value of say $1.50 a share, maybe we’ve got a couple or three million shares to transfer. So, that’s a large number. And second, the potential outcomes here are at opposite extremes. There’s a real possibility these shares will be worth zero, but also a real possibility it will be worth many times their gift tax value. And third, we’ve got a fairly finite timeframe. We will know, thumbs up or thumbs down, in two years.
A Perfect Vehicle for this Situation
So, these considerations suggest using a GRAT (Grantor Retained Annuity Trust). A GRAT is pretty much a perfect vehicle for this situation. There’s really zero risk. If the SPAC fails, there’s no downside, and if the SPAC is successful, there will be a tax-free transfer. And who knows whether a valuation will be challenged, but with the GRAT approach, it doesn’t matter if the valuation is challenged because we’ve got a built-in valuation clause, and again, if this thing is successful, it’s going to be really successful.
In general, a five-year GRAT would work quite well. There’s a relatively low payment due back to the grantor after the first year, and with any luck, there will be a business combination before the second GRAT payment has to be made. So, a GRAT is a pretty good strategy for dealing with some interests in a SPAC.
To sum it up, SPACs are here today. We’re not sure they’re here to stay, but right now they provide a potentially valuable, but very volatile, currency for making gifts. And a GRAT is perfect to take advantage of the potential upside without having to deal with the risk of a very real potential downside.
Excellent. Thank you so much, Kim and Marc, for joining us today and educating us on SPACs. We appreciate your time.
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