How do special purpose vehicle companies (SPVs) work in venture capital (VC) and startup investing? Securing the right funding can be a game-changer in the fast-paced world of venture capital and startups. Fund managers (also known as general partners or “GPs”) raise venture capital funds to invest in multiple startups over several years. By investing in such a fund, investors (also known as limited partners or “LPs”) get exposure to a basket of different companies, creating a diversified portfolio.
But what if LPs only wanted to invest in one specific company? What if a GP doesn’t have a fund at the time they come across a promising investment opportunity?
That is where Special Purpose Vehicles (SPVs) come in. Every year, GPs raise thousands of SPVs on platforms like AngelList. Each of these SPVs invests in a startup, allowing both GPs and LPs to seize unique opportunities.
In this post, we explain the basics of SPVs: what they are, how they work, and why investors use them in venture capital. Whether you’re a startup founder seeking funding or an investor looking for lucrative opportunities, understanding SPVs could be your key to success.
What are Special Purpose Vehicle Companies (SPV)?
A legal entity, an SPV isolates financial risk for a specific business purpose. In venture capital and startups, investors often use SPVs to pool funds for a single company or project. This setup allows investors to participate in high-potential opportunities while mitigating individual risk.
An example from Brightspark
Benefits of Special Purpose Vehicle Companies (SPV) for Startups
- Access to Larger Pools of Capital: By attracting multiple investors, startups can secure significant funding that might be unattainable from a single source.
- Simplified Capital Structure: Instead of managing numerous individual investors, startups deal with one entity, streamlining equity distribution and decision-making processes.
- Enhanced Credibility: SPV backing can enhance a startup’s credibility, making it easier to attract additional funding and strategic partners.
Benefits of SPVs for Investors
- Risk Mitigation: SPVs spread investment risk across multiple investors, reducing the financial impact on any single participant.
- Diversification: Investors can participate in multiple SPVs, diversifying their portfolio across various startups and industries.
- Access to Exclusive Deals: SPVs often provide access to investment opportunities that might not be available to individual investors, including high-growth startups and innovative projects.
How Do SPVs Work?
SPVs are typically structured as limited liability companies (LLCs) or limited partnerships (LPs). Here’s a step-by-step overview of how they operate:
- Formation: A lead investor or sponsor creates the SPV, defining its purpose and investment strategy.
- Fundraising: The SPV raises capital from multiple investors, each contributing a specified amount.
- Investment: The pooled capital is used to invest in a target startup or project.
- Management: The lead investor or sponsor manages the SPV, making investment decisions and overseeing operations.
- Returns: Profits or losses are distributed to investors based on their share in the SPV.
The Investment Side of SPVs
SPVs serve dual purposes for both companies and investors. Let’s explore the investment side, where SPVs can create syndicates, pledge funds, and managed funds.
Syndicates: Teaming Up to Invest
In simple terms, a syndicate is a group of investors who come together to invest in a single target company. Syndicate investing is popular among angel investors looking to invest in fast-moving startups. Typically, a ‘lead investor’ with domain knowledge leads the syndicate’s investment.
SPVs form a dedicated legal entity for the syndicate, acting as a vehicle for those transactions. Syndicates involve several key parties working together:
- The Lead Investor: This individual sources the deal, negotiates terms, and rallies other investors to participate. The lead investor must contribute their own capital.
- The Follow-On Investors: These individuals are brought in by the lead investor. They usually pass on their voting rights to the lead investor as a proxy to simplify governance.
- The Nominee: Nominees act as the legal owners of the syndicate’s shares, while individual investors remain the beneficial owners. This keeps the cap table clean.
- The Target Company: The company in which the syndicate is investing.
If the lead investor does not invest “materially” themselves, they need to be regulated, creating a Managed Fund structure. Key criteria for a syndicate to satisfy if the lead investor is not a regulated fund manager include:
- The lead investor must personally invest a material amount.
- No upfront “deposits” may be collected from investors.
- Each investor must retain a say in share voting and management.
