What’s with this “Pre-IPO Code” Stuff from Jeff Brown?

Checking out the teaser pitch from Brownstone's Blank Check Speculator

By Travis Johnson, Stock Gumshoe, January 19, 2021

I’ve gotten a lot of questions in the past couple days about Jeff Brown’s “Pre-IPO Code” presentation, in which he teases the idea of this “Pre-IPO” investing strategy as he pitches his new Blank Check Speculator newsletter.

And I’ve got good news… and bad news.

The good news is, I can explain what he’s talking about and answer some of those reader questions, and provide some perspective…

The bad news is, he doesn’t drop any hints about which specific “Pre-IPO Codes” he’s recommending, so we won’t be providing that kind of answer today.

Brown’s offering, by the way, is one of the typical infomercial “hard sell” stories — you’ve got to “get in now,” and he “fought with his publisher” to make sure he could offer it for $2,000 instead of the $4,000 “retail price.” That $2,000/yr comes with few guarantees and absolutely no refunds — the guarantee is that “I pledge to identify a SPAC that combines with a unicorn in your first year of service, or you get another year free” … which I guess is better than no guarantee at all, it means he won’t just take your money and disappear, but it certainly doesn’t mean that Brown has to have a successful year… that might be the easiest promise to keep that I’ve ever heard of in newsletter world. And it certainly doesn’t mean that he’s taking any risk — it remains, of course, only your money, that $2,000 plus whatever you risk on his investment ideas, on the line.

So what’s the deal? The presentation is structured as a interview by Chris Hurt, who is introduced as the Host and seems like some kind of in-depth 60-minutes interviewer but is, as is typical of these kinds of “presentations,” actually an actor — a guy who followed up his career as a Disney tour guide with a career as a self-employed voice over artist and spokesperson-for-hire (according to his LinkedIn profile, at least). Not that there’s anything wrong with that, but I find pricking a little bit of the bubble of silliness that surrounds these ad pitches is useful in helping us to think a little more slowly and deeply about what they’re actually selling.

The basic pitch is that you can be part of the new wave of IPOs, of companies that will change the world, and that you can get in before the IPO excitement and therefore collect massive rewards. Here’s a little bit of the “story” of the kinds of companies that are being created:

“In the Southwest, the world’s first commercial spaceport is ready for launch. In Silicon Valley, a college dropout has all but won the self-driving car race. And in the rust belt, GM has shipped thousands of jobs overseas until… the local plant was saved by an electric truck company.”

And because we’re all primed to believe that the secret cabal of insiders are keeping the best stuff for themselves, we’re primed to believe it when we’re told that these IPOs are shaking Wall Street to its core, and “Jeff Brown says it’s being kept from you.”

Plus, to be even sexier, “there’s a code”… And Jeff Brown says that, “if you know this code, you can invest before IPO day and see the potential millionaire-making names once reserved for the wealthy.” More from the presentation:

“The Pre-IPO code is a new innovation that will let you secure a stake in billion-dollar tech unicorns before IPO day. With the right codes, you don’t need to be an accredited investor, and taking advantage of these kinds of deals could mint millionaires.”

So what do these codes get us?

“The moment you enter a Pre-IPO code and click buy, you’re awarded units — not ordinary shares of stock, I mean units, contractual share of the enterprise you’re buying.

“Back the visionaries, men and women who are bold enough to change the world.”

And that is, of course, all a lead-in to a pitch about Special Purpose Acquisition Corporations (SPACs), which are often also called “blank check” companies. They’ve been around for decades as a marginal part of the investment banking world, with occasional little jolts of interest, but over the past two years or so they have exploded and become dramatically more popular. Jeff Brown insists on calling the lack of public awareness of SPACs a “cover up,” which seems to just be conspiratorial goofiness, but it’s true that they are not often well-understood — even by the folks who got really excited over the past year and started speculating on lots of these stories.

