Scores of companies that went public during the Spac boom are heading into the financial year-end with weaknesses in their accounting practices, raising the prospect that their annual reports may not paint a true picture of their financial health.
The failures of internal controls and poor bookkeeping practices, disclosed in quarterly reports over the past month, add more evidence for critics of special purpose acquisition companies, who say the trend has resulted in a large number of immature and potentially risky new listings.
The companies themselves, meanwhile, are faced with escalating costs as they race to hire more accounting staff and reach the higher audit standards demanded by public markets.
“A lot of people were caught up in the glow of, ‘Hey I can go public now, it’s a bull market, everyone’s really excited about my company and my vision’,” said Kris Bennatti, a former auditor who now runs the investment research firm Bedrock AI. “The glow is gone. Reality has come to bite us.”
More than 350 companies have gone public in the US since the start of 2020 by merging with a Spac, a cash shell set up specifically to make an acquisition. The arrangement allows a company to avoid a traditional initial public offering, which can be more expensive and bars executives from making speculative forecasts about their future prospects. Companies that come to market via a Spac are sometimes called “de-Spacs”.
After an initial clamour among investors, many de-Spac share prices have crashed amid notable disasters and a wider rethink of the value of early-stage businesses. They include revelations of fraud at the electric truckmaker Nikola and a warning of possible bankruptcy by the crypto miner Core Scientific.
Research by Bedrock in September found 49 per cent of the quarterly financial filings by de-Spacs since 2020 contained an admission of ineffective internal controls. A review of more recent filings, covering the third quarter, shows only a small number of the companies with problems had been able to rectify them.
The media group BuzzFeed, for example, said on November 14 that “although management designed remediation plans in 2021, due to resource constraints and lack of sufficient staff with technical expertise, the necessary business process and IT general controls were partially implemented or not executed consistently”.
Dozens of others included similar language in their third-quarter filings. Redwire, a space infrastructure business assembled through a string of acquisitions since 2020, said work to improve its accounting controls would continue into next year. Auditors had forced Redwire to restate earlier financial filings, and the company blamed compliance problems on the failure to set the right “tone at the top”.
Other space ventures still reporting material weaknesses include Rocket Lab USA, Astra Space and Virgin Orbit, the satellite launch business fronted by Richard Branson. A material weakness is typically said to open a “reasonable possibility” that a financial misstatement “will not be prevented or detected on a timely basis”.
Redwire was among many companies saying they were hiring additional accounting and IT staff to improve its internal controls, but it added: “These remediation measures will be time consuming, will result in the company incurring additional costs, and will place additional demands on our financial and operational resources.”
Investors in a Spac have the option of getting their cash back instead of keeping shares in the company after a merger, and companies that had high investor redemptions are about 50 per cent more likely to have reported material weaknesses in their financials, said Michael Ohlrogge, a New York University law professor who studies Spacs. The higher the level of redemptions, the less cash is available to the de-Spac company, and the fewer outside investors might be scrutinising the company.
“Not only are there fewer big shareholders to hold their feet to the fire, there is also less liability risk,” he said. “It’s also of course possible that the high redemption Spacs had high redemptions because investors realised the target companies were not well run, ie the low quality could in some cases be causing the high redemptions, rather than the other way around.”
Another reason for the elevated level of accounting weaknesses among de-Spacs could be that Spacs are exempted from some of the securities laws governing IPOs, Ohlrogge said. In an IPO, an underwriter is liable for misstatements in a company’s flotation documents, which can push them to improve the quality of their accounting practices before going public.
Bedrock’s research this year found that the 49 per cent of filings with material weaknesses among de-Spacs compared with 20 per cent across US public companies over the same period.
Bennatti cautioned investors not to dismiss such red flags in the financial statements.
“If you can’t report your revenue line correctly under generally accepted accounting principles, you are probably not tracking your key performance indicators very well,” she said. “All of these things are related to each other and they do matter.”