Startup founders and entrepreneurs often grapple with the challenge of raising capital without diluting their cap table with numerous investors. This clutter can lead to administrative headaches and potential misalignment of interests. The solution at hand is: Special Purpose Vehicles (SPVs). These legal entities allow multiple investors to come together, pooling their resources to invest in a single promising startup.
With SPVs, founders can efficiently manage their cap table while investors get the opportunity to be part of a collective investment, simplifying the fundraising process for both parties.
What Is a Special Purpose Vehicle (SPV)?
A Special Purpose Vehicle (SPV) is a distinct legal entity created for a specific purpose. In the context of startups and venture capital, SPVs are primarily used to pool money from a group of investors to make a single investment in a startup. This allows multiple investors to come together and invest in a particular company without each one being individually listed on the company’s cap table. Instead, the SPV appears as a single entry, simplifying the administrative process for the startup.
- From the investor’s perspective, SPVs offer a way to invest in a specific company of interest, rather than spreading their investment across multiple companies in a fund. On platforms like AngelList, SPVs are commonly used, allowing investors to pool their resources and invest in promising startups.
- For startup founders, SPVs provide a streamlined way to accept capital from a group of investors without the administrative complexity of adding each one to their cap table.
Navigating the Benefits and Risks of SPVs
The creation of an SPV involves transferring assets from the parent company to this new entity. This move effectively isolates these assets, shielding them from the financial turbulence that might affect the parent company. For investors this offers a layer of protection and assurance, allowing them to focus on growing their operations without the constant worry of financial risk.
However, it’s essential to understand that while SPVs can be powerful tools for financial management and risk mitigation, they must be used responsibly.
If misused or manipulated, they can become vehicles for hiding company debt, leading to disastrous consequences. A stark example of this is the Enron scandal of 2001, where accounting loopholes were exploited, leading to one of the most infamous corporate bankruptcies in history.
How Do Special Purpose Vehicles Work?
- Structure and Ownership:
- Special Purpose Vehicles (SPVs) are often established as limited liability companies (LLCs) or limited partnerships.
- They function as “pass-through vehicles,” owned by members.
- Income or losses generated by the SPV are distributed to members based on ownership stakes.
- Investment and Membership:
- Individuals/entities investing become “members” of the SPV.
- Capital contribution results in a “membership interest,” usually represented as a percentage.
- Example: $10,000 investment in $100,000 total capital = 10% ownership.
- Singular Investment in Startups:
- SPV consolidates funds and makes a single investment in a startup.
- Target company’s capitalization table shows SPV as a single entry.
- Direct Stake and Distribution:
- Investor holds a stake in SPV, not the startup directly.
- Income/returns from SPV’s investments distributed proportionally to members.
- Example: $10 million proceeds → 10% ownership = $1 million distribution.
- Carried Interest and Fees:
- SPVs can charge carried interest and management fees, similar to venture funds.
- Key difference: All capital usually called at SPV’s start, unlike multiple calls in traditional funds.
- Customization and Features:
- General Partners (GPs) can customize each SPV differently.
- Unique features possible: waterfall provisions, hurdle rates, redemption rights, distribution timings, etc.
- Investor Limits:
- Number of participants regulated based on capital raised.
- SEC regulations:
- $10 million or less raised → Max 250 accredited investors.
- Over $10 million raised → Limit of 100 investors.
- Compliance and Transparency:
- Regulations ensure SPV operations comply with standards.
- Transparency maintained through investor limits and regulatory oversight.
Things To Make Sure of When Setting an SPV
Here’s a step-by-step guide on how to establish an SPV as a way to o mitigate risk and streamline their business acquisitions:
Identify the Promoter or Sponsor
The first step in setting up an SPV is identifying the promoter or sponsor. This is typically the parent company, which initiates the creation of the SPV. The promoter or sponsor plays a crucial role in establishing the SPV and setting its strategic direction.
Establish the SPV as a Separate Legal Entity
Next, the SPV must be established as a separate legal entity. This means that its assets and activities are not affected by the ups and downs of the parent company.
Ensure Adequate Distance Between the SPV and the Parent Company
The distance between the sponsoring company and the SPV is crucial. If there isn’t adequate distance, the SPV could be considered a subsidiary company rather than a separate entity. This could undermine the purpose of the SPV and expose it to the financial risks of the parent company.
Maintain Independence from the Sponsoring Company
Lastly, a good SPV should maintain its independence from the sponsoring company. While this can be challenging in practice, it’s essential for the SPV to operate effectively. Independence ensures that the SPV can pursue its objectives without being unduly influenced by the parent company.
Steps To Create a Special Purpose Vehicle
Here are the steps to create a Special Purpose Vehicle (SPV):
- Decide on the SPV Structure: Determine whether you want to set up the SPV as a limited company, trust, or partnership.
- Visit Companies House Website or Engage an Accountant: Go to the Companies House website or seek the assistance of an accountant to initiate the SPV registration process.
- Provide Essential Information: Furnish the necessary details, including appointing at least one director and one shareholder. Specify the company name, registered address, and information about the directors.
- Define Business Activities: Prepare the Memorandum of Association (MOA) and Articles of Association (AOA) clearly outlining the business purposes of the SPV.
