Investing through a Special Purpose Vehicle (SPV)

Investing through a SPV is one of the best ways for angel investors to get started. These days, even experienced investors, Limited Partnerships (LP), and fund managers use it more often than they used to. As an investor, a SPV is a potential way to diversify your portfolio without the same large commitment you would have to have on your own or as part of a fund.

In this blog post, we cover what is a special purpose vehicle (SPV), how SPVs work and why they are used, a comparison of SPVs with Venture Capital funds, how to decide when to use SPVs, limitations of investing through SPVs and our final thoughts.

What is a Special Purpose Vehicle

Often abbreviated as SPV and known as a special purpose entity (SPE), a Special Purpose Vehicle is an entity created for – you guessed it – a special purpose. In startup investing, the purpose of this entity is to invest in a single startup.

A SPV is a separate company with its own balance sheet. SPVs can be set-up as a trust, a corporation, a limited partnership, or a Limited Liability Company (LLC).

The concept of SPVs has been around for a long time, but it is gaining more popularity now due to its potential advantages. This key innovation can be structured favorably for the participating angel investor as well. In the world of startup investing or angel investing, SPVs are often called Syndicates.

How Investing in a SPV (or SPE or Syndicate) Works

In most cases, when you invest in a SPV, you are putting your money into a holding company designed to make a single investment. Once funds are collected, they are invested in a startup, and the SPV becomes an investor in the startup.

Distribution is made to the SPV in a liquidation event, which then disburses money to the investors in the SPV. Your ownership on the company capitalization table (cap table) is reflected through your right in the SPV as an investor.

In the world of startup investing, most SPVs are often registered as Limited Liability Companies (LLCs). Individual investors in each LLC are called ‘members.’ There is an overall LLC manager. Investors typically sign a Subscription Agreement and an Operating Agreement at the time of investing. Read your documents carefully to understand who is your Manager and what your rights are within the LLC.

Why Special Purpose Vehicles are Used

The SPV structure provides flexibility. The main purpose of a SPV is to make startup investing accessible and affordable to ordinary accredited investors.

Historically, startups have raised money from individual angel investors – typically checks of $25,000-$50,000 from each angel investor. Angels invest their dollars and receive stock of the startup in exchange for their investment. Each investor appears on the startup’s cap table – this is a typical example of a ‘direct’ investment.

The problem is that this is unaffordable for most accredited investors. Here is some math: assuming you invest in 20 startups in order to create a diversified portfolio, you would typically need to allocate $500,000 (=20*25,000). If you wanted to give no more than 5% of your net worth to startups, this means you need a net worth of $10mm or more to get started (5% of $10M = $500,000).

Historically, this high net worth requirement has been a barrier for ordinary accredited investors to invest in startups. Most people do not have this kind of net worth to be able to invest in multiple startups 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. For example, a Propel(x) SPV accepts as little as $5,000. It means that you can build a diversified portfolio of 20 startups with as little as $100,000. And if you want to keep startup investments at 5% of your net worth, this means you now only need a net worth of $2M (versus the $10M net worth needed when investing directly).

Because SPVs generally come with lower investment minimums than traditional VCs or funds, investing through a SPV gives investors access to investments they would not usually have. The entry point is attainable, and these vehicles make it easier for angel investors to participate.

Notably, a SPV gives lower net worth angel investors access to the same deals as higher net worth individuals without a significant commitment.

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.

Groups of investors will often invest together and create a new SPV, or Syndicate, every time they invest. This is common in angel networks, venture capital firms, and many other types of investment groups. This arrangement helps to simplify the startup’s cap table while still ensuring a potential return for multiple investors.

Special Purpose Vehicles vs. Traditional VC Funds

Another way to invest in startups is to invest in a Venture Capital Fund. SPVs are similar to traditional VC funds in that both SPVs and traditional Venture Capital (VC) Funds invest in startups. However, there are several key differences between investing in a VC fund and purchasing a membership in an SPV.

