Financial Poise

Co-Investment SPVs: Access or Excess?

Avoid These Common Mistakes in Venture Capital

The modern venture capital fund structure dates back to the 1960’s – but change is coming fast and furious! This article can help you make money in venture by conveying an insider’s tips and tricks into how to build a better venture portfolio, while avoiding common mistakes that venture investors all too frequently make.

Venture Capital was once an elite game played almost exclusively by modern royalty. Wealthy blue-chip venture capital firms on Sand Hill Road partnered with wealthy blue-chip banks, pensions and endowments in order to guarantee that all parties involved made a lot of money.

For 50+ years, these General Partners organized funds, stockpiled Limited Partner investors, and, for the most part, followed the 2/20 (2% annual management fee and 20% carried interest – or profit sharing) compensation structure.

But there is nothing the internet hates more than a middle-man. And a Venture Capital (VC) fund sits between the people with the money (the limited partner investors) and the companies that ultimately receive the money (the funded startups).

The Jumpstart Our Business Startups Act (JOBS Act), passed in 2012, arguably began the democratization of venture capital by expanding the list of investors beyond traditional blue-chip institutions. Separately, family offices began investing much more actively, and directly rather than through venture funds, since about the same time.

[Editor’s Note: For more information please see our webinars ‘Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds‘ and ‘Due Diligence Before Investing‘]

Prevalence of SPVs

Credit must go to Naval Ravikant, founder of Angel List, for developing a product to fill this direct investing desire, through its ‘Syndicates’ project. These syndicates generally allowed existing individual investors in a company to offer up to new investors, the opportunity to invest in that company’s upcoming financing round. This would be accomplished by the existing investors using their right-to-invest, or ‘pro rata right,’ to let other investors ride their investing coattails, via their syndicate.

Each Angel List syndicate invested in one company through an SPV, a ‘special purpose vehicle.’ An SPV is a venture capital ‘fund’ with one investment but is subject to all of the SEC regulations governing a traditional venture capital fund. These regulationsAngel Investor include restrictions on general solicitation, numbers and types of investors, State level Blue Sky filings, Federal Reg D filings, annual tax returns and K-1 preparation. An SPV is a high-cost, high-burden tool for one investment. Yet it remains the only vehicle available for pooled direct investments that comfortably rides the rails of SEC compliance.

After recognizing Angel List syndicates’ popularity, the recently emerged class of small venture funds, the Micro-VCs, began integrating direct investing through SPVs into their models. Why? Two reasons:

  • A smaller fund has, by definition, smaller investors. Many smaller investors prefer picking the companies in which they invest, versus being a passive LP in a fund.
  • An SPV generates both additional income as well as potential upside for the Micro-VC. The compensation norm for smaller VC SPVs is around 1/10 (1% management fee per year and 10% carry.) The carry is ‘deal carry’ which is much more valuable than fund carry, since the individual losers are not netted against each of the winners.

SPV Excess

Just as Wall Street took low-documentation mortgage loans to excess almost a generation ago, many Micro-VCs are now taking direct investment SPVs to excess.This begs the question: is the GP bringing something special, such as an investment that is otherwise impossible to access? Or is it bringing a commodity, and simply boosting its assets under management to excess, by bringing a pedestrian investment that anyone can access?

In other words, are you being selective and buying this co-investment as a complement to your current portfolio? Or are you being sold something you don’t want or need?

