Special purpose acquisition companies (SPACs) have been around for at least a decade and have recently gained greater popularity as evidenced by the number of public listings in recent years. Most recently, there have been at least 50 SPAC IPOs in 2020 through July 31, 2020.^[1] To put this in context, according to NASDAQ, the NASDAQ Capital Market has hosted 185 SPAC listings between 2010 and 2020, reportedly equal to 76% of all SPAC listings, implying approximately 243 total SPACs during this period.^[2] SPACs raise hundreds of millions of dollars through the public market for a potential business acquisition, or billions, as in the case of the eye-catching $4.0 billion raised by Pershing Square Capital Management’s Pershing Square Tontine Holdings in July 2020.^[3] The sponsors of these vehicles often have incentive-based economic interests that provide unique estate-planning opportunities for members of the sponsor entity.^[4]

What Is a SPAC?

A SPAC is a special purpose acquisition company that raises capital in the public markets via an initial public offering (IPO) in order to pursue an acquisition of a private company. Sponsors need not have an acquisition target identified at the time of the IPO, but SPACs have no other business purpose except to find a company to acquire or merge with. In this regard, they are often referred to as “blank-check companies” because investors are placing capital with them in order to find and consummate an investment. SPACs typically have up to 24 months from the time of their IPO before they must have identified an acquisition target, with a possible extension to complete the deal.

Investors in a SPAC IPO have their funds placed into a trust account to be invested in money market funds or treasuries until the SPAC sponsor identifies a business combination. They also have the option of having their shares redeemed for their pro-rata share of the trust account if they decide not to participate in the eventual business combination. At the time of the IPO, each share of stock usually comes with a fraction of a warrant, and the sponsor often purchases a certain number of warrants in order to provide the SPAC with working capital. With minor exceptions, the initial IPO proceeds (net of issuance costs) are not expended and are reserved for the eventual business combination.

What Are the Typical Economics?

All SPACs are not equal, but many are structured such that they offer Class A common stock (ordinary shares) to investors along with a warrant or fraction of a warrant to purchase additional shares at a set price. Additionally, before their IPO, most SPACs have often already issued Class B common stock (or some other class besides Class A, and referred to as founder shares) to their sponsor, and the sponsor has often purchased or agreed to purchase a certain number of warrants. Founder shares are typically issued for a nominal fee of $25,000, regardless of the number of shares. They are convertible to ordinary common shares at the time of the business combination, typically for 20% of the total common shares (including the founders shares as converted), but they expire worthless if a business combination is not consummated. Accordingly, if a merger is consummated, the sponsor will own 20% of the equity and investors will own 80% (ignoring warrants and other equity transactions accompanying the merger). In this regard, founder shares have some similarities to the carried interest received by the general partner (GP) of a private equity (PE) fund, which is another common asset to use in estate planning.

Comparison of SPAC Founder Shares With Carried Interest in a PE Fund

All PE funds are not equal, but many are structured such that limited partners’ (LPs’) investment proceeds are split between the LPs and the GP as follows:

1. first, 100% to LPs until they have received distributions equal to the amount of capital invested, plus any un-returned capital of previously realized investments (“return of capital”)^[5]
2. second, 100% to LPs until they have received a preferred return on their contributed capital (“preferred return”)^[6]
3. third, 100% to the GP until it has received an amount equal to 20% of the sum of (a) the preferred return distributions and (b) the distributions made in this third stage (“catch up”)^[7]
4. and thereafter, 80% to the LPs and 20% to the GP (“profit split”)

In the above waterfall, the distributions to the GP in the third and fourth stages represent the carried interest allocation of the LPs’ share of investment proceeds. As can be seen, there is no value to the carried interest unless the fund’s investments increase in value beyond the rate of the preferred return. There is also a clawback feature in most, if not all, funds in which the fund must have generated at least the preferred return on all investments when the final investment is realized and all proceeds have been distributed.^[8] If at the end of the fund’s life, when it has realized all investments, it has not generated a return at least as high as the preferred return, then any carried interest previously distributed will be clawed back from the GP and redistributed to LPs.

