SPV investing is one of the most effective ways for angel investors to get started. Even seasoned investors, Limited Partnerships (LP), and investment managers use it more frequently than in the past. An SPV is a potential method for investors to diversify their portfolios without committing as many investors as they would on their own or as part of a fund. This article discusses what a special purpose vehicle (SPV) is, how SPVs function, and why they are utilized.
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What Is A Special Purpose Vehicle (SPV)?
SPV is an acronym for Special Purpose Vehicle, which refers to a legal entity founded for the exclusive purpose of generating cash to invest in a certain offering. Most SPVs through the Republic Deal Room are organized as limited investors with a General Partner, Investment Advisor, and Limited Partners (LPs).
The SPV pools capital from investors acting as Limited Partners and invests in a single portfolio company in compliance with Regulation D of the Securities Act of 1933 by purchasing securities in a private placement.
Some offers on the Deal Room platform utilize the SPV structure. An SPV investment is not made in a single firm; rather, the SPV acquires a position in a company.
How SPVs Work？
Typically, SPVs are organized as limited liability corporations (LLCs) or limited partnerships. In either instance, SPVs are referred to as “pass-through vehicles” since they are held by their members and distribute profits (or losses) proportionally to each member’s shareholding.
When a limited partnership invests in an SPV, it becomes a member of the SPV. In exchange for their capital contribution, LPs receive “membership interest” in the SPV. Typically, this interest is indicated as a percentage. For instance, a limited partner who invests $10,000 in an SPV that raises a total of $100,000 will obtain a 10% membership stake in the SPV.
Once an SPV has completed its capital-raising efforts, it makes a single investment in a startup by sending the business a single wire. The SPV will show as a single entry on the capitalization table of the corporation.
The LP is an investor in the SPV (but not in the underlying portfolio company), while the SPV is an investor in the company.
Since SPVs are pass-through vehicles, the SPV’s profits are distributed to its members. To return to our example, if the SPV obtains $10 million in acquisition proceeds, our LP with a 10% membership interest will earn $1 million, subject to carried interest.
SPVs, like conventional venture capital firms, can charge carried interest and management fees. But unlike funds, all capital is often called at once, as opposed to numerous times over the life of the fund (a characteristic known as “capital calls”). Remember that no two SPVs are identical. GPs can arrange an SPV to include specific waterfall provisions, hurdle rates, redemption rights, distribution timings, and other elements.
Depending on the amount of capital raised by the SPV, there are restrictions on the number of investors who can invest in the SPV. The SEC allows a maximum of 250 accredited investors in SPVs funding less than $10 million; for SPVs funding over $10M, the maximum number of investors is 100.
Why Should We Use An SPV?
SPVs can appeal to business owners and investors for various risk minimization and financial return-related reasons. Here are four main reasons why a business might utilize an SPV:
1. To encourage equity investment:
Equity investors, lenders, and hedge fund managers are frequently attracted to the risk of SPVs as a strategy for investment. Although the issuer of loans may perceive SPVs to be somewhat less reliable in capital markets, for many investors, the potential for significant returns outweighs the dangers.
2. To avoid administrative burdens:
Some SPVs allow business owners to lawfully circumvent rules or taxes imposed by the US Securities and Exchange Commission (SEC) and Internal Revenue Service (IRS), but their parent businesses are unable to do so.
3. To facilitate asset transfer:
SPVs simplify the securitization procedure for particular assets. The sale of a tranche (or pool of asset-backed securities) may be simpler and more cost-effective than the sale of individual assets. This is helpful if you’re attempting to gain access to extra financial liquidity or acquire a speedier estimation of the SPV’s overall value.
4. To isolate financial risk:
The special purpose vehicle is a bankruptcy-remote entity, which means that its prospective insolvency and that of the parent firm cannot jeopardize the financial security of the other. For example, suppose something interrupts an SPV’s receivables, and it cannot satisfy its debt commitments. In that case, this will have no impact on the parent company because it is a different scenario. This is the reason why many are more inclined to use SPVs with a larger credit risk than their primary enterprises.