First, a SPV typically only invests in a single startup. Therefore as an investor, you know in advance where your dollars are invested. On the other hand, a VC Fund collects a large pool of capital, which is then allocated to a portfolio of startups over time. As an investor in a VC Fund, you will not know in advance how your dollars are being invested.

Second, the entry point into a fund is usually very high – typically $250K- $1M for smaller funds. The entry point for SPVs, however, is much lower – as discussed earlier. With lower investment minimums for SPVs, your net worth can be lower, you can still diversify, and you will pay fewer fees over the long term.

Finally, you should consider the fees: VCs typically charge 2% management fees annually (totaling 20% over the life of a ten-year fund), plus a 20% carry interest. 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. SPVs charge varying amounts of management fees but rarely close to 20%. For example, Propel(x) syndicate fees are:  a 7.5% one-time fee and a 10% carried interest on SPVs.

Historically, VC Funds were differentiated because they actively manage the portfolio. However, now most online platforms have portfolio management teams as well.

However, there are limitations of SPV structure. The key benefits of a VC fund are that they are convenient for a wealthy investor who does not have the time to source or evaluate each investment opportunity individually. Additionally, the top-performing VC fund managers usually generate significant returns for the investors. However, most top-performing VC Funds are not accessible to the ordinary accredited investor.

When to Invest in Which Entity

We have outlined three ways to invest in startups – Direct, SPV, and VC Fund. There is a time and a place for each type of investment, based on your specific goals, objectives and financial situation

Investors in a SPV do not have direct access to the company. The owner of the SPV manages the investment, so individuals must first take their concerns to the Manager, who can work with the company on their behalf.

However, SPVs are good ways to invest in things that may fall outside the scope of any fund you may be a part of. They are also good  mechanisms for new angel investors to get started. In terms of getting started in angel investing, a SPV will help you get your feet wet..

On the other hand, investing in a fund you will have some winners and some losers. You are diversifying your portfolio, and even if one company fails, the chances are you will have another one that succeeds. You are less likely to lose 100% of your money if you buy into a fund. Investments have risk and there is always the risk of losing all of the funds that you have invested.

It is also more likely that you will get regular reports on portfolio performance as a part of a fund. Everyone in the fund has the same exposure to the same companies, making it easier for fund managers to send quick updates more often. That is not to say that you would not get updates as part of an SPV, but they may not be as detailed or frequent.

Limitations of Investing Through a SPV

There are several limitations to the SPV structure. For one, there is a 99 person rule. Only 99 people can invest through a single SPV, which sounds like a lot. However, if the company has garnered a lot of interest and you are participating with a pool of other angel investors, you will have to commit soon enough to make it into the first 99, or you are out.

You also have to take it upon yourself to monitor the performance progress of the company on your own time. Investment updates sometimes do not come as readily from individual startups as they do from VC fund managers, so you are responsible for keeping tabs on your own investments.

There is a huge risk on the carry. When you invest through a SPV, you are all in. The SPV makes a single investment into one company, and if that company fails, you stand to lose everything, including the fees you pay in. In a VC fund, you may pay more in fees, but your portfolio becomes more diversified over time, usually with some wins and some losses. One way to mitigate this situation is to have a portfolio approach to all of your angel investments. Try to invest in a portfolio of 15-20 startups. Another way to mitigate risk of losses is to diversify your startup investments across different startups, stages and sectors.

Final Thoughts

While there are limitations to investing through SPVs, they are one of the best ways to quickly and easily raise funds for a particular purpose. They have lower investment minimums than other investment vehicles, making them more accessible to beginning angel investors and those who have a lower net worth than might be required for more significant commitments.

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.

Private Placements are a high-risk investment, and an investor could experience an entire loss of principal.  Private investments are highly illiquid and risky and are not suitable for all investors. Investments in early-stage private companies should only be part of your overall investment portfolio.

Past Performance is not a guarantee of future performance. There is no guarantee that any exit strategy will come to pass and there is no guarantee that an investment will be profitable.

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