- Optional: Add Additional Directors or Company Secretary: If needed, include additional directors and/or appoint a company secretary to manage administrative tasks.
- Allocate Percentage Share to Shareholders: Distribute a percentage share of the company to each shareholder according to their investments.
- Identify Persons with Significant Control (PSC): Identify any shareholder holding more than 25% of the shares as a person with significant control (PSC).
- Provide PSC Details: Submit the name of each PSC, their date of birth, service address, and year of nationality. This information will be made available on the public register.
- Assign Appropriate SIC Code: Choose the appropriate Standard Industrial Classification (SIC) code to accurately represent the SPV’s business activities.
Types of Special Purpose Vehicles
Here are some of the key types of SPVs:
- SPVs Established by Banks/Financial Institutions for Securitization
Banks and financial institutions often establish SPVs for securitization purposes. In this setup, the bank’s assets, such as loans and receivables, along with their future cash flows, are transferred to the SPV. The SPV can then raise debt backed by these assets and their future cash flows.
The profit of the SPV is the difference between the income from the receivables and the cost of servicing the debt. This type of SPV separates the risk associated with these assets from the general business of the bank, providing a layer of protection.
- SPVs Formed by Government under Public-Private Partnerships (PPP)
Governments often form SPVs for specific projects under public-private partnerships. These SPVs are typically involved in infrastructure projects and are funded by both the government and private sector participants.
This type of SPV can streamline the approval process at various government levels and provide an easy exit route for the government once the project is completed.
- SPVs by Foreign Institutional Investors (FII)
Foreign companies often use SPVs to enter business areas that are otherwise prohibited under the automatic route. By using an SPV, foreign investors can navigate around restrictions and access the market.
- Synthetic Leasing
In synthetic leasing, an SPV is used to acquire assets indirectly, thereby avoiding the tax net. The sponsor leases the assets from its SPV, and the rent expenses are tax-deductible.
Meanwhile, the SPV acquires the asset through debt, the interest on which is also tax-deductible. This arrangement allows for tax savings and keeps the debt off the sponsor’s balance sheet.
- Real Estate Investment Trusts (REITs)
The emergence of SPVs in the market has led to the creation of Real Estate Investment Trusts (REITs). Similar to mutual funds, REITs allow investors to pool funds with real estate as the underlying asset class.
What Are the Uses of SPVs?
As the renowned investor Warren Buffet once said, “Risk comes from not knowing what you’re doing.” In the realm of business acquisitions, Special Purpose Vehicles (SPVs) can be a powerful tool for managing risk and facilitating growth.
Here are some of the key uses of SPVs:
- Risk Sharing
One of the primary uses of SPVs is risk sharing. When a corporation embarks on a project with significant risks, it can create an SPV to legally isolate these risks. This allows the corporation to share the risk with other investors, thereby reducing its own exposure.
- Securitization
Securitization is another common use of SPVs. For instance, a bank issuing mortgage-backed securities from a pool of mortgages can create an SPV to separate these loans from its other obligations. This ensures that investors in the mortgage-backed securities receive payments before other creditors of the bank, providing an added layer of security.
- Asset Transfer
Transferring certain types of assets can be challenging. In such cases, a company can create an SPV to own these assets. When it’s time to transfer the assets, the company can sell the SPV as part of a merger and acquisition (M&A) process, simplifying the transfer process.
- Property Sale
In situations where the taxes on property sales are higher than the capital gain realized from the sale, a company can create an SPV to own the properties. The company can then sell the SPV instead of the properties, paying tax on the capital gain from the sale rather than the property sales tax. This can result in significant tax savings.
Special Purpose Vehicles FAQs
How Does an SPV Make Money?
An SPV, functioning as an extension of a parent corporation, generates revenue through a strategic process. The parent corporation offloads assets from its balance sheet to the SPV, which, due to its own legal status, can independently attract equity investors. These investors then purchase debt obligations, providing an indirect financing channel for the parent corporation. This setup not only helps isolate financial risk but also creates a revenue stream for the SPV.
Special Purpose Vehicle (SPV) Vs Joint Venture (JV)
A Joint Venture (JV) is a business arrangement where two or more parties share rewards and risks equally. In contrast, an SPV is a setup by a parent company to manage financial risks, particularly in the event of a financial crisis or bankruptcy. The key difference lies in the distribution of risks and rewards and the level of financial protection provided.
Why Would a Company Form an SPV?
Companies form SPVs for several reasons. SPVs provide protection for a parent company’s assets and liabilities and offer a safeguard against bankruptcy and insolvency. They also present an easier way to raise capital. Furthermore, SPVs enjoy more operational freedom as they aren’t as heavily regulated as the parent company. This flexibility can be advantageous in executing specific projects or strategies.
Bottom Line
Special Purpose Vehicles (SPVs) serve as a powerful tool for investors and entrepreneurs, particularly those looking to grow their operations through business acquisitions. By creating a separate company that operates independently from the parent company’s balance sheet, SPVs provide a strategic way to isolate financial risk. This unique structure allows the SPV to function much like a fund manager, overseeing specific assets or projects.