So let me explain SPACs as well as I can, just to make sure you know what you’re getting yourself into, and then I’ll get back into some other examples and notions that Brown shares in the ad. I’ve shared some of these words with the Irregulars in the past, but here are the basics on SPACs:

A Special Purpose Acquisition Corporation (SPAC) is often called a “blank check” company — these are companies that go public in a regular IPO, raising money from the public on the strength of some internal and institutional sponsorship and a vague notion of what they might do with the money they’re raising.

That sounds inherently risky, and it is, so to make it palatable and less likely to screw over investors who are putting money into this pool of capital with no promise about what might happen to it, there’s both a sweetener and an escape hatch:

The escape hatch is that the SPAC sponsor has a set amount of time, usually two years, in which to find a use for the capital that they control, which is tied up in a trust fund — typically, that means they leverage both of the SPACs assets (their public listing and their pool of cash) to take a private company onto the public markets (or sometimes more than one company, as when what became DraftKings was formed from DraftKings, the gambling tech company SB Tech, and the Diamond Eagle Acquisition SPAC).  

The “escape hatch” opens right before that deal to merge with another company is consummated, and only for a brief while — shareholders of the SPAC get to vote on the deal, which gives them some power, but, more importantly, they also get the right to redeem their SPAC shares for their portion of the trust fund at the time the deal is done. If no deal is ever found, that trust fund gets distributed back to SPAC shareholders. The trust fund’s value to shareholders is essentially the $10 per share that almost all SPACs start out with (there are occasional exceptions), plus a tiny bit of interest… the estimated per-share redemption value is usually disclosed in filings along the way to keep shareholders updated.

And the sweetener is warrants. Each SPAC goes public initially as a stapled unit, typically with a U at the end of the ticker (so in the case of Yellowstone Acquisition Corporation, for example, it is YSACU). That unit includes one share of equity (YSAC), which is what can be redeemed at the time of deal consummation or if no deal is found before time is up, and usually a portion of a warrant.

There is no rule that says all SPACs have to be identical, but in general each unit will have one warrant if the manager is not well known enough to easily raise capital, or a half or a third of a warrant (or less) if that’s all that’s needed to get attention (particularly if they have a strong brand name with investors, like Bill Ackman’s Pershing Square or Chamath Palihapitiya’s Social Capital). A third of a warrant per unit seems to be most common now (each Yellowstone unit, to continue the example, includes half of a warrant).  

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Within the first two months or so after the SPAC units go public, the Units can be separated at the investor’s option, and they will begin trading separately as regular equity shares (YSAC) and publicly traded warrants (YSACW). SPACs are the source of most of the publicly-traded warrants that exist in the markets these days.

A warrant is essentially like a call option, with a few key differences. They are individual securities, and they are not standardized, so you have to pay attention — but almost all the time they are five-year warrants (starting from the date the SPAC consummates a deal) that give you the right to buy the underlying stock at $11.50 a share, so that’s kind of like a long-term call option… with the leverage somewhat limited because there’s typically an early redemption or expiration right, at the company’s option, that kicks in if the shares trade above a certain level (usually $18 for 20 days out of 30).

Warrants require active attention, because they do not get exercised automatically by brokers like stock options do — so they can expire worthless even if they should be “in the money” and valuable, and that’s particularly true if the share price soars to that $20+ neighborhood and the company chooses to redeem the warrants early. If you aren’t paying attention and don’t exercise them or sell them before redemption, the company can seize your warrant for a penny (depending on the specifics in their prospectus), and you’re out of luck. Watch your mail and broker notifications about corporate events, and watch your SPACs.

The fractional nature of warrants sometimes gets confusing, too, so make sure to pay attention to the filings and understand, in each case, how many warrants are attached to your SPAC units, and what the exercise terms of the warrants are — sometimes a warrant is effectively for a half share, for example, so it might require two warrants plus $11.50 to exercise, and there are many different permutations out there that impact the value. Most of them follow the same basic structure, but, like snowflakes, no two are exactly alike.  If you don’t want to read SEC filings, SPACs are probably not for you.

