You have undoubtedly read about the continuing popularity of special purpose acquisition companies (SPACs). According to SPACInsider, year-to-date there have been 242 SPAC IPOs, with an average IPO size of $334.9 million. This is remarkable as the next highest year was 2019 when there were 59 SPAC IPOs with an average size of $230.5 million. See the chart below to show the 2020 spike.
As a refresher, SPACs are public shell companies (i.e., blank check companies) formed to use their IPO proceeds to acquire a private company via merger, share exchange, asset acquisition, reorganization or similar business combination within a specific timeframe, usually 18-24 months. A SPAC structure essentially creates another mechanism through which a private company can go public, along with a traditional firm commitment underwritten offerings, direct listings (becoming more popular), and others.
SPAC Mergers with Private Companies
The focus of this post is on the back half of the SPAC life: the SPAC merger with the private company. SPACInsider reports there are approximately 228 SPACs that have completed their IPO and are currently searching for private acquisition targets to take public. Since most of these SPACs will need to find a target in the next 18-24 months (or less), there will be high demand for private companies that have the maturity, growth prospects, experienced management and operations in place to function as a public company.
This “deal or die” structure is one reason why the Securities and Exchange Commission (SEC) has historically viewed SPACs with a skeptical eye, particularly as the pressure mounts for the SPAC sponsors to find a deal before the SPAC’s self-destruct feature is triggered and the sponsors potentially lose a ton of money. Moreover, even if a target is found, the SPAC may not gain enough investor support for the transaction. (For a recent article on the issues associated with corralling investor support for the SPAC merger, see this article authored by Okapi Partners’ Bruce Goldfarb as well as a related blog post here.)
Details of SPAC Merger Due Diligence: Legacy Acquisition Corp. & Onyx Enterprises Int’l Corp.
Given these factors, I thought this recent SEC Staff comment letter in connection with a SPAC merger between Legacy Acquisition Corp. (the SPAC) and Onyx Enterprises Int’l Corp. (the private company target) was interesting. In particular, I was interested in the SEC Staff’s request for Legacy Acquisition Corp. to disclose in the background of the merger section a summary of “the financial, business and legal due diligence questions that arose during its diligence meetings” because it gives us an inside glimpse at the diligence process involved in this transaction.
The SPAC structure essentially has a self-destruct mechanism that requires the SPAC sponsors to locate a private company target to take public within usually 24 months. In light of this pressure “to get a deal done,” the intent behind the Staff’s comment might have been probing the diligence process so that investors would have the benefit of comparing the diligence process against the rigorous diligence process that occurs in other M&A transactions or the diligence process undertaken by underwriters in connection with a firm commitment IPO to establish their due diligence defense under Section 11 of the ’33 Act.
6. Please provide a summary of the financial, business, and legal due diligence questions that arose during your diligence meetings.
The Company acknowledges the Staff’s comment and respectfully submits that in conjunction with negotiation of the Business Combination Agreement, Legacy and Legacy’s legal counsel and other advisors continued to conduct substantial business, financial and legal due diligence on Onyx. The Legacy management team and its advisors performed certain financial and business due diligence procedures in connection with the contemplated business combination with Onyx. Legacy’s financial due diligence included, without limitation, review of Onyx’s historical audit information, including the last three years of audited financial statements, financial records including all balance sheets, income statements, cash flows and statements of ownership; supporting data on historical trends as well as changes in business and market dynamics behind those trends. Legacy also analyzed financial projections and underlying assumptions behind those projections.
Legacy’s financial diligence also included analysis of the contents of the Onyx data room, specifically the following: monthly and quarterly financial reporting, actual results versus budget and forecast, cash management and working capital results to date and projections, capital expenditures and future requirements, gross margin analysis and reasons for changes, revenue by product line and store, taxes and insurance, as well an analysis of SG&A spending, by element. In conducting this diligence, Legacy had several meetings with Onyx management to understand their handling of revenue recognition, accounting policies, key customers, internal control procedures and monthly reporting schedules as well as expected steps to handle public company reporting requirements.
Legacy’s business due diligence included, without limitation, assessing the strength of Onyx’s marketing and advertising, operations, portfolio of vendors and distributors, e-commerce platform, cybersecurity, enterprise resource planning (ERP), order, shipment, billing, customer service and logistics, proprietary algorithms, governance of intellectual property, risk management, and the senior management team. Legacy evaluated Onyx’s markets served, macroeconomic trends, competitive environment, seasonality, core customer demographic profile and on-line discovery and purchase habits within the automotive aftermarket parts sector, and their vendor and distributor service level agreements. Legacy also examined Onyx’s organization health, staffing and employment matters, remuneration, benefits and contracts, and public company readiness. Legacy further investigated Onyx’s technology and its Ukraine third party technology and business support teams to understand their technology development, coding and the modularity of their platform.
Legacy’s legal due diligence included the delivery by Legacy’s M&A counsel to Onyx’s legal counsel, a customary, comprehensive legal due diligence request list. The requested information about Onyx included the following categories, among other items: corporate and organizational information; financial information; tax matters; contracts; employment matters, including employee benefits; litigation and compliance issues; owned and leased real property; environmental, health and safety matters; intellectual property; and information technology and cybersecurity. In the course of reviewing information provided by Onyx in response to the due diligence request list, Legacy’s M&A counsel engaged in multiple conversations and email exchanges with Onyx’s legal counsel in order to identify and clarify key issues and to make supplemental diligence requests. In conjunction with doing so, Legacy’s M&A counsel and Legacy’s management had numerous emails and phone calls to discuss potentially significant issues arising throughout the due diligence process. The most significant due diligence questions related to the Stockholder Litigation and to Onyx’s practices of engaging hundreds of independent contractors in the Ukraine to develop Onyx’s intellectual property. In considering the Stockholder Litigation, the key questions related to the potential impact of the litigation on the ability to close the Business Combination, on conducting business operations following the Closing, on stockholder relations after the Closing, and on the financial consequences to Onyx by virtue of being a party to the litigation and claims for indemnification by Onyx’s directors and officers. With respect to Onyx’s practices in the Ukraine, the key questions related to Onyx’s ability to safeguard its intellectual property and to retain key individuals having substantial knowledge about Onyx’s intellectual property. In addition, and among other matters, Legacy’s M&A counsel and Legacy’s management discussed other litigation and compliance matters impacting Onyx, details regarding Onyx’s intellectual property, and Onyx’s various contractual obligations to third parties.
Legacy has included the above details regarding its due diligence in the Background of the Business Combination section of the Information Statement.
If you have any questions regarding any of the topics covered in this blog post, please feel free to email the author directly or, if applicable, contact your primary Bass, Berry & Sims relationship attorney.