Contrast this with a SPAC, in which the founder shares will receive their 20% interest so long as a business combination is consummated, regardless of how the purchased company ultimately performs after merging into the public shell of the SPAC. In this regard, investors in a SPAC are betting that the sponsor will not only be able to identify a suitable target with which to merge, but one with which the sponsor can create at least enough value to overcome the dilution from the founder shares. Contrast this with a private equity fund, in which investors know that they are at least entitled to receive their full contributed capital back before there can be an allocation to carried interest.

Estate Planning Opportunity

As with carried interest in a PE fund, there is an opportunity for members of the SPAC sponsor to engage in estate planning with their founder shares (or, more accurately, interests in the sponsor entity holding the shares).^[9] Some may be tempted to assume the nominal price they paid for the founder shares would also be the fair market value, which is the standard of value for estate-planning transfers. Fair market value is the price at which the asset would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of all relevant facts. This considers that a buyer and a seller transact based on the expected economic benefits to be generated by an asset over its life.

In the case of a SPAC, it is easiest to think about the economic benefits of the founder shares through an example. On July 31, 2020, E.Merge Technology Acquisition Corp. (“Emerge Tech”) successfully launched an IPO of its Class A shares at $10 per share on the NASDAQ under the ticker symbol “ETACU,” raising $522,000,000 (52,200,000 Class A shares), ignoring underwriter fees and other costs of the public listing. As noted previously, in many SPACs, the founder shares get converted to 20% of the total shares outstanding at the time of a business combination, and that is true for Emerge Tech. Prior to the IPO, E.Merge Technology Sponsor (“Emerge Sponsor”) was issued 13,050,000 Class B shares for nominal consideration of $25,000.^[10] Ignoring warrants and any forfeiture of shares, upon successful completion of a merger with an acquisition target, Emerge Sponsor’s Class B shares will automatically convert to Class A shares and comprise 20% of the total shares outstanding. 

Emerge Sponsor’s 20% interest will equate to $104.4 million if the business combination occurs and all $522 million is utilized.^[11]  Accordingly, there is the potential for the founder shares to be worth $104.4 million in the near future. This value must then be adjusted to present value, adjusted for the risk of any founder shares being forfeited as part of the transaction, and adjusted for the probability of the business combination ultimately occurring. For simplicity, let us assume a 50% all-in adjustment for these items, which would yield a probability-weighted expected present value of $52.2 million.^[12] Accordingly, in this example, the founder shares would be worth $52.2 million at the time of the IPO. An additional probability adjustment would be applied if the shares are transferred in advance of the IPO, taking into account the risk of the IPO not moving forward. Finally, assuming the transfer of a non-controlling interest in the sponsor entity, valuation discounts would also be applied in order to determine the fair market value for estate and gift tax purposes.

Valuation Discounts

The sponsor’s interest in the SPAC is comprised of private shares that are not available for public trading, at least until a business combination occurs and the shares are converted to the class of shares that is publicly traded. The founder shares are also typically subject to lock-up restrictions even after the business combination. For instance, in the case of Emerge Tech, Emerge Sponsor’s founder shares are not transferable or salable until one year after a business combination is completed, or earlier if the Class A common stock trades for at least $12.00 per share for 20 trading days in any 30-trading-day period; but in no case earlier than six months from the date of completion of a business combination unless the company is sold or otherwise liquidated in that time frame.^[13]  Based on the restrictions placed on the founder shares, a discount for lack of marketability is applicable at least through the end of the applicable lock-up period and possibly longer for large blocks of stock.  

