SEC Disclosure Matters

The SEC has issued its long-expected proposed rules regarding SPACs. Here are the proposing rule release and the shorter press release. The SEC has always been skeptical of SPACs, and the rules are generally designed to impose new disclosure requirements on SPACs that make the rules more aligned with those applicable to traditional IPOs. One of the reasons SPACs had their moment in the sun recently is that they are easier to complete than IPOs, so the rules, if enacted, could have the effect of severely dampening the market for SPACs, even if they do nothing to directly restrict them from being done. In fact, the general expectation that rules like these were coming down the pike has, anecdotally, been a factor in the SPAC market slowing down recently.

One of the key areas in the proposed rules relates to projections. Under current rules, companies merging with a SPAC can include projections about the company’s future expected results and can benefit from a safe harbor protecting it from litigation if the projections don’t come to pass, as long as the projections are accompanied by a disclaimer and the companies don’t have actual knowledge that they won’t come true. In contrast, companies going public the traditional way don’t have the benefit of this safe harbor. The proposed rules would eliminate the safe harbor in the SPAC context, which would have the practical effect of precluding most projections from being presented.

There are exceptions, but companies doing traditional IPOs are generally more mature than those seeking to go public via SPAC, which are often pre-revenue (or at least pre-profit). This doesn’t mean the companies are inherently dodgy; rather, there are hurdles to meet, like further research and development, regulatory approvals, etc., before they can actually realize a profit. In a way, it makes sense that these early-stage companies would want to include projections to give potential investors a picture of how an investment could perform, since the historical financial statements don’t provide much useful information about where the company is going. However, trying to project future financial results for companies before they are fully doing the thing that they’re hoping to do is an inherently imprecise undertaking.

Suppose a company projects that its revenues will increase twenty-fold over the next five years, which could be a completely legitimate, good-faith estimate in particular contexts (though laughably unrealistic in others). If this company actually ends up achieving a fifteen-fold increase, most early investors would be happy with that result and wouldn’t feel aggrieved, but the projection would have been off by hundreds of percentage points.

I’m not a regular investor in early-stage companies, just an advisor and observer, but from my perch I can see that there is high demand for projections – investors want to see them to inform their go/no-go decisions and companies want to make them to attract investment with blowout return scenarios. But making a decision based on whether the projected numbers reach an exact threshold you have in mind seems misguided, whether it’s the company or the investor making the projection. The whole point of equity investing versus debt is that you have theoretically unlimited gains, paired with a higher risk of losses. If you’re going to be in the business of investing in early-stage companies, the general strategy is to diversify: do whatever due diligence you can, but accept that success is inherently uncertain and hope that by spreading the investments to a wide number of ventures, the outsized gains from the hits will more than offset the failures. Trying to artificially impose precision on this by distinguishing between a projection of 10X or 50X or whatever doesn’t seem to be to be a productive use of an MBA.