Special purpose vehicles, also known as “SPVs,” are among the most common on-ramps to startup investing. Unlike a venture capital fund, which typically invests in dozens of companies over a period of several years, SPVs pool money together from a group of investors with the express purpose of deploying that capital into a single company. 

For investors that are new to VC, or investors that don’t have enough capital to invest in a fund, an SPV can be a great way to gain exposure to the startup economy, learn the nuances of startup investing, and build an investment track record. This is because SPVs typically require lower investment minimums than funds (often as low as $1k), plus the flexibility for investors to select the specific startup investments they’re interested in (investors often don’t have much of a say over how funds deploy their capital). 

But before investors deploy capital into an SPV, it’s important to understand what can happen to their money over the SPV’s lifetime, and how it differs from what they might experience when they invest in a fund. And to understand that, it first helps to explain exactly how an SPV investment works.

How SPVs Work

SPVs are formed as LLCs or limited partnerships and function as “pass-through vehicles”—meaning they pass through income or losses to members in proportion to each member’s ownership. 

“Members” of an SPV are its investors. These members receive what’s known as “membership interest,” typically expressed as a percentage. For example, an investor that invests $5k in an SPV that raises $100k has 5% membership interest in the SPV.

When an SPV invests in a startup, it comes in as a single line on the startup’s cap table. This means the SPV’s investors (also known as “limited partners” or “LPs”) are not investing directly in the startup. Instead, the SPV is investing in the startup, and the investor holds an ownership stake in the SPV.

If and when the startup exits, the SPV will receive proceeds from the exit in proportion to its equity stake in the business. The SPV will then typically pass those investment returns along to its members in proportion to each member’s membership interest. Note that these proceeds are subject to carried interest and management fees. 

Also note that the SEC places strict limits on the number of investors that can invest in an SPV:

• SPVs raising $10M or less: 250 accredited investors maximum
• SPVs raising $10M+: 100 accredited investors maximum

While we’ve provided an overview of how a typical SPV may function, it’s important to understand that each SPV differs based on its governing documents. These documents, which include the limited partnership agreement (LPA), private placement memorandum (PPM), and subscription agreement, detail terms like voting rights, carried interest, liquidation preferences, and more. These terms are determined by the SPV manager.

Unlike a direct investor in a startup, SPV investors are entirely beholden to the terms of the SPV, and may not receive the same rights and privileges as others who invest directly in the business. 

Why Are SPVs Used?

SPVs are commonly used by funds to invest in follow-on rounds when the fund doesn’t have enough capital left to deploy, or to invest in startups that may fall outside of a fund’s investment thesis. 

While SPV investments offer LPs a direct way to invest in startups, it’s worth noting that SPVs are not diversified given each SPV invests in only one startup. Additionally, SPV managers can pick and choose who they allow to invest in their SPV, so access to SPV investments isn’t evenly distributed.

Now that we understand how SPVs function on the purpose they serve in the startup ecosystem, let’s go through some examples of what could happen when you invest in an SPV.

Seed SPV Investment That Reaches IPO

Let’s say Hustle Fund creates an SPV to invest in the seed round of a startup, Widgets Inc. Widgets Inc. is raising $4M at a $10M post-money valuation with 6M shares outstanding. This would make the pre-money valuation $6M, which in turn would value each individual share at $1 ($1 x 6M shares = $6M valuation). For the sake of simplicity, let’s say Hustle Fund’s SPV raises $1M to invest in Widgets Inc., and the $1M comes from 10 different LPs each contributing $100k.

This means each LP has a 10% membership interest ($100k is 10% of $1M), and the SPV holds a 10% equity stake in the business ($1M is 10% of $10M). Now let’s assume that at some point in the future, Widgets Inc. decides to IPO. What does this mean for the seed SPV investors?

Generally, it means these investors are in line for a big payday, given early-stage investors usually purchase shares at a much lower value than what’s offered to the public market. For example, a $5k investment in Uber’s seed round in 2009 was worth nearly $25M when Uber IPO’d at $45 per share in 2019.