Potential Structures for SPVs
Special-purpose vehicles may be constructed in a variety of ways. Here are five types of SPV business enterprises:
1. Joint venture:
SPVs can function as joint ventures between many businesses. If two companies believe they can work on a specific project without needing a full merger, an SPV is a viable option.
2. Limited liability company:
A limited liability company (LLC) or limited liability corporation (LLC) protects business owners’ personal assets in the case of a lawsuit. As a result of forming an SPV as a limited liability company, both the primary business and the owners’ personal money are protected from the risks that the SPV assumes.
3. Limited partnership:
A limited partnership function similarly to a joint venture, with the exception that the former is typically a long-term commitment between two or more organizations to work together, whilst the latter is project-specific. Creating an SPV simplifies the partnership formation process for businesses wishing to collaborate.
4. Public-private partnership:
Occasionally, governments will let corporations incorporate SPVs to help them in attaining a shared objective, such as infrastructure or public defense projects. This serves as an incentive for businesses, as they will be required to assume less risk to support the state as a result of the formation of the SPV.
5. Structured investment vehicle:
A structured investment vehicle (SIV) is created when an SPV is designed to generate profits on the difference between securities and obligations.
Uses of Special Purpose Vehicles
The most prevalent reasons for constructing SPVs are as follows:
1. Risk sharing
A corporation’s endeavor may involve substantial dangers. Creating an SPV enables the company to legally separate the project’s risks and subsequently distribute them to other investors.
2. Securitization
The securitization of loans is a common motivation for establishing an SPV. For instance, when a bank issues mortgage-backed securities from a pool of mortgages, it can create an SPV to segregate the loans from its other liabilities. The SPV enables investors in mortgage-backed securities to receive loan payments before the bank’s other debtors.
3. Asset transfer
Transferring some sorts of assets might be challenging. Consequently, a business may establish an SPV to own these assets. When they choose to transfer the assets, they can sell the SPV as part of a merger and acquisition (M&A) transaction.
4. Property sale
If the taxes on property sales exceed the capital gain obtained from the transaction, a firm may establish an SPV to own the properties for sale. The company can then sell the SPV instead of the properties and pay tax on the capital gain instead of the property sales tax.
Benefits of An SPV Investment
Depending on your goals for the SPV, you may find that certain perks appeal to you more than others. And while this list is not exhaustive, since there are a substantial number of benefits you are likely to recognize, these top five benefits should provide you with a general grasp of how an SPV investment could benefit your company or capital project.
1. Risk Sharing
As discussed previously, a special purpose vehicle can shield the parent firm from project-related risk. Obviously, some projects carry a greater financial risk than others, but by establishing an SPV, your company may legally isolate these risks.
By mitigating risk in this manner, the special purpose vehicle can enjoy greater operational flexibility, secure in the knowledge that the parent business will not be burdened by any potential burden associated with the SPVs linked to risk.
2. Capital Management
One of the most typical motivations for establishing a special purpose entity is the potential to pool funds. An SPV permits up to 250 certified investors to combine their investment resources, which can be very useful for early-stage startup enterprises.
In addition, fundraising through a special purpose company in this manner can assist keep a startup’s cap table clean, which is essential not just for a successful launch but also for continuous financial record-keeping.
3. Flexibility
Investors favor SPVs over other investment techniques primarily because of their flexibility. Special purpose vehicles are not a one-size-fits-all investment and can be tailored to your exact requirements.
And while businesses value the financial model they provide, SPV investing is not exclusive to startups and may be designed to suit a variety of investment strategies, including real estate, private funds, and other assets.
4. Securitization
There is no doubt that investors desire a guarantee of repayment, which is attainable with SPV investing because the investors’ pooled assets are isolated from the parent firm and under their control.
Securitization is essentially the transformation of illiquid assets into liquid ones, hence expanding credit and financial possibilities.
5. Taxes
Numerous investors find the tax implications of SPV investing to be an attractive feature. For instance, when it comes to real estate investing, the taxes on the sale of a particular property may exceed the profit made from the sale. However, by establishing a special purpose vehicle that owns the property, the parent company can sell the SPV instead of the properties, resulting in the parent company paying taxes on the SPV’s gains rather than the property’s sales tax.
