Startup creators and business visionaries frequently face the dilemma of securing funding without overcrowding their capitalization table with numerous investors. This overcrowding can result in administrative complications and possible disagreements in interests. The remedy available is Special Purpose Vehicles (SPVs). These legal structures enable multiple investors to unite, combining their resources to invest in a solitary promising startup.

Through SPVs, creators can effectively oversee their capitalization table while investors gain the chance to participate in a collective investment, streamlining the fundraising procedure for all involved.

What Is a Special Purpose Vehicle (SPV)?

An SPV, or Special Purpose Vehicle, stands as a distinct legal entity crafted for a particular objective. In the realm of startups and venture capital, SPVs serve primarily to consolidate funds from a collective of investors for a singular investment in a startup. This facilitates multiple investors joining forces to support a specific company without the need for individual listings on the startup's cap table. Instead, the SPV is represented as a single entity, simplifying administrative tasks for the startup.

From the investor's viewpoint, SPVs present an avenue to invest directly in a chosen company rather than dispersing investments across various companies within a fund. Platforms such as AngelList frequently leverage SPVs, enabling investors to combine resources and back promising startups.

For startup founders, SPVs offer a streamlined means of acquiring capital from a group of investors without the administrative burden of individually adding each investor to their cap table.

Navigating the Benefits and Risks of SPVs

Establishing an SPV entails the transfer of assets from the parent company to this fresh entity. This maneuver effectively segregates these assets, safeguarding them from the financial upheavals that could impact the parent company. For investors, this offers a protective layer and reassurance, enabling them to concentrate on expanding their endeavors without persistent concerns about financial jeopardy.

Nevertheless, it's crucial to recognize that while SPVs can serve as potent tools for financial administration and risk mitigation, their usage must be judicious.

If mishandled or abused, they can transform into mechanisms for concealing company debt, leading to catastrophic outcomes. A glaring instance of this is the Enron scandal of 2001, where accounting loopholes were exploited, culminating in one of the most notorious corporate bankruptcies in history.

How Do Special Purpose Vehicles Work?

Structure and Ownership:

Special Purpose Vehicles (SPVs) are typically formed as limited liability companies (LLCs) or limited partnerships, operating as "pass-through vehicles" owned by members. Income or losses generated by the SPV are distributed to members in accordance with their ownership stakes. In both LLCs and partnerships, distributions generally follow the same ownership structure, though LLCs offer greater flexibility in terms of liability protection. However, a key reason members often choose LLCs over partnerships is the faster LLC approval time, as it typically takes less time than setting up a partnership.

Investment and Membership:

Individuals or entities investing in an SPV become "members" of the entity. Their capital contribution results in a "membership interest," often depicted as a percentage. For instance, a $10,000 investment in a total capital of $100,000 equates to a 10% ownership stake.

Singular Investment in Startups:

An SPV consolidates funds to make a single investment in a startup. The target company's capitalization table reflects the SPV as a single entry.

Direct Stake and Distribution:

Investors hold a stake in the SPV rather than in the startup directly. Income or returns from the SPV's investments are distributed proportionally to its members. For example, if there are $10 million in proceeds and an investor holds a 10% ownership stake, they would receive a $1 million distribution.

Carried Interest and Fees:

SPVs may charge carried interest and management fees, similar to venture funds. A key difference lies in the fact that all capital is typically called at the SPV's inception, unlike the multiple capital calls seen in traditional funds.

Customization and Features:

General Partners (GPs) have the flexibility to customize each SPV differently. This allows for the incorporation of unique features such as waterfall provisions, hurdle rates, redemption rights, and distribution timings, among others.

Investor Limits:

The number of participants in an SPV is regulated based on the capital raised. According to SEC regulations, if $10 million or less is raised, there is a maximum of 250 accredited investors allowed. If over $10 million is raised, there is a limit of 100 investors.

Compliance and Transparency:

Regulations ensure that SPV operations comply with established standards. Transparency is maintained through investor limits and regulatory oversight.

Steps To Create a Special Purpose Vehicle

Define the Purpose: Determine the specific purpose for which you want to establish the SPV. This could be to invest in a particular asset, acquire a business, or undertake a specific project.

Choose the Legal Structure: Decide on the legal structure for the SPV. Common options include forming it as a limited liability company (LLC) or a limited partnership (LP), depending on factors such as liability protection and tax considerations.

Name and Registration: Choose a name for the SPV that reflects its purpose and is compliant with legal requirements. Register the SPV with the appropriate regulatory authorities in the jurisdiction where it will operate.

Draft Operating Agreement or Partnership Agreement: Prepare an operating agreement (for an LLC) or a partnership agreement (for an LP) that outlines the rights, responsibilities, and governance structure of the SPV. This document should address key issues such as capital contributions, profit distribution, decision-making procedures, and exit strategies.

Capitalization: Determine the capitalization structure of the SPV, including the initial capital contributions from investors or partners. Clearly define the ownership interests of each participant based on their contributions.

Open Bank Account: Open a separate bank account for the SPV to handle its finances independently from other entities. This account will be used for receiving capital contributions, making investments, and managing expenses related to the SPV's operations.

Execute Legal Documents: Execute all necessary legal documents, including the operating agreement/partnership agreement, articles of organization/certificate of formation, and any other required filings with regulatory authorities.

Fundraising: Begin fundraising efforts to attract investors or partners to participate in the SPV. Clearly communicate the investment opportunity, the potential risks and rewards, and the terms of participation to prospective investors.

Acquisitions or Investments: Once sufficient capital has been raised, use the funds to acquire assets, invest in businesses, or pursue other opportunities as outlined in the SPV's purpose.

Ongoing Management and Compliance: Manage the SPV's affairs in accordance with the terms of the operating agreement/partnership agreement and applicable legal requirements. Maintain accurate records, conduct regular meetings, and ensure compliance with tax, reporting, and regulatory obligations.

By following these steps, you can establish an SPV effectively to mitigate risk and streamline your business acquisitions.