By: Brian Bernstein
This is business advice not legal advice. For all transactions make sure to speak to counsel
MVCA members often have more access to deals than actual dollars to deploy. This leaves a lot of money on the table. Because Miami is still not a well-developed capital market for early stage companies, we need approaches that work for our ecosystem at its present level of development to get deals funded and closed.
Within MVCA, there are members who have raised several funds, raised a single fund, or are working on building a track record for their first raise. There are also super angels, family offices, and existing funds who invested in an opportunity on their own, but need to raise additional capital if they want to continue to participate in subsequent rounds because the capital ask exceeds their capability to fund on their own. What all these members have in common is the goal to raise more money to take advantage of opportunities that their deal flow presents to them in a time efficient manner while following the best practices of being a fiduciary for limited partners.
A solution is to raise a single asset fund via a special purpose vehicle (SPV)
For new prospective GP’s who have never raised a fund, and therefore lack track record, it can be nearly impossible to raise a blind pool of capital for a first fund. Investors want to see two things: track record, and a reason the GP will have a proprietary edge in deal flow that will lead to alpha. These two things that are nearly impossible for most new prospective GP’s to show. However, if a prospective VC finds a single deal, and secures the right to invest in it with an SPV, the investors they approach will no longer weigh the opportunity against the GP track record, but on the merits of the specific deal itself. If the deal is compelling, the investors will allocate to the GP, and the GP will finally be able to start building a track record and investor relationships, leading to a possible fund with the same backers at a later date.
Sometimes existing venture funds and family offices get involved at deals at Seed or A but want to follow on in later rounds. They may be unable to do so due to: lack of capital, because taking such size either increases single position risk to an unacceptable overweight relative to their portfolio, or because it would limit their ability to invest in further opportunities presented by their deal flow channel. These groups can also take advantage of an SPV in order to gain upside from these follow-on rounds.
While many of you know that SPV’s are a good solution to specific problems, and some of you have completed one or several SPV raises, there are a number of things you can do to make sure you are successful in getting your SPV deals closed.
(1.) SPV’s are two sided deals – you are negotiating with investors in your fund at the same time your fund is negotiating terms, dollar amounts, and closing time periods with a company. Have one side locked in if you are going to attempt to do an SPV.
I have seen so many SPV deals fall apart because a promotor has no money when negotiating with a company, leading the negotiation to drag on for weeks or months. The ongoing investor discussions result in the size of investment moving around frequently, or the terms being changed to accommodate the whims of the most recent coffee with a prospective investor. This means that if you are going to do a deal, have a proprietary relationship with a company who knows you don’t have the money raised yet, and is willing to give you static terms and adequate time to both raise the money and paper up the documents. In the alternative, you could have cash to close the deal yourself, and warehouse the stock until your investors close with you. There are many ways to handle the double-sided deal problem, but they all come down to the same thing – get one side of the deal closed or de risked before you start.
(2.) Make the SPV’s small enough that you are nearly certain to get them closed successfully.
This should seem obvious, but I see promotors, time and time again, who have never raised 100k on a deal try to raise 10m. Sure the fees look bigger, but a substantial majority of the time, these promotors only harm their reputation. Everyone tells you they would love to invest with you, but until you put a specific deal in front of them and ask for a check in the next two weeks you have no idea who is real. Start small. Do 100k, then 250k, then 500k, then 1m, then 5m, and so on.
Also, have the cash to close on your own. If you sign a term sheet with a company, you are expected to follow through. YOU are taking the risk that you will be able to raise capital successfully, not the target company. While nothing in life is completely predictable, you should have ample cash to fund whatever shortfall happens in a raise. The best deals, that you have the highest conviction on, are often harder to raise for than inferior but sexier story deals. Having a balance sheet can really help here.
Also, documents and ongoing legal and accounting support from top providers is expensive. While partnerships often pay for them, have the money on hand to front if you have to pay expenses before your SPV closes. With that said, its worth paying up for great legal and accounting. Cheap transactional work isn’t worth expensive litigation later. Having great counsel will keep you out of trouble.
(3.) Have terms that protect your investors and increase the likelihood of returns.
