SPVs aggregate many small investors into a single investment to simplify startup cap tables
You’re raising a million dollar pre-seed round and have lots of folks offering you money. But instead of two investors putting in $500K each, you’ve got a whole bunch of individuals who want to write checks ranging from $100 to $100K.
If you accept all those investments, it’ll make a mess of your cap table.
The Special Purpose Vehicle — SPV for short — aggregates those small checks into a single investment to simplify your cap table management.
The SPV is an important, but obscure part of the plumbing of the startup ecosystem. Most early-stage startup founders haven’t even heard of them much less know when it makes sense to use one and when it doesn’t. Surprisingly, most angel investors know little about them and are unaware of the trouble they can cause for their personal tax filings.
While the administration of an SPV is complicated, that will be handled by specialists (for a substantial fee). For what founders and investors need to know, read on…
The Problem With Messy Cap Tables
In the grand scheme of startup challenges, a messy cap table filled with individual investors is hardly the most daunting problem. But it will cause difficulties, the most important of which is that big VCs that invest in later rounds will gag at sharing a line on the cap table with small investors like me.
Other hassles include:
- Every time you amend your corporate documents, which can be quite frequent for early-stage startups, you’ll need a vote of all shareholders. If you want to raise a new round, or extend the current round, you’ll need everyone’s approval. Good luck chasing down all those individual investors.
- Every shareholder may have information rights, pro-rata rights, audit rights, or other legal rights as a minority owner of the business.
- Every shareholder will have the right to sue you, and the company, and the board of directors if they feel they were lied, or mislead, or defrauded in any way.
- Every shareholder, no matter how small, will feel they have the moral right to call you at 2 AM to check on their investment.
Big public companies may have more than 10,000 shareholders, so the number shareholders itself is not a problem. But those companies spend millions of dollar on investor relations, money you can use in better ways. Having a small, simple cap table will make it easier to manage your investors.
The Solution: SPV
The simple solution to having a lot of investors without having a lot of investors is the “Special Purpose Vehicle”.
An SPV is a separate company with a single purpose: to invest in your startup. Instead of writing you checks for $1,000 each, investors write checks to the SPV. The SPV aggregates the money from all the investors and makes a single investment in you.
In your $1M raise, let’s say $500K is from one VC and the rest comes from dozens of angels. The angels put their money in the SPV, which then makes a single investment in your startup. Voila! Instead of dozens of investors to manage, you have only 2 (plus founders and the options pool).
That means you have only 2 investors in the pre-seed round that will have to approve later fundings. You have only 2 investors you need to notify of quarterly earnings and board meetings. You have only 2 investors that have the right to sue you.
In other words, you’ve moved the messiness of dealing with dozens of investors back to the investors themselves. They own shares (well, technically “units”) of a company that owns shares in your company.
The SPV will have its own administration of ownership, decision making, fees, and distribution of income when the company exits.
Legally, the SPV is an LLC, making it a pass-through entity. Investors get to keep the tax benefits of investing in startups, and the SPV itself doesn’t pay taxes. But it does raise other complications.
Downsides to SPVs
While the SPV doesn’t pay taxes, it does have annual tax and corporate reporting requirements that incur significant costs.
The SPV has to report to the IRS, state tax authorities, and state corporate regulators every year.
Even if the cost of administration is only $1000 per year, over the 10 years before the company exits, that comes to $10,000. Add setup fees of another $5K and you may be looking at a total cost of $15,000.
On a $2M investment, $15K in SPV fees is not a problem. On a $50K investment, it’s a non-starter.
As an LLC, the income and losses from the SPV company are passed through to the investors. This is done with a K-1 form sent to each investor showing our share of the SPV’s income that we need to include on our personal income tax filings.
My experience is that the K-1s are frequently late, which means I have to delay filing my personal taxes. Chasing down missing K-1s is a major hassle. At least one K-1 each year turns out to be wrong, which requires me to amend my previous tax filings, and sometimes pay fees and penalties to the IRS, as well as keeping my accountant busy with billable hours.
In other words, filtering the investments through an SPV rather than accepting a direct investment in the company makes the founder’s life easier by making my life harder. The SPV is a not-insignificant barrier to my decision to invest.
Less obvious but more important is that the SPV adds a layer of insulation between startup founders and investors. In fact, that’s the point.
If I was simply looking for somewhere to invest my retirement savings, I’d put it in S&P index funds or real estate where returns are higher with better liquidity and far less risk. If I wanted to add investments in startups, I’d hand my money to a VC fund and let them do all the work.
But as an early-stage investor, I want to be involved with the company. I want to be part of the team. I want see the quarterly updates, hear the company’s challenges, and yes, call the CEO with my unsolicited advice (though I promise not to call at 2 AM…except when I’m in Japan). Otherwise, what’s the point?
When to Use SPVs and When Not
If I’m investing $100K in your startup, I expect to be treated as part of the team. If I’m investing $100, I obviously don’t. So where’s the cut-off?
In a friends and family round, it’s common for start-ups to set a $10K investment minimum to keep the cap table manageable.
In a pre-seed raise being pitched to angels, the minimum check size is almost always set at $25K. Startups demanding a $100K minimum usually hit a wall finding investors willing to stump up that much at an early stage.
In the seed round where most of the investors are VCs, if angels are even solicited, the minimum is usually set at $100K. However, for investors already on the cap table from earlier rounds, the minimum for a follow-up investment is usually kept at $25K. Pro-rata investment rights may require the startup to take smaller investments from existing investors.
If there’s interest from angels and angel groups for investments below those minimums, then it makes sense to set up an SPV to aggregate the smaller investments. My angel group does this whenever we have at least $100K of investments to offset the cost and hassle.
We use a SPV most often in the seed round where few angels want to put in $100K, but we may have 5–10 angels interested in investing $25K each.
Not All SPVs are Equal
As an angel group, we set up and pay for the SPV ourselves. The fees are taken out of the collected investment. If we raise $200K and have $10K in fees for the SPV, we invest $190K in the startup. Any income from the startup exit is distributed pro-rata. This is the most simple and basic SPV.
Participation in the angel group SPV is limited to members. If the startup has other people interested in joining, it makes sense for the founders to set up an SPV itself open to all investors.
VC funds may sometimes open an investment to outsiders. They might, for example, invest $500K from their own fund and solicit another $500K from interested LPs (investors in the venture fund), individual GPs (fund managers) for personal investments, and outside angels, giving them full control over the total $1M. They’re likely to charge a 2% per year management fee and keep 20% of the earnings themselves.
I’ve even participated in a small group where one person bought an allocation of shares in a later-stage startup, then resold them to friends and acquaintances through a group SPV, reserving a 10% cut of the profits for himself as the manager.
For startups raising crowd funding, whether that’s to a general audience like Start Engine or focused on accredited investors like AngelList, SPV administration is part of their offering, and the SPV fees should be included in their costs.
Setting up an SPV is complicated, with myriad federal and state corporate and tax filings required. Fortunately, there are specialists like Carta and Sydecar that for a fee, usually between $10K and $20K, take care of the administrative details.
For startup founders, what’s important to consider is when to use an SPV to help manage your cap table, and when it’s better to avoid that layer of insulation and work directly with your investors.
Caveat: I’m not a lawyer. I’m not an accountant. I’m not a tax specialist or even a finance pro. I’m just another startup founder and angel investor who’s collected enough dumb mistakes to be confused with wisdom. As always, consult with your advisors before making any decision. If your advisors disagree with me, find better advisors.
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