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Venture Special Purpose Vehicles—No Longer Just for Unicorns

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Special Purpose Vehicles (SPVs) for the 140 late-­‐stage “unicorns” are cooling from their white hot run in the wake of the public market downturn, Fidelity’s unicorn revaluations and Square’s disappointing market debut. Simultaneously, demand for earlier-stage venture capital co-investments from Limited Partners is heating up, which has fueled a new breed of mainstream venture SPVs.  SPVs are no longer just for unicorns—today they are used to help finance the other 3,500 venture-backed companies, roughly 96% of the market.

What is an SPV?  Typically, it’s a Limited Liability Company (LLC) formed for the specific purpose of holding one or more direct co-investments.   SPVs are not new and have been used for years in the buyout world.  General Partners seeking more money than is practical from the main fund to invest in a single company will create and manage an SPV (funded by the Limited Partners) to hold the excess investment dollars.

However, SPVs for earlier-stage companies are new to the VC market.  And these mainstream SPVs are beginning to experience some growing pains—most of which could be avoided with a few tweaks to the SPV structure and improved Limited Partner investment processes.

Mainstream SPVs Need to Plan for Future Funding Rounds

Popularized by successful SPVs for companies like Facebook and Twitter prior to their IPOs, venture SPVs have principally been used for later-stage investment in unicorn companies unlikely to raise further private funding rounds.

Yet today, SPVs are used to fund Series A rounds in companies with minimal revenues, uncertain business models and likely additional future capital raises. The structural implications of future funding rounds may have been overlooked when considering whether to raise a new SPV for a follow-on financing or restructure the existing SPV; how distribution waterfalls and carry calculations will change; and how dilution and governance will impact non-participating investors.

While these issues may seem like a structural nuisance in a rising market, they may fuel cries of SPV foul play in a down market.  Through their core funds, VCs may decide to participate in cram-down rounds that would have onerous terms typically at the expense of Mainstream SPVs that invested in a prior round but that did not participate in the cram-down.  Such conflicts may stoke Machiavellian suspicion between VCs and Mainstream SPV investors, and worse, they are likely to pit SPV investors against one another as some investors in the SPV may want to participate in the cram-down, while others may not.

The brittle structures of today’s Mainstream SPVs may cause further growing pains for ill-prepared SPV investors who likely have not set aside reserves for follow-on investments and whose limited staff and investment committee processes are not set up to evaluate follow-on investments in short time frames.

Mainstream SPV Investing is Direct Company Investing

Investing in a Mainstream SPV is essentially entering the direct investment business.  Investment committees, staff and boards of directors considering Mainstream SPV investing need to alter their organization’s DNA from passive limited partner fund investing to active direct investing.  They need to accept that money will be lost on some investments and therefore build a portfolio of SPVs reserving capital for follow-on investments and establishing processes to accommodate agile decision-making in more rapid time frames.  Mainstream SPV investors need to be intellectually honest as to whether their organizations are capable of making such a transition in their investment approach.

VCs also must recognize the considerable time and effort required to negotiate the SPV terms and conditions.   A fund manager who recently completed an SPV confided that he would not have created the SPV in retrospect due to the inefficiency of the set-up process and tortured negotiation with multiple investors.  VCs should also consider the prospect of losing credibility with entrepreneurs when SPVs are not supportive of companies experiencing challenging follow-on financings.  VCs, who typically pay lots of attention to syndicate partners in deals, may find they have inadvertently weakened a syndicate by forming a Mainstream SPV with investors ill-equipped for the task.

Structural flexibility is key. Separate SPVs for each investor work well for transactions with few investors, while the Share Class structure is best when multiple investors participate in a single Mainstream SPV.

Mainstream SPVs Are Here to Stay

While SPVs are not new, we applaud their use in venture capital, particularly as a way to satisfy the growing appetite for Limited Partner co-investment. These mainstream venture SPVs are really co-investment funds and are fundamentally sound for the venture ecosystem with a permanent role to play in the financing of the next generation of innovative companies.

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