However, the size of that payday varies depending on the degree to which Hustle Fund’s SPV investment was diluted (i.e., a decrease in ownership percentage of Widgets Inc. by the SPV when new shares are issued). All early-stage investors are diluted as a startup scales and raises additional rounds of funding, given the startup needs to issue new shares to raise capital. Some early-stage investors protect against dilution by also investing in the startup’s subsequent fundraising rounds, thereby maintaining, or even increasing, their ownership stake. However, Hustle Fund is primarily focused on early-stage startups, so we’re going to assume for this example that Hustle Fund did not follow-on in Widgets Inc.'s subsequent fundraising rounds. 

Now let’s say Widgets Inc. is going to IPO at a valuation of $1B and a price-per-share (PPS) of $10. This would mean the value of Hustle Fund’s SPV investment has 10x’d, from $1M to $10M, even while the SPV’s ownership stake has been diluted down from 10% to 0.1% ($1M is 0.1% of $1B).

In the lead up to the IPO, the manager of the SPV will likely be contacted and informed by Widgets Inc. of the company’s plans to go public. The SPV investors may also be subject to a quiet period during the underwriting and pre-marketing period, during which time they’ll be prohibited from sharing information or opinions about the firm publicly. 

Once the company IPOs, the SPV will also likely be subject to a lock-up period, or a period of time (usually anywhere from 3-24 months) during which the SPV is not allowed to sell any of its shares of stock. Once the lock up period expires, the SPV can liquidate its position. The decision to liquidate is typically at the discretion of the SPV manager, and will be outlined in the SPV’s governing documents.

Assuming the PPS held at $10 during the first few months of trading, the SPV will return $10M to investors—or roughly $1M per investor (minus management fees and carried interest). This income is taxed as long-term capital gains (assuming the investor held the asset for more than a year). Depending on the investor’s tax bracket for the given year, the current rates are 0%, 15%, or 20%. Additionally, if the shares in Widgets Inc. met the criteria for qualified small business stock (QSBS), then the investor can enjoy a 100% capital gains tax exclusion up to the greater of:

• $10M
• 10x the original purchase price of the shares

Seed SPV Exits (Non-IPO)

Instead of an IPO, let’s imagine Widgets Inc. was acquired by a larger organization. Statistically speaking, this is a much more likely outcome than an IPO, as nearly 90% of private companies that exit do so via M&A. 

In the instance of an acquisition, the value of the SPV investment will depend on the negotiated terms between the startup and its acquirer. Let’s say the acquiring company makes an all cash offer that values Widgets Inc. at $500M, or $5 per share. Assuming once again that Hustle Fund didn’t participate in any of Widgets Inc.’s subsequent fundraising rounds prior to acquisition, this would mean the value of Hustle Fund’s SPV 5x’d, from $1M to $5M. 

Once the transaction is processed, the $5M in funds are dispersed to the SPV’s LPs in proportion to their membership interest (so, $500k per LP), minus management fees and carry. There is no lock-up period with an M&A deal, given the shares are not available to the public market. This income is taxed as long-term capital gains (assuming the investor held the asset for more than a year), plus additional exclusions depending on if Widgets Inc. met the criteria for QSBS.

Seed SPV Sells its Shares in a Future Funding Round

Let’s say Widgets Inc. hasn’t exited yet, but Hustle Fund wants to liquidate its shares. While not common, a fund might do this if it receives a compelling offer on the secondary market, if it needs to free up capital, or if it’s not bullish on the long-term prospects of the business.

For the sake of this example, let’s say another investor offers Hustle Fund $2M to purchase its SPV’s shares of Widgets Inc. This would value each individual share at $2, or 2x the original purchase price. If Hustle Fund wanted to proceed with this transaction, it’d have to clear two hurdles. The first hurdle would be approval from Widgets Inc.’s existing shareholders. Typically, investors in a startup must agree to a right of first refusal (ROFR), which stipulates that the existing shareholders get “first dibs” on the sale of any shares on the same terms as the original third-party offer. This provision ensures the founders and investors can control who owns equity in the business. 