Special Purpose Vehicles Versus Traditional Venture Capital Funds
Another method of investing in businesses is through a Venture Capital Fund. SPVs are comparable to conventional VC funds in the sense that both invest in startups. However, numerous significant distinctions exist between investing in a VC fund and obtaining an SPV membership.
First, an SPV invests in a single startup on average. Therefore, as an investor, you are aware of where your money is placed in advance. On the other hand, a VC Fund amasses a big pool of capital, which is then distributed to a portfolio of entrepreneurs over time. As an investor in a venture capital fund, you will not know in advance how your money will be allocated. Second, the minimum investment into a fund is normally between $250,000 and $1,000,000 for smaller funds. The entrance point for SPVs, however, is far lower, as was explained previously. With reduced investment minimums for SPVs, your net worth can be less, you can still diversify, and you will incur cheaper long-term expenses. Finally, fees should be considered: Typically, venture capitalists demand 2% yearly management fees (totaling 20% over the life of a 10-year fund) plus a 20% carried interest. Carried interest, sometimes known as “carry,” is the portion of investment returns distributed to general partners of a venture capital firm. SPVs impose variable management costs, but they rarely approach 20%.
Constraints of Investing Via An SPV
There are a number of restrictions on the SPV structure. There is a 99-person rule, for starters. A single SPV can only accept investments from 99 individuals, which may seem like a small number. However, suppose the company has attracted great interest, and you are competing with a pool of other angel investors. In that case, you must pledge quickly to be among the first 99, or you will be eliminated. Additionally, you are responsible for monitoring the company’s performance on your own time.
Individual startups may not provide investment updates as frequently as VC fund managers; thus, you are responsible for monitoring your own investments. There is a significant risk associated with the carrier. When investing through an SPV, you are fully committed. The SPV makes a single investment in a single firm; if that company fails, you risk losing everything, including the fees you pay in. You may pay higher fees in a venture capital fund, but your portfolio diversifies over time, typically with some successes and losses. A portfolio-based strategy for all your angel investments is one way to mitigate this issue.
Attempt to invest in between 15 and 20 businesses. Diversifying your startup investments across startups, stages, and industries is another method for mitigating the risk of loss.
SPV Vs. SPAC
Besides the SPV, there is also the SPAC. These are two unique investing strategies, and they should be considered as such. Prior to taking any further action, both should be thoroughly examined.
A SPAC, or special purpose acquisition company, is a corporation founded to raise investment capital via an initial public offering (IPO). The SPAC allows investors to invest in a fund that will acquire a business in the future. The invested funds are held in trust until either the acquisition of another company is completed or a predetermined time period expires.
If the time limit is reached, the SPAC must return all investments to the investors. The SPAC has no intrinsic value because it is merely a placeholder for the future acquisition of a company. As a result, the investors invest in the businessmen and businesswomen who decide which companies to present to their investors for acquisition. In most cases, these businesspeople are also investors in the SPAC and stand to profit from the future company.
Due to the IPO, banks are heavily involved in a SPAC. Then collect fees to guide everyone through the IPO, and they keep all IPO proceeds until a viable buyer is identified.
After raising cash, the SPAC has two years to complete its mission and acquire another company. The acquired company must be closely tied to the value of the SPAC.
Despite the fact that SPACs are attractive to many investors, they must undergo a public offering, which can be fraught with complications. SPVs have fewer hoops to go through in order to attain the objective but to each his own. Both of these entities are viable methods for investing in other investments.
Final thoughts
SPVs are one of the finest ways to swiftly and easily acquire funds for a specific purpose, despite having some restrictions. They have lower investment minimums than other investment vehicles, making them more accessible to novice angel investors and individuals with a lower net worth than would be required for larger investments. SPVs preserve the integrity of the capitalization table while ensuring that each investor receives the payouts to which they are entitled in the event of a liquidation. There is no such thing as a perfect investment vehicle, but SPVs are adaptable and have the ability to perform in a variety of circumstances, making them one of the more beneficial advances in angel investing. Their increasing popularity is a reflection of their utility for authorized investors.