This can mean having participating preferences that guarantee a minimum IRR before anyone else in a waterfall gets a distribution, having a redemption right or put option to sell your shares back to the company after a period of time at a specified price, or having a convertible loan that is senior in the capital stack and has teeth, making sure that it will be paid back if the company does not deliver. You may want board seats or board control. You are a fiduciary for your limiteds, and you need rights to protect them.
(4.) Give yourself ample closing time, or be prepared to make a bridge round to your fund to close on time with the target company.
SPV documents take time to put together, especially if it’s your first time. They do get faster. We have had to advance money in the form of a loan to a partnership at the minimum rate allowed by the IRS in order to get a deal closed where we were still waiting for investor wires. Good legal advice helps here. The more things you document, like a loan to an SPV, the higher the closing costs will be. There is always another deal, don’t try to close without adequate time
(5.) Synthetic equity and liability are two sides of the same sword.
When you do an SPV, your GP group is entitled to a percentage of the capital gains and cash flow over the life of the investment, usually around 20 percent, plus a 2 percent management fee, and possibly acquisition and disposition fees. You can ballpark the value of your GP position by taking the present stock price of the position, times the number of shares, times your carry percentage, and subtracting the original investor contribution. Many people want to do as many SPV’s as possible to increase their net worth as represented by synthetic equity on their balance sheet, but each deal has liability. You are a fiduciary, and if something goes wrong, investors will look to you for recourse, to the extent permitted in your subscription documents. This is why as a GP you want to disclose every possible risk explicitly and openly, as this will protect you substantially, while limiting liability triggering events and capping damages in your subscription docs. Every deal you do has risk as well as potential reward, and you can’t assume it will all go well.
(6.) Align your incentives with your limited partners
I have seen plenty of conflict in SPV deals, especially where a firm does an SPV in an A round, and then wants to do a second SPV in a B round. In this case, the firm has an incentive to maximize negotiated price for it’s A round investors, while its incentive is to minimize price for its B round investors. If these groups don’t have 100 percent overlap, then you as the promotor have a conflict. Possible conflict is not always avoidable, but it MUST be disclosed. Then your investors can make an adequate decision on what is in their best interest to do with all the facts. The same issue comes up in handling when a GP fee gets triggered. If a company has an IPO, then the investor captures value after the IPO price without any fees going to the GP. This creates a risk that the GP will delay the IPO or exit to maximize their fees. This is ok if there is no risk of a diminished likelihood of a successful exit, but often the longer you wait to exit an investment, the more things can possibly go wrong, and that must be weighed against potential future profits. Again, you are a fiduciary. Be long term greedy. If you do what is in the investors best interest you may make less in the short run, but you will raise FAR MORE MONEY in the long run. If you are looking to get rich quick this business isn’t for you, most of these deals are seven to ten year hold periods. We often trade liquidity for long term IRR.
(7.) Do deals that Cash Flow to Investors Immediately
Yes, startups are high growth and capital constrained, but your investors and you have a capital cost, and you should at least be partially compensated. If you invest in equity, get preferred with a coupon, and have an aggressive ratchet if the company defaults on the coupon. If you invest via a convertible note, get paid your coupon in cash. If they don’t pay you, it’s a default. Focus on deals that will grow with good enough unit economics and margins that they can support a reasonable coupon payment annually. Investors like getting checks in the mail. I have done SPV’s that pay quarterly coupons, and it makes raising from existing investors for future deals very easy. If it means a company grows a little slower, its fine, getting rich slowly is often getting rich safely. Coupons paid annually aren’t as good as those paid quarterly. Those paid quarterly are inferior to those paid monthly. Be the promotor with cash flowing deals, and you will out raise all other VC promotors in today’s yield starved market. Invest with a margin of safety or low LTV to the companies breakup or sale value, and your investors will have several levels of protection.
You can get all the best legal and business advice in the world, but the important thing is to learn by doing. Each SPV you do should be faster, smoother, and better than the last. We all make mistakes, and markets change, but if you are active in the SPV market you will get better and you will deliver returns. If Miami sees a successful SPV ecosystem develop for primary deals or fund side cars, you can count on us having lots of successful large VC fund raises in the future. Get in, get out, and get your investors paid, and Miami will be better for it.