If, say, the Widgets Inc. founders (who maintain the highest ROFR) decide they want to repurchase Hustle Fund’s SPV's shares, then the SPV manager would also have to seek approval of the sale of shares from the existing SPV investors (assuming these investors have voting rights, as outlined in the SPV’s governing documents).

Similar to our previous examples, if the sale is approved the funds are dispersed to the SPV’s LPs in proportion to their membership interest (in this case, $200k per LP), minus management fees and carry. Assuming the SPV was invested in Widgets Inc. for 1+ years, the income to LPs would be taxed as long-term capital gains, plus additional exclusions depending on QSBS eligibility. 

Unsuccessful SPV Investment That Returns Some of the Principal to Investors

The scenarios we’ve gone over so far are all exceedingly uncommon. The vast majority of SPVs actually lose money because 90% of startups fail. When a startup fails or is in the process of failing, the founders have two options: cut their losses and return whatever capital they can to investors, or go for broke and see if they can pull the business out of a tailspin.

Let’s say the founders of Widgets Inc. opt for the former option. First, they have to get approval from their investors to liquidate, which usually requires a board vote. The SPV’s investors would not get a say in this scenario because they’re not direct shareholders in the business. 

If the vote is approved, the order in which Widgets Inc.’s stakeholders are paid out will depend on the capital stack. At the top of this stack is debt, such as bills owed to creditors, landlords, and suppliers. Next comes the preferred shareholders (i.e., the investors). Within this group, the order of payout normally depends on the liquidation preference, which usually gives priority to the startup’s most recent investors (e.g., if the startup’s most recent fundraising round was a Series B, then the Series B investors get paid back first). If there’s anything left over after all investors are paid out, the common stockholders (i.e., the founders and employees), will receive their portion of the returns.

The amount each SPV investor gets paid back when Widgets Inc. returns capital after a wind down depends on the value of Widgets Inc. at the time of liquidation. When a business liquidates, its officers typically have a fiduciary duty to maximize the value of the entity on behalf of their investors and other stakeholders. This means Widgets Inc. would try and sell off assets (e.g., inventory, IP, supplies) to increase the amount of capital it can return to investors. As such, the SPV will be paid back in proportion to the marked down value of Widgets Inc. So if, for example, the liquidated value of Widgets Inc. came out to $0.25 per share, the SPV would receive 25 cents on the dollar for its original investment. This loss is distributed amongst the SPV’s investors proportional to their membership interest. 

The time it can take for capital to be returned to SPV investors after a failed startup investment varies depending on the capital stack, business structure, where the business is based, and other factors. Generally, investors should anticipate at least 2-3 months for a wind-down to be completed. In terms of taxation, VCs often use the capital gains loss from their failed startup investments to offset capital gains income from successful investments. 

Unsuccessful SPV Investment That Returns No Capital to SPV Investors

Our final scenario is also our most likely scenario. Most startups that fail don’t try and cut their losses because their investors often don’t want them to. VCs are generally comfortable with any individual investment going to zero because they understand venture returns follow a power law curve—meaning a vast majority of their returns are driven by a small portion of their investments. 

As such, if Widgets Inc. were in a death spiral, it’s likely their investors would encourage the founders to take care of their debt obligations, and to not be overly concerned with returning capital to their investors. Obviously, in this scenario, the SPV’s investors would not receive any of their principle back. Again, this loss can be used to offset capital gains income. 

Anything Can Happen When You Invest in an SPV

Every startup is different, so every SPV outcome will differ. We hope we’ve provided you with a basic understanding of the potential outcomes associated with SPV investing. As an SPV investor, it’s always important to keep in mind that you’re not a direct stakeholder in the business, meaning you’re “along for the ride” and won’t have any say over day-to-day operations. Therefore, it’s crucial to align with SPV managers who will represent your interests and keep you informed—and to back SPVs investing in startups you believe in.

For more guidance on investing in startups, consider joining Hustle Fund’s Angel Squad. Angel Squad members receive direct guidance from VCs on how to approach startup investing, plus access to high-quality SPV deals. To learn more, visit our website >>>