Late-stage startups that are considering a potential de-SPAC transaction as a means of going public should consider updating certain terms in their organizational documents and contractual arrangements.

In the last year, a merger with a special purpose acquisition company (SPAC) — known as a de-SPAC transaction — has gained tremendous popularity as a way for many companies to enter the public markets. De-SPACs are especially appealing for late-stage startups seeking strategy capital infusion from the cash in the SPAC’s trust account as well as additional funds raised in the form of a “PIPE” investment. For companies considering this path, now is the time to begin preparing for a potential de-SPAC by taking a closer look at their organizational documents and contractual arrangements.

This memorandum provides an overview of how de-SPACs work, as well as the documents and terms that late-stage startups should examine in preparing for a potential de-SPAC transaction.

A de-SPAC transaction enables a company to go public by merging with a SPAC. As with most initial public offerings (IPOs), the company’s majority stockholders do not change after a de-SPAC transaction. Instead, the private company’s stockholders will receive shares in the public company on a pro rata basis, barring any specific considerations of stockholders with economic rights that would result in holders of preferred stock receiving a different allocation of consideration than common stock (such as the liquidation preference exceeding a pro rata share of consideration, participating preferred or special waterfall return requirements).

While standard venture financing forms include provisions for an exit through a merger or IPO, these documents typically do not contemplate a de-SPAC transaction. A company’s warrants, convertible notes and equity incentive plan (EIP) also may not contemplate a de-SPAC transaction. Accordingly, late-stage startups should consider amending their preferred financing documents, warrants, convertible notes and EIP as they near a potential a de-SPAC transaction to ensure all stakeholders have a common understanding of the consequences of the de-SPAC transaction.

Certificate of Incorporation

Deemed Liquidation Event Definition

A startup’s certificate of incorporation, or charter, adopted after a preferred stock financing includes a definition of Deemed Liquidation Event (DLE).

The standard DLE definition included in the charter captures a merger that results in a change of control (COC), or a sale of all or substantially all assets. Although a de-SPAC transaction is typically accomplished through a statutory merger, it would not trigger the standard DLE definition since the company’s stockholders would continue to hold a majority of the company’s capital stock after the merger.

As a result, if a late-stage startup has an opportunity to amend its charter in connection with a financing or other event, it should consider updating the DLE definition to cover “a business combination involving the Company and a publicly listed special purpose acquisition company, whether by merger, consolidation, stock purchase, asset sale or otherwise.” Simply updating the DLE definition should suffice if the pro rata allocation of the consideration in the de-SPAC transaction exceeds the liquidation preference of the preferred stock.

Mandatory Conversion Provision

However, if a startup has a more complicated liquidation structure involving participating preferred or a liquidation preference in excess of deal value, the company should consider whether the holders of preferred stock should be entitled to their liquidation preference or be treated on a pari passu basis to common stock. Since a de-SPAC transaction is akin to an IPO, liquidation preference can be avoided by converting all preferred stock to common stock, pursuant to the mandatory conversion provision in the charter. To ensure this option is available, companies should review and potentially update the mandatory conversion provisions in the charter to include a de-SPAC transaction as a triggering event.

Voting Agreement

In a de-SPAC transaction, a company may seek to use the drag-along provisions included in most preferred stock financing voting agreements. In this way, the company can require those stockholders subject to the drag along to waive their statutory appraisal rights in the de-SPAC.

The drag along is usually tied to a DLE or a COC stock sale. By amending the charter to include a de-SPAC transaction as part of the DLE definition as described above, companies can also help ensure the drag-along provisions are available to the company in the event of a de-SPAC, if appropriate.

Termination Provisions of Shareholder Agreements

All stockholder agreements (typically an investor rights agreement, voting agreement, and right of first refusal and co-sale agreement) and side letters (typically management rights letters) should terminate automatically upon a de-SPAC transaction.

If possible, companies should try to have the requisite stockholders consent to terminating all such agreements and side letters. Alternatively, the termination provisions in each of these documents should either tie to an amended DLE definition in the charter or specifically call out a de-SPAC transaction.

As a best practice, any outstanding warrants or convertible notes should provide that they will be automatically net-exercised in connection with the closing of a de-SPAC transaction. Warrants and convertible notes typically auto net exercise in connection with a COC, but the definition of COC usually does not capture a de-SPAC transaction. Consequently, the COC definition could be updated to provide for auto net exercise immediately prior to the closing of a de-SPAC transaction. This approach helps avoid going public with warrants and convertible notes outstanding at an entity that will be a subsidiary of the public company. 

A startup generally does not want its options to accelerate in connection with a de-SPAC transaction because a de-SPAC is more akin to an IPO and not a COC. As such, the public company typically should assume the options. However, if the terms of outstanding options provide for acceleration upon an IPO, then acceleration for those specific grants can be respected.

Accordingly, if a startup has the opportunity to amend its EIP, it should consider extending to the administrator of the plan flexibility in treatment of equity awards in connection with a de-SPAC transaction, similar to the administrator’s authority for a COC, but without inadvertently triggering any acceleration rights which are applicable in a COC. In this way, the plan administrator gains flexibility regarding the treatment of the options.

Although it is ideal for a late-stage startup company to adopt these changes in preparation for a potential de-SPAC transaction, the timing of these changes is also very important. The best time to effectuate these changes to amend a startup’s preferred stock financing documents, warrants, convertible notes and EIP may be at a natural inflection point, such as in connection with a late-stage financing. In the context of negotiating a financing, investors may be amenable to these changes to ensure the company is best positioned for any possible exit, including a de-SPAC transaction.

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