Warrants can be bought or sold, of course, and speculators often trade them, so they should trade at a price that equals their exercise value (usually the current share price minus $11.50), plus some assessment of the “time value” of the warrants, adjusted for any early-exercise rights… but they don’t always trade at a price that makes immediate sense in relation to the underlying share price. And they can’t be exercised until the shares are registered to underly those warrants, which usually takes place shortly after the merger deal is consummated but can vary (back when the government shut down over budget disputes a couple years ago, for example, the SEC went deep underwater and it took months for some shares to actually get registered, so there was very little trading volume and some thinly traded SPAC shares and warrants traded at nutty prices — look at the chart of PHUN in January of 2019 if you want an example).

A few other things to note: If you buy a SPAC unit (with the U on the end of the ticker), you’re buying what originally went public, including whatever warrant(s) are stapled to that SPAC share. If you buy after the split, (YSAC instead of YSACU, to continue with the example of Yellowstone), you don’t get any right to that warrant. Once the units split you can also buy just the warrant if you prefer, which, to continue the Yellowstone example, most brokers will report with ticker YSACW (or YSAC/W or YSACws or some similar notation).

If you wish to use a SPAC as a low-risk option on a possible future company combination, as many institutional investors do, then the redemption value is critical. If you buy SPAC units at $10 a share, you’re taking very little risk because of the redemption right, it’s just that your money is “tied up” to some degree (you could always sell your SPAC units, of course, but at the market price, which might not necessarily be as high as the full redemption price). It used to be fairly common for SPACs to trade at a little less than their $10 “trust” value when they were in “seeking a deal” mode, mostly because nobody loved SPACs and the market’s expectation was that they would probably make a dumb deal and would continue to be below-average investments in the long run… but given the current SPAC mania, finding a SPAC trading well below the trust value is pretty unusual.

If you pay meaningfully more than $10 per share for a SPAC share (the regular equity, so YSAC in this case), everything above $10 is your speculation on what company the SPAC will merge with, and how successful they’ll be. If you pay very close to $10 a share for the original SPAC units (YSACU, in this case), then you are essentially getting all the leverage of the warrants for free.  You will have a redemption right that hits within two years that will almost certainly be for very close to $10, perhaps a little higher ($10.15-$10.20 or so seems pretty average), so you get to know that you have the option to participate or not participate in the deal at that point… but if you buy the original units you also get the warrants as a free option on that future potential.

Nothing is guaranteed like Treasury Notes or a bank account are gauranteed, but I’m not aware of any SPACs that have blown up, due to fraud or anything else, and not paid out their redemption value. That’s why hedge funds love investing in SPAC IPOs — they can get in at the $10 IPO price, which most of us cannot (as with all IPOs, the original fundraising for SPACs is usually directed to the broker’s favorite customers — who are mostly high-volume traders and hedge funds). If you get in on that IPO, there’s no downside if you hold until the redemption date, and there’s possible upside from the equity, if investors get excited about it after a deal is rumored or announced, and from the “free” warrant (many hedge funds and institutional investors just do an arbitrage to get a small return plus free warrants — buy the SPAC units at the IPO, with the intent of redeeming, effectively just getting the cash-like return to the redemption date and earning some free warrants, while also maybe getting lucky if investors bid the SPAC up for some story-driven reason along the way). Brown teases it as being somehow special and avoiding the con men on Wall Street, but Wall Street always does get at least a little taste — the sweetest deal is always off the table before “regular folks” get access — getting in on a SPAC IPO at the $10 IPO price is essentially a no-brainer, a guarantee of no downside and some possible upside.

Who pays for all of this? The founding sponsor of the SPAC who originally takes it public… but you don’t have to thank them, because they also reap a huge portion of the reward. In exchange for buying founders shares or founders warrants that are not redeemable (or publicly traded), and which essentially cover the cost of the IPO and of the manager’s overhead for the two years that they spend looking for a deal, they typically get a huge chunk of the equity in the new company that is created out of the SPAC when a deal is done (usually 20%, though sometimes it’s adjusted down to make a deal work). If a deal is not done, they eat those costs and generally get nothing.  It’s a bargain for them, their initial investment in getting this set up and buying those founders warrants or getting that free future share is often just $25,000 or so, total, for 20% ownership of a SPAC that could raise maybe $200-500 million (some founders invest a lot more into their SPACs than that, but many don’t).

