Today, many investors prefer to choose tangible and comfortable ways to invest in emerging technologies and prospective industries such as the Longevity Industry. High net-worth individuals (HNWIs), families, or retail investors without access to investment opportunities in fast-growing technology companies commit to venture funds and rely on their investment committees for access to follow-on investments. Sometimes even such funds can miss a great investment opportunity. In such a situation, a special purpose vehicle (SPV) is a great option for modern investors.
Also known as a special purpose entity (SPE), an SPV is an entity created for a special purpose. In start-up investing, the purpose of this entity is to invest in a single start-up or company.
Special purpose vehicles (SPVs) are similar to traditional venture capital (VC) funds. However, there are several key differences between investing in a VC fund and purchasing a membership in an SPV. First, an SPV typically only invests in a single start-up. Therefore, investors know in advance where their financial resources are invested. On the other hand, a VC fund collects a large pool of capital, which is then allocated to a portfolio of start-ups over time. Investors in a VC fund will not know in advance how their money is being invested. Second, the entry point into a fund is usually high — typically $250,000-$1 million for smaller funds. The entry point for SPVs, however, is much lower. Third, according to Assure, one of the largest SPV creating platforms, it takes, on average, 38 days to find the minimum required amount of funding for closing an SPV deal, compared to 650 days to raise the first blind pool for a VC fund.
An SPV is a separate company, with its own balance sheet, that can be set up as a trust, a corporation, a limited partnership (LP), or a Limited Liability Company (LLC). Institutional investors may also look to increase their allocations to companies that are rapidly gaining in value through SPVs. When executed appropriately, SPVs can lead to outsize returns for both the VC and the LP investors that make up the SPV.
Private companies in the USA, Western Europe, and other developed countries maintain the list of members of the company independently without the involvement of external depositories and registrars.
In the USA, the restriction for Private Equity (PE) is legally fixed — at no more than 150 members of the LP or private company. If this line is crossed, a private company must become public in a very short time — i.e., enter the stock exchange through an expensive initial public offering (IPO) or direct listing procedure.
In any case, publicity imposes a number of new obligations on the company: strict requirements for reporting under IFRS, its audit, disclosure of internal information in order to protect the rights of shareholders. And most importantly, an unplanned and premature entry into the stock exchange can seriously harm the plans of the owners and management of the company. For example, an owner plans to launch an IPO only after launching a new product, gaining a certain market share, or reaching operational break-even. By presenting certain achievements to the market, a private company in the process of offering shares is more valuable to investors.
The register of shareholders in the USA is called the Cap Table. To get a new participant into the register, in most cases it is necessary to undergo a special issue procedure by the legal department of the company, in some cases with the involvement of regulatory authorities. This procedure is called the right of first refusal (ROFL).
By creating an SPV and attracting investments through it, a number of tasks are solved:
An unlimited number of new shareholders, represented by a single representative, can participate in the Cap Table of a private company through a representative office of an SPV. At the same time, a startup holds only one investor on the Cap Table — an SPV.
In some cases, it is not necessary to obtain permission, or it is possible to circumvent the ban on attracting investors related to politics or from undesirable jurisdictions.
For a private investor, a transaction to participate in private equity through an SPV usually looks like this:
Searching for a suitable offer from a variety of disparate investors and organisers of the infrastructure of SPV funds.
Passing the Know Your Client (KYC) procedure by the SPV fund.
The signing of documentation is usually an Operating Agreement (an agreement to participate in the fund) and, less often, a Side Letter, which separately prescribes special conditions for a particular investor, if they differ from the basic ones.
Provision by a private investor of signed documentation to the bank for making a payment with the need to pass currency control for payments to foreign counterparties.
Receiving an official confirmation of the transaction payment from the fund manager.
The conditions for exiting PE transactions are usually prescribed in the memorandum of the SPV fund. In most cases, they are tied to the occurrence of a corporate event for the investment object — a private company. Withdrawal from the transaction is carried out after the placement of the company’s shares on the stock exchange. Most often, the fund manager decides to sell a stake in the company independently, immediately in relation to all investors of the SPV fund. Less often, investors themselves can choose the moment to sell shares or receive shares to their own brokerage account anywhere in the world.