Why Angel Investors Use SPVs
Angel investors often choose to invest via SPVs as they enable them to expose their cash to asset classes or investment types they’re unfamiliar with, forming a community of like-minded investors with close relationships to the lead investor or fund manager.
By joining forces with other angels and forming what’s known as an angel syndicate, you can pool your resources and actively pursue co-investments. Key benefits include:
- Access to More Deals: By banding together with other angels in an SPV, you can invest larger amounts than you might individually. This opens up a broader range of investment sizes, including later-stage deals that may have previously been out of reach.
- Diversification Made Easier: With a wider variety of investment opportunities, SPVs make diversifying your portfolio easier. By allocating smaller amounts across different industries and stages, you can spread your risk and potentially optimize your returns.
- Increased Negotiating Power: Investing as part of a syndicate SPV gives you more negotiating power. With a larger investment amount at stake, you can often secure better deal terms and more favourable conditions than you could as an individual investor.
- Staying Competitive in Follow-On Rounds: As your portfolio companies grow and raise subsequent rounds, it can be difficult to keep up as an individual investor. However, by pooling your capital with other angels through an SPV, you can remain competitive in those larger follow-on deals.
SPVs on AngelList & Carta
AngelList and Carta facilitate the creation and investment in SPVs by handling tasks such as entity formation, fund maintenance, financial and tax reporting, compliance, and distributions. Consequently, they simplify the process and ensure efficient management for investors and startups alike. These platforms connect GPs with LPs, simplifying the process of raising capital.
Frequently Asked Questions About SPVs
Are SPVs Only for Large Investors?
No, SPVs can be tailored to accommodate a wide range of investment sizes, making them accessible to both large and small investors. This inclusivity allows more individuals to participate in high-growth opportunities.
What Are the Costs Associated with Special Purpose Vehicle Companies (SPV)?
Costs can vary but typically include legal fees for setting up the SPV, administrative fees for managing the entity, and performance fees based on the success of the investment. Despite these costs, the potential returns often outweigh the expenses.
How Are Returns Distributed?
The SPV usually distributes returns based on each investor’s contribution proportion. For example, if you invest 10% of the total capital, you receive 10% of the profits. The SPV’s operating agreement outlines specific terms.
Can you use SPVs for Non-Equity Investments?
SPVs not only structure equity investments in startups but also support debt investments, real estate projects, and other asset classes. Consequently, they provide the flexibility needed to achieve various investment goals.
Key Considerations for Startups and Investors
For Startups:
- Choose the Right Lead Investor: Ensure the lead investor or sponsor has a strong track record and aligns with your company’s vision and goals.
- Understand the Terms: Carefully review the SPV’s terms, including the cost structure and the rights of investors, to avoid any future conflicts.
For Investors:
- Due Diligence: Thoroughly research the target startup and the SPV sponsor before committing funds.
- Review the Operating Agreement: Understand the investment terms, management fees, and distribution structure outlined in the SPV’s operating agreement.
Risks Associated with Special Purpose Vehicle Companies (SPV)
Any early-stage venture investment comes with certain risks. Here are some risks that SPV investors should be aware of:
- Lack of Diversification: SPVs invest in a single company. If that company fails, investors in the SPV may not see any return on their capital.
- No Voting Rights: LPs inside the SPV do not have voting or information rights. They need to trust the GP to represent their interests.
- Preferential Treatment: Sometimes, GPs only open an SPV to a specific group of LPs, limiting access for new LPs.
- Fees: Investments in SPVs may be subject to carried interest and management fees. Many LPs view this as the cost of getting access to great deals.
Conclusion
Special Purpose Vehicles offer a powerful mechanism for both startups and investors to maximise their potential. By pooling resources and mitigating risks, SPVs open doors to exclusive investment opportunities and significant capital for innovation and growth. As the startup ecosystem continues to evolve, SPVs will likely play an increasingly vital role in shaping the future of venture capital.
Amit Khanna, 7startup Founder
Amit is an investor and advisor with two decades of experience and an MBA. He supports entrepreneurs with fundraising & go-to-market expansion in Saudi Arabia. His strategy is built on two pillars: deep investment acumen and a vast operational network. Reach out to us today and see if we’re a fit!
