John Mannes
Like an oasis in the desert, special purpose vehicles (SPV) can offer investors critical liquidity and capital to exercise pro-rata rights, even in a world where overall returns in venture capital have been decreasing. With new regulations taking effect around secondary transactions, and recent clarification of the definition of the “accredited investors” allowed to participate in financing startups, entrepreneurs and investors must remain keenly aware of incentives to increase risk across the tech ecosystem.
Just like entrepreneurs, venture capitalists regularly seek capital from potential limited partners (pension funds and university endowments). Pension funds and endowments typically see venture capital categorically as a high-risk asset class. To remain competitive against other high-risk arbitrage vehicles like hedge funds, VCs must get increasingly creative to convince their investors that their fund will generate returns that justify their high-risk long-term investment.
One creative investment vehicle for increasing returns is the SPV — essentially off-book shell corporations that act as investment vehicles for aggregating capital outside the limitations of a fund’s initial structure, strategy and design agreed upon by limited partners. Investors from outside the limited partnership can organize themselves around an SPV rather than injecting capital directly into companies through a traditional syndicate.
Within these funds, a unique limited partner advisory board exists to provide oversight to the investment process. Governing rights can be assigned to lead investors or other designated individuals by the lead investor creating the fund. SPVs come with increased risk and exposure for investors. Additionally, they can be organized very quickly and their innately separate qualities offer protection in case the value of their investment is significantly reduced or lost.
The rise of seed-stage capital as a means of accessing deals earlier and more cost-effectively via valuable pro-rata rights is a key concept in understanding the rise of SPVs. Pro-rata rights enable investors to receive first dibs on follow-on investment rounds in a company in which they were an early investor. These are the rights that let venture capitalists capitalize on their wins while combating dilution and limiting exposure to bad investments. Of course, the catch in this use of SPVs is that the “winners” that SPVs fund are, by definition, not yet winners.
Birchmere Ventures, a micro-VC in Pittsburgh, is a great example of a fund that benefits from its use of SPVs. Seán Sebastian, a partner at Birchmere, explains that his SPVs typically fall between 3 and 8 million in size. Despite the fact that SPVs only offer exposure to a single investment, they can provide the same 20 percent carry at the time of exit.
Birchmere runs their SPVs as opt-in opportunities that are first offered to investors who have contributed above a pre-set percentage to Birchmere’s general fund. If the SPV is still not full, the opportunity is offered to all limited partners of Birchmere. Finally, if there is still room in the vehicle, the opportunity can be opened to outside investors.
Outside of micro-VCs and seed investors, investment banks have been known to employ SPVs to fill a market demand for liquidity. In recent years, banks have been offering secondary fund vehicles in the form of SPVs. Unlike SPV use by micro-VCs, SPV use by investment banks focuses on late-stage startups.
Tech unicorns, companies with valuations over a billion dollars, are especially targets of investment banks for such vehicles. These SPVs can easily break 300 million dollars in size. Typically, these shares are sold to top clients of the investment bank and wealthy individuals who meet investor requirements.
It is important to take a step back and recognize that SPVs are far from inherently bad. The increased flexibility they offer presents tangible value for both founders and investors. Additionally, when risk is properly assessed, all parties can benefit from follow-on capital from known investors possessing a strong positive relationship with the portfolio company.
Early on in the life cycle of a venture-backed startup, the company is given a valuation from investors. This valuation is typically an aggregate of addressable market value and comparable market exits, among other things the specific investor values (voodoo).
Statistician Nate Silver is, in part, known for discussing the contrast between signal and noise. The gist of his argument is that the world is full of information; some of it is accurate and valuable (signal), while other components are counterproductive and can produce systemic entropy (noise).
Venture capital investors are well accustomed to both types of information, and it is essentially their job to distinguish between the two, taking into account risk and uncertainty. Below is a loose diagram of the post-money valuation over time of a randomly selected tech unicorn that recently underwent an initial public offering (IPO).
Long before a company becomes a hot spot for college interns and a metaphor for founder success, it is a relatively scrappy entity. Most of the information fed to investors comes directly from the company itself (burn rates, key hires, strategic partnerships, etc.). As the company grows, there is more company data to parse through (sales metrics, complex capitalization tables, etc.). At a certain point, however, the company begins to generate exponentially growing noise.
This noise comes in the form of headlines and t-shirts, and the general marketing buzz that any self-respecting startup desires. Unfortunately, while venture firms have access to both sets of information, it can become difficult, especially when outside investors come in to separate the two. Economists call this signaling bias. Much like the problem of the chicken and the egg, it becomes difficult to differentiate between a valuation rooted in projected exit value and a valuation rooted in perceived market value.
The same buzz investors sought to create to draw interest to their investment can come back like a boomerang and artificially create feedback, signaling investors that an increased valuation makes sense. As has been popularly publicized, this creates a prevailing sense of FOMO, or the “fear of missing out.”
One can imagine a situation fairly easily where valuations do not adjust downward because of the willingness for increasingly risk-seeking and uninformed investors willing to invest in SPVs. Most worryingly, the failure of an SPV does not negatively impact a general fund’s internal rate of return (IRR) or reduce the carry of the general partners outside the SPV.
SPVs have the potential to directly hurt wealthy investors and indirectly hurt startup employees. California, the center of venture capital and tech startups, happens to be unique in having laws that make the enforcement of non-competition clauses very difficult. This means that many employees in California-based startups are attracted and retained with stock options that vest over a finite period of time.
These options, typically of common designation, do not hold the same rights of influence that preferred stocks offer. Additionally, option holders are only entitled to the profit of an option between its strike price and its sale price. Therefore, if a company fails to reach a liquidity point (IPO or M&A) or the company’s value decreases before the end of a vesting period, employees will never receive their chunk of a company’s success.
The investment banking usage of SPVs to provide liquidity for late-stage startups directly enables startups to stay private longer without engaging in an IPO or M&A transaction. The longer a company stays private, presumably the higher its valuation will be at the time it exits the market. In a worst-case scenario, investor liquidity by means of SPVs prevents overvalued companies from achieving a valuation correction in the efficient open markets.
On the flip side, things can turn even darker when overvalued private companies attempt to exit the market. Much like how signaling had the potential to create an artificial valuation spike, it can also work in reverse. Average investors and talking heads generating noise will not differentiate the nuance between SPV losses and venture capital losses in general funds. The mere headline of VC portfolio companies taking a valuation hit, or, more appropriately, a valuation “adjustment,” will do little to quell fears in public markets.
To overcome this liability, investors would be forced to sell more assets to cover losses. This ultimately lowers prevailing market valuations and creates a devastating spiral that is hard to escape as the public markets contract and less money is available in the original pension funds and endowments to allocate toward high-risk asset classes.
Ultimately, it is unlikely that SPVs will be the horseman of the future tech apocalypse. The potential is clearly there for SPVs to create a liquidity crisis that could hurt the full spectrum of stakeholders, from startup employees to investment bankers. SPVs contribute to startups and investors alike when they are fully understood and implemented with a disciplined mission.
Left unregulated and misunderstood, they will continue to morph in structure and implementation until someone overclocks market risk and loses money. It’s human nature to seek an oasis, even in the desert.
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