It is also possible that a transferred interest in the sponsor entity could relate to a sizable implied position in the stock of the public company, implying blockage issues if the shares were eventually to be sold.There is an abundance of empirical data and a long record of tax court cases supporting the application of a discount for lack of marketability to illiquid equity securities. Accordingly, a discount for lack of marketability would apply to the founder shares in advance of a business combination or during the lock-up period thereafter. One method for determining a discount for lack of marketability is through an analysis of restricted stock studies, such as the Stout Restricted Stock Study.^[14] Among other factors, discounts for lack of marketability depend heavily on the expected time to liquidity and the financial characteristics of the subject company.

It is also worth noting that founder shares are not able to be redeemed in lieu of participating in the business combination. As mentioned previously, those with Class A common shares are typically given the right to have their shares redeemed at the time of a business combination, in addition to being able to sell their shares in the market or maintain their shareholdings in the post-merger company. Holders of founder shares, on the other hand, are typically obligated to vote in favor of a business combination, even before an IPO; this, in combination with the aforementioned sale restrictions, means they have no control over their position at the time of the business combination, and they will not gain control until their lock-up restrictions end. Under the fair market value standard, a hypothetical buyer would not be a member of the sponsor entity (such a member would know at the formation of the entity that they will be voting in favor of a business combination) and would accordingly take into account that they have no control over their investment at the time of the business combination. This could be factored into the discount for lack of marketability or possibly in a separate discount for lack of control.

The Effective Planning Tool

The initial fee paid for the founder shares (i.e., usually a nominal amount like $25,000) is inappropriate to use for estate and gift tax purposes given the potential value associated with the shares. There is still an opportunity, however, to transfer a potentially high-value asset at a much lower, risk-adjusted, discounted current value. Though it may be frustrating for members of the sponsor entity to know that the founder shares are worth more than the nominal fee paid for them, a transfer of a sponsor interest, especially at or before the SPAC’s IPO, can be an effective planning tool if handled correctly.

1. According to spacresearch.com, data pulled August 7, 2020.
2. "SPACs: Special Purpose Acquisition Companies Listing a SPAC on Nasdaq," Nasdaq.com, updated June 2020. 
3. Pershing Square Tontine Holdings, Form S-1, SEC, filed July 16, 2020.
4. Interestingly, Pershing Square decided to forego the use of an incentive structure in Pershing Square Tontine Holdings and instead relied entirely on the use of warrants to generate potential returns for the sponsor entity. For more information see the S-1 filed by Pershing Square Tontine Holdings with the Securities Exchange Commission.
5. This is an “American” waterfall; in a “European” waterfall, all committed capital is returned to LPs in the first stage, including capital invested in deals not yet realized as opposed to on an investment by investment basis. This stage often also includes a return of capital that has been contributed for management fees and other fund expenses.
6. In some funds, particularly venture capital funds, the preferred return requirement may not exist.
7. For funds without a preferred return requirement, there is no catch-up stage and profits are allocated according to the Profit Split stage.
8. If there is no preferred return feature, then investors must simply receive all their capital back in order for there to be a carried-interest allocation at the end of the life of the fund.
9. Due to concerns about running afoul of section 2701 of the Internal Revenue Code (“Section 2701”), many estate-planning transfers of carried interest also include the transfer of an equal share of the partner’s capital interest in the fund. This is commonly referred to as the transfer of a “vertical slice.” For more information about estate planning with a vertical slice, see a previous article co-authored by Bryce Geyer: “Estate Planning with the Private Equity Vertical Slice,” Practical Tax Strategies, June 2016.
10. E.Merge Technology Acquisition Corp., Prospectus, SEC, July 30, 2020.
11. For simplicity, we have not considered the impact of warrants warrants or any forfeiture of shares that might occur as part of the transaction negotiations.
12. In practice, these probability adjustments would be informed by past consummation results of other SPACs, with particular emphasis on any past activities of the sponsor entity.
13. E.Merge Technology Acquisition Corp., Prospectus, SEC, July 30, 2020.
14. The Stout Restricted Stock Study, which has analyzed over 750 transactions involving restricted stock of public companies through 2016, allows for direct comparisons with restricted stock data, based on financial characteristics.