Access Over Excess

Investing in venture capital is all about pattern recognition.After 20 years, seven venture funds, 100+ companies, and 35 pro rata based SPVs, I have discerned a pattern that can help distinguish between a great co-investment opportunity and one that should send you running. A few things to avoid when you invest in a venture-backed company – because the best way to make money is to first not to lose it:

Five Reasons to Not Invest in a Co-Investment

  1. The performance of the business is a well-kept secret: This sounds simple, but a mere glance at the syndicates on Angel List will show you that most give little to no information about the actual financial performance of the company. Revenue, gross margin, and operating loss are often missing. Why? Because most individuals who post syndicates on Angel List do not have access to this information. Instead, they want you to invest in the company because of their reputation, or the reputation of the company. Just say no to information-light companies.
  2. The financing round is a bridge note to a larger round of financing: Avoid these ‘opportunities’ like you would avoid a person with the Black Plague. If the insiders are not willing to bridge the company to the next financing round, then why would an outsider want to do so? Never walk across a bridge round.
  3. The company is struggling to raise money: Perhaps the company has been raising this round of funding for a long time. It may have a hole to fill in the funding round. The person bringing you this ‘opportunity’ is helping the company fill that hole, but they are also helping themselves, as a prior investor in the company, by protecting the money they already invested. If you invest here, and help fill the hole, perhaps that is less they have to invest. Never fill a hole in a round.
  4. The group bringing you the co-investment is not investing in this round, is investing very little, or is simply a middle man: Do you really want to be marking up someone else’s investment? Ask yourself: If this is such a good investment, why is the “sponsor” not investing much money, if any? In the venture world, great companies do not need third party help to raise money (unless perhaps for a mega-funding round.) If an investment bank is shopping the investment to you, then, except in rare circumstances, the investment is not ‘in demand’ and thus is not hard to access. Do not invest unless your co-investor is writing a meaningful check alongside you.
  5. There are no recognizable venture capital funds investing in this round: Entrepreneurs usually seek out top brand name venture firms to lead their financing rounds. Financing rounds which lack brand name institutional capital are often a signal of deeper problems with the company, the market, or the entrepreneur – which would explain why no venture funds chose to invest in them. Don’t fly solo – look for a good VC to be your wingman.

If you follow the five rules above, you are likely to avoid bad co-investments.

But how to filter for those potentially GREAT investments? Once again, pattern recognition can suggest a few things that most great investments have in common.

Five qualities of a good co-investment

  1. The Company is the clear category winner or a close #2: Think Uber/Lyft, Bird/Lime or Beyond Meat/Impossible Foods. In venture, the majority of value created by a company in a new market or a new category goes to the winner. Half as much goes to the runner up. And everyone else is left to split 20% of the value of the market. Go big or go home.What Makes a Good Co-Investment
  2. The financing round is led by a top 20 VC: Top VC firms wield disproportionate influence in the venture ecosystem. If a top firm is an investor, it is easier to raise follow-on financing, usually at higher prices. When a company is sold, it often commands a higher price if a top group is involved. When you write a check, follow an industry leader.
  3. The financing round is intensely competitive: The company likely has multiple lead term sheets and is well oversubscribed. People want to put $100M into the company, but the company only wants to take $35M. You will be lucky to get into the round. This is true access. These types of investments are often the hardest to find, and they move quickly. Don’t take too much time deciding. The more competitive the round, the better.
  4. You are investing at the same entry point as the group that brought you the investment: Co-investment in private equity began in the buyout world, when the PE fund brought their larger LPs directly into the investment at the moment when their fund first deployed its capital. This aligns the interest of the fund and the LP, since they both are buying into the company at the same time. Apply the same rule to venture capital. Invest alongside your partner, not after.
  5. The company has product market fit and is growing 2X+ per year: The hardest thing to get right in venture is timing. Is the market here, today? It is very costly to be right about the idea, but wrong about the timing. The only way to make sure you get this timing right is to invest in companies with real product, which people are buying today. A 2X growth also suggests they have been selling long enough to work the kinks out and are ready to grow even more quickly. Prioritize real products and real growth.

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About John Backus

John Backus has been investing in venture capital for over 20 years. His firm, PROOF.VC, is the pioneer in using the pro rata rights of smaller VCs to gain unique access to many of the fastest growing venture-backed companies, while also extending that access to his LPs through co-investment SPVs. Prior to his career as…

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