When I started investing as an Angel, I rarely had the opportunity or capital to follow on and invest in future rounds. As a Venture Partner at Ignition Partners, I learned about pro-rata rights (the opportunity) and reserves (the funds) to follow out of a $300M fund. Now as a small VC with < $50M under management, I often have the opportunity (pro rata rights) but not always the reserves. What are small VCs to do?
Make SPVs (special purpose vehicles) your new best friend.
First, some background.
Setting up a Venture Capital firm used to be a complicated and expensive process requiring a significant back-office investment that led to the ideal fund size being> $100M and requiring multiple partners. In the last decade, companies like AngleList, Carta, and others have productized the VC back-office, enabling an order of magnitude more VCs to operate on a much smaller fund size. My first fund was $2.5M. According to Crunchbase, sub $50M VCs grew 120% recently, and this report predicts an explosion of micro VCs in the next five years. VC accelerators like VCLAB are now churning out hundreds of new VCs a year.
SPVs also used to be expensive to set up and manage. The first ones I did cost $30K in legal fees, and we had to pay separately for yearly accounting and K1s. SPVs were typically done by angel groups to simplify the cap table for companies taking many small investors. Today, the SPV process has been integrated and productized into a small (typically under $8k) one-time setup fee and a very robust online platform (Angellist, Carta, Sydecar, etc.). Many platforms will also connect you to LPs to invest in your SPVs. When I started angel investing, sharing deals with my investor friends was full of friction. It was like herding cats. In 2019 I decided to start an AngelList syndicate as an easier way to share my diligence with my friends and make it easier for them to invest. I simply wanted to make it easy for my friends to invest into companies I was already investing in.
Twenty years ago, a venture-backed startup’s first round of financing would be Series A. For example, DocuSign’s first round in 2003 was a $4M Series A. Today, many companies raise 3-6 financing rounds prior to Series A, including Angel, Pre-Seed, Pre-Seed+, Seed, Seed+, and so on. With medium to large funds typically requiring 15-25% ownership, their minimum check size is typically larger than many of today’s early rounds. These early rounds are the opportunity for small funds. According to Crunchbase, over 70% of Unicorns were funded by a Tier 1 firm in Series A, while less than 5% were funded by a Tier 1 in the pre-seed. Big funds with large AUM and large teams dominate Series A and beyond. Earlier is the territory of small funds.
If you are a reasonably good picker as an early VC and your companies go on to raise more money, you will be faced with a choice. To follow on or not to follow on? This will be, in large part, determined by your reserve strategy in your fund. Regardless of how big (or little) your reserve strategy is, your demand for follow-on financing will likely exceed your reserves. For example, I had a Series A pro-rata in my first $2.5M fund that was $2.7M – larger than my whole fund! This is a problem every small manager I know faces.
Enter the SPV.
SPVs are not just for grouping small investors anymore. SPVs have become a strategic part of the small fund strategy. SPVs can expand your reserves strategy opening up more investment opportunities than your fund size alone. Jason Calacanis at Launch is one of the more well known VCs executing the combined SPV and Fund strategy. The combination strategy makes so much sense, I belive every sub-$50M manager should have an SPV strategy.
SPVs are good for…
- LPs. Many LPs in your fund also invest directly and are looking for quality deal flow. They may already know something about your fund companies from LP updates. You can provide access through your pro-rata that LPs might not otherwise have.
- The Company. They can raise more capital from investors already on their cap table. The SPV single line item simplifies their cap table. If they like you as a manager, they will want to take more money from you and your network.
- The Manager. You will receive additional carry (and sometimes fees) from the SPV while doing a similar amount of work that you would already be doing.
Here are a few things to watch out for with SPVs…
- If you have a fund, you must first invest out of the fund. You are a fiduciary of the LPs capital and likely have a clause in there that limits your ability to invest outside the fund. If you run an SPV without investing from the fund, you could run afoul of the “cherry picking” provision in your LPA.
- If you have written your standard check from the fund, and have additional allocation, you can do an SPV for the balance, but I personally do not do that. I have found it can confuse LPs and they generally want to invest later as the company becomes de risked, so I only offer follow-on pro rata. You should determine your own strategy in consultation with your LPs.
- Make sure to get CEO approval for any SPV. They may not want anyone outside your firm to see company pitch decks or details. Keep the CEO in the loop.
- Ensure everyone who sees the SPV offer is an accredited investor. The LPs in your fund likely all are, but if you send it to a larger group, you may run afoul of the SEC Solicitation rules. Offering an SPV is in fact a securities offering and is covered by SEC rules. Most SPV providers will do KYC, AML and other SEC required checks for you, but don’t post SPVs on Twitter or in public forums.
- Be cautious about co-syndicating or allowing market makers to “help with your SPV”. Again, SEC regulations around broker dealers, etc.
- If the stock you are buying with SPV comes with pro-rata rights, be clear with your LPs who retains those rights. One SPV manager I have invested with retains those rights and does NOT grant them to LPs. Regardless of your strategy, be transparent with LPs.
- SPVs are a point in time, limited capital vehicle. If the stock you buy with it has additional capital requirements in the future (Pay to Play, legal, etc.) you are going to have issues (the subject of another post). Be prepared for these ahead of time.
- Use a stable platform as your SPV provider. Assure was an very inexpensive SPV platform until their business model imploded and they shut down. All the SPVs they managed had to move to other providers and pay additional fees for accounting, management, etc. Don’t be penny-wise and pound-foolish with an SPV provider; choose wisely.
Some best practices for VC fund managers when considering SPVs
- Use a well-funded, proven SPV vendor. You don’t want to move your SPV.
- Consider not charging management fees. You are already getting management fees for the fund, your LPs will thank you. And LPs hate SPV management fees.
- Consider lowering the carry for fund LPs in your SPVs. Typical SPV carry is 20%, just like the fund, but managers who lower this to 10-15% generate significant good will with their fund LPs.
- Build a network of LPs outside your fund who are just interested in SPVs. Many investors outside your fund just want deal-by-deal opportunities. I have 3000 of these LPs in my Angellist syndicate.
- Forward management updates to SPV LPs and/or summarize them as you would for fund LPs. SPV LPs tend to get the short end of the information rights stick. If you provide updates, you will stand out.
A successful $10M pre-seed fund will likely have $30-$40M in pro rata opportunities over its lifetime. By adding an SPV strategy, you will be helping LPs, the company, and yourself. You owe it to them all. Make SPVs your new best friend.