An SPV, or special purpose vehicle, is a legal entity that allows multiple investors to pool their capital and make an investment in a single company.
SPVs have multiple use-cases in the business world. Public corporations sometimes use SPVs to isolate certain holdings from the parent company’s balance sheet. In the venture capital sector, fund managers often launch SPVs to establish a track record before they raise a traditional venture fund. They also use them to invest in companies that don’t fit their fund’s investment strategy or that falls outside their fund terms.
SPVs vs. venture funds
Timing and investment allocation are the main differences between SPVs and traditional VC funds.
The number of investments
The biggest difference between an SPV and a traditional venture fund is that an SPV invests all of its capital in one company. Traditional VC funds, on the other hand, invest in many companies operating within the stages and industries that fit the fund’s investment thesis.
Traditional VC funds are long-term investments. It can take up to 10 years before a VC firm exits every investment in a fund’s portfolio. In contrast, SPVs typically seek to return money to investors in a much shorter period of time because realizing a return depends on just one company reaching an exit, such as an acquisition or an IPO.
Why VC firms use SPVs
SPVs are an investment vehicle VCs can use to optimize for liquidity, asset diversification, or even fund reputation. Here are some common scenarios when SPVs make sense instead of a traditional fund:
The deal doesn’t fit with the fund’s investment thesis
If a VC firm wants to invest in a startup that doesn’t meet the criteria set out in their fund’s limited partnership agreement (LPA), the GPs can set up an SPV, raise additional capital for it, and invest in the company with money that doesn’t belong to the fund.
The deal would exceed the fund’s concentration limits
A fund’s LPA will sometimes limit how much capital the fund can invest in a single company, sector, stage of investments, or geography. If making an investment in a certain portfolio company would fit the investment thesis but violate these concentration limits, a GP can instead use an SPV to back that company.
Similarly, a GP can use an SPV to “top off” an investment the fund has already made (or plans to make) in a company. In this scenario, the GP raises an SPV to invest alongside the fund, to increase ownership in a company beyond what the fund’s LPA permits.
The fund is outside of its investment period
A fund’s LPA sets a specific time interval during which the fund will deploy assets. If the GPs wish to make an investment outside this period, they can form an SPV to do so. Often, they may call upon the same LPs from the fund to capitalize the SPV.
First-time investors want to establish a track record
Raising a debut venture fund can be daunting for first-time investors, especially during difficult fundraising periods. Before trying to raise a first-time fund, some aspiring fund managers will start by forming one or several SPVs to invest in individual companies. Even a small portfolio of SPVs will give LPs a tangible track record to consider when it comes time to invest in a new manager’s first VC fund.
The fund is out of capital
If the fund has already invested most or all of its capital, but the fund managers want to pursue another deal, they may launch an SPV and use it to make another investment.
The investors are looking to extend the life of investments
If a VC firm has a fund that’s nearing the end of its 10-year lifecycle but the fund managers aren’t ready to sell the remaining assets, they can set up an SPV to hold those specific assets. This is known as a continuation fund or a continuation vehicle. In this scenario, LPs will usually have the option to sell their stakes in the portfolio company or transfer their stakes into a new SPV that will give the fund managers more time to prepare the business for a sale.
How an SPV works
When a fund manager sets up an SPV, they typically form it as either a limited partnership, a limited liability company (LLC), or a series LLC.
In each of these cases, the SPV is a pass-through entity, which means investors are responsible for paying personal income taxes on any profits earned through the SPV. The SPV entity does not pay any taxes.
Here are other key features of how SPVs operate:
Fund payment structures
General partners (GPs) operating an SPV sometimes go with the same “two-and-20” payment structure often used for traditional VC funds. This means that GPs charge a 2% annual management fee on the total assets under management (AUM) and take a 20% cut of the profits after the SPV hits the hurdle rate laid out in its LP agreement. The hurdle rate is a percentage return the fund has to provide to investors before the GPs start to earn their share of the fund’s profits.
If the deal was a competitive one for the GP to win, they might raise the management fee or carried interest to something higher than two-and-twenty. In contrast, a GP might decide to offer more favorable terms to attract reluctant LPs to a deal.
Unlike traditional VC funds, which call capital gradually when they are ready to make individual deals, fund managers using SPVs typically call all of the capital from investors up front.
SPVs are subject to the same laws and regulations as other private funds.
Advantages to using an SPV
Isolate financial risk: If GPs set up an SPV and the investment performs poorly, it does not impact the VC firm’s flagship funds. This is advantageous for GPs raising a follow-on fund; the SPV won’t weigh down the IRR or TVPI for their firm’s core investment funds.
Expand LP access: For LPs, it’s much easier to invest in an SPV than a traditional VC fund or PE fund. The cost to invest is usually lower, with some LPs investing as little as $1,000. Meanwhile, LPs are typically required to invest at least $500,000 to get access to a larger VC fund.
Less expensive to set up than a VC fund: Traditional VC funds vary in terms of administrative costs, but they are expensive to take to market. Legal fees for setting up a traditional VC fund can eclipse $50,000. Setting up an SPV usually costs a fraction of that amount.
Some LPs have historically viewed SPVs as funds for investors not yet ready to break into VC. But that stigma has lessened in recent years as more investors choose SPVs to supplement their fundraising efforts.
Still, there are some potential drawbacks. For instance, it might be challenging to align your LPs and portfolio company on exit terms if you want to set up an SPV as a continuation fund. And because SPVs typically only invest in one company, they aren’t as diversified as a typical VC fund.
But they’re inexpensive, easy to set up and lower the significant barriers to breaking into the VC ecosystem–especially when the private markets are slumping.