That is the primary problem with SPACs, historically — founders get outsize rewards and take almost no risk, and to earn those rewards they are highly incentivized to make a deal, which means that during a time like this when there are SO MANY SPACs out there seeking deals, I’d worry that the edge goes to the seller of those companies, not the buyer. That’s not necessarily true in each specific deal, but it’s certainly true for the “hotter” names that are out there, like the well-known venture-funded technology companies, so those private owners are sometimes getting awfully good deals from these SPACs.

Other important things to note? The “escape hatch” redemption clause is not perpetual — you get to exercise your right to redeem your shares for your portion of the trust fund only at the point when a deal is made or the point that the deadline (usually two years) expires. If the deal is not easy or quick to close and the deadline is about to be reached, then most SPACs have an automatic extension right of a few months, or can go back to SPAC holders and ask them to approve a longer extension, but the extension itself is the second trigger for redemption — if they ask for an extension, they can have it but you also get the right to redeem for your $10 or so instead of leaving your capital in the pool for that extended period. You usually get a set amount of time in which to exercise your redemption option, it won’t be very long, so do pay attention to whatever notification you get — those redemption requests would typically be placed through your broker, and may incur a fee from the broker for doing that work.

Traditional SPACs are pretty ugly when it comes to egregious compensation for the sponsors, which is one reason why they have historically not done terribly well as investments after the SPAC deal has been struck (recent “story stock” victories like Virgin Galactic, Quantumscape and Draftkings notwithstanding), so I would never argue that they’re a good deal as an asset class — but I still think there are occasional interesting deals in SPAC mergers, and that buying a SPAC at the IPO price remains a pretty easy “free option” if you have cash lying around. And certainly there’s been a mad rush into SPACs over the past year, so a lot of folks have enjoyed trading profits on some hot stories… which feeds on itself, sending more investors into the weeds to look for what they hope will be the next SPAC to make a high-profile deal.

There was a good story on Bill Ackman’s SPAC in Institutional Investor a little while ago, here’s a little excerpt about that compensation issue:

“One of the things SPACs have in common with other forms of asset management — specifically alternative asset managers — is the outsize compensation for their founders.

“‘SPACs are a compensation scheme, like people used to say about hedge funds, but it’s even worse,’ Ackman tells Institutional Investor. ‘In a hedge fund, you get 15 to 20 percent of the profit,’ he says, in reference to the incentive fees hedge funds earn on the gains in their portfolio. ‘Here you get 20 percent of the company.’

“For a small fee of $25,000, he explained in a recent letter to investors in his hedge fund, ‘a sponsor that raises a $400 million SPAC [the average size this year] will receive 20 percent of its common stock, initially worth $100 million, if they complete a deal, whether the newly merged company’s stock goes up or down when the transaction closes.’

“Even if the stock falls 50 percent after the deal closes, ‘the sponsor’s common stock will be worth $50 million, a 2,000 times multiple of the $25,000 invested by the sponsor, a remarkable return for a failed deal,’ he wrote.

“Meanwhile, Ackman noted, the IPO investors will have lost half of their investment.

“And there is another advantage: The 20 percent stake is also referred to as the ‘promote,’ a nod to the work sponsors perform in landing a deal. However, that money is considered an investment, not a fee, which means sponsors can pay a lower capital-gains tax on the return if the stock is held longer than a year.”

Ackman’s SPAC Pershing Square Tontine Holdings (PSTH), by the way, is non-standard — it uses a tontine structure for warrants, doesn’t have the same free founder’s share position as most, it was priced at $20 instead of $10, it’s much larger (they raised $4 billion). Pershing Square Holdings, Ackman’s hedge fund, is the main sponsor, and is likely to provide most of the extra capital required to consummate a deal, if any, so there might not be a private funding round in connection with whatever deal they manage to find (those private investment in public equity deals, called PIPE deals, are also often close to a “free money” opportunity for the founders and institutions). PSTH trades at a premium price, which is one reason I haven’t put capital into it, particularly since I’ve already got quite a bit of exposure to it through Pershing Square Holdings (PSH.AS, PSHZF), and I think owning