One more advantage of an SPV form of investment is to make it affordable for investors. For example, an investor aims to invest in 20 start-ups in order to create a diversified portfolio, so they would typically need to allocate $500,000 (=20*25,000) (20 deals with a minimum typical check of $25,000). If this investor wanted to give no more than 5% of their net worth income to start-ups, this means they need a net worth income of $10mm or more to get started (5% of $10 million = $500,000) (considering the accredited or sophisticated investor). Depending on how much capital the SPV raises, there are limits to how many investors can invest in it. For SPVs raising $10 million or less, the SEC permits a maximum of 250 accredited investors. For SPVs raising over $10 million, the limit is 100 investors.
Historically, this high net worth requirement has been a barrier for ordinary accredited investors to invest in start-ups. Most people do not have this kind of net worth to be able to invest in multiple start-ups and thus build a diversified portfolio. Hence, this is where SPVs come into the picture.
SPVs offer attainable entry points, giving access to most accredited investors. Some of them make minimum entry checks at $5,000, while others allow you to invest in the joint ventures (JVs) formed by the most promising startups in some industries. While SPVs are often used for a single investment into a company, they are also sometimes used for follow-on investments or as a sidecar investment to a fund. Often, SPVs are created for the investment, once a verbal commitment has already been made.
The term sidecar (also called an angel syndicate or angel fund) implies that there is a lead investor who sourced the deal, performed due diligence, is investing directly in the entity, and is usually putting their name and brand behind the deal. The lead investor, known as the organiser, typically receives compensation in the form of management fees and carried interest. The advantage for startups looking for financing is the invisibility of the sidecar SPV process. Other than having one more entry on the cap table, there is no added complexity to the deal process. Furthermore, as the SPV process is organised by a lead investor, the start-up management is not obligated to conduct pitching meetings to investors with small checks.
On the whole, the following characteristics make SPVs an excellent private equity fundraising instrument:
A convenient and clear investment trajectory for all types of investors.
Allowing their members to participate in investments on a deal-by-deal basis, making multiple direct investments in companies at different stages.
The investment network of a given SPV is already adjusted for in-depth performance analysis. This network allows for tracking and measuring the performance of every given investment.
Because of the legal definition of an SPV, it is possible to create it in many different types and forms, tailoring it for the immediate needs of the investor and the specific transaction in question.
SPVs are appropriate for Family Offices, Angel Syndicates, and Investors aiming to diversify their allocations.
SPVs allow investors to dissect every deal and protect themselves from non-compliance or inherent financial risks.
All stages and internal processes within SPVs will align with the initial investment vision/thesis because of the legal structure of such entities.
Use of SPVs by startups enables late-stage startups to stay private longer without engaging in an IPO or M&A transaction. The longer a company stays private, presumably the higher its valuation will be at the time it exits the market.
Startups use SPVs to ensure their future growth and follow-on financings won’t be at risk. With an SPV, founders can have an unlimited number of smaller investors grouped into one large entity, with voting power directed by a lead investor.
SPVs are often designed for large rounds that go beyond the individual investor capacity for making a deal. VC funds also use SPVs in large seed rounds, and from As to Ds. Sidecar SPVs could be established by VC funds, primarily micro VC funds and family offices, to fill a fund’s pro-rata allocation where significant investment capital limits exist. For example, such micro VCs could easily participate on the pre-seed stage but it is much more complicated on the later stages of financing where the deal amount reaches hundreds of millions of dollars. The possible solution is a sidecar SPV with dozens of LPs.
Groups of investors will often invest together and create a new SPV, or Syndicate, every time they invest. This is common in angel networks, VC firms, and many other types of investment groups. This arrangement helps to simplify the startup’s Cap Table while ensuring a potential return for multiple investors.
One more advantage of an SPV form of investment is the fees. VCs typically charge 2% management fees annually (totaling 20% over the life of a 10-year fund), plus a 20% carry. Carried interest, otherwise known as “carry,” is the share of profits from an investment that is paid out to general partners at a VC firm. The averages of 1.2% for an SPV management fee and 11.9% (Assure data) for carry are smaller than what’s normally budgeted for a micro-VC, indicating that co-investing is still largely a supplemental business, and co-investments are a feature that SPV sponsors can offer to other investors.
LPs select funds based on the GP and their investment thesis — but they don’t have a say in the specific investments the GP makes. With an SPV, everyone knows what the investment is, meaning no LP has to be part of an investment they’re not interested in. SPVs keep the company Cap Table clean while ensuring that each investor gets the distributions they are entitled to, in case of a liquidation event.
There is no such thing as a perfect investment vehicle, but SPVs are versatile and potentially work in various situations, making them one of the better innovations in angel investing. Their rising popularity reflects how useful they can be for accredited investors.