DISCLAIMER: Things I am not: an accountant, a lawyer, a fiduciary to any reader, or a registered advisor. I’m just a guy writing a newsletter so none of this constitutes any tax, accounting, legal, life, or investment advice.

Following up from the last two weeks

I was thrilled to hear from so many that last week’s issue on the Milken Global Conference was so valuable to so many of you. It’s one of the reason’s I love writing a newsletter, my niche knowledge can spread more widely and help more people. As a reminder please let me know if you’re going to be in LA for Milken!

Finally, as a heads up there will be no new detailed post next week as I’ll be attending Milken, instead you’ll get a Roundup covering the last three issues, including this one.

For our 10th installment we’re back to Risks, for the first time since our Subscriber Exclusive Issue #4. This time it’s to focus on the risk component of participating in syndication vehicles, with a focus on a core risk of RUVs as an example. If you’re a family office who does co-invest, or someone who regularly participates in deals on AngelList or similar platforms — today’s issue is a must read.

Risks
The Hidden side of SPVs

Special Purpose Vehicles are how most people invest in to startups. Every angel on AngelList is investing in to some form of SPV, and most co-invests by funds are operated as SPVs (yes, there are actually other structures). Nearly everyone who lists SpaceX, Databricks or any other decacorn on their investments list who came in to a late round, did so via an SPV.

Managers^* with access to deals use SPVs to bundle investors together. This lets the the manager get access to a deal by meeting the company’s minimums by bundling up smaller checks. This can also be used by a manager to reach a plateau for certain investor rights and generally functions in one of a few ways (enticement for fundraise, co-invest for LPs, syndicate only syndication) which we’ll cover in a future The AGM issue.

_{* I use “managers” intentionally rather than “fund managers” since many of those running large syndication platforms lack any discretionary committed capital for which they, and they alone can deploy.}

The risks with an SPV are different, and usually greater (but importantly, not always greater) than investing directly on cap-table. SPVs can also give an LP anonymity, and help the company keep their cap table clean. We’ll highlight many of the risks associated with SPVs but I’m sure I’ll miss one so tell me what’s the biggest problem you’ve encountered investing in SPVs?

The Basics

This is not an issue about SPVs. It’s an issue about the risks of investing in SPVs. We’re not going to cover any of the risks you encounter investing directly with a company, those are assumed. We are focusing only on the risks that are additional when investing via a normal special purpose vehicle or RUV (an AngelList specific type of SPV).

We’re going to focus on three major risks though many more exist and deserve to be covered. The risks we’ll cover are fee risks, administrator risks (these first two are intertwined), and incentive misalignment risk which covers exits and rights.

This is a Risks issue so we’re focusing on the risks, not the constraints — and the constraints/advantages are likely enough for a full additional issue in the future.

We’re not going to get in to specific contract terminology, or SPV structures. Just assume that these are all standard docs, as many of the docs in my experience are generally very standard.

The Fee Risk Landscape

My number one rule of investing in SPVs is to never invest in an SPV which charges a management fee. I want incentive alignment. Most families I talk to have this same overarching rule as it relates to SPVs.

However very few ever consider the impact that administrator selection has fees. In some cases for early stage rounds, the wrong choice of fund administrator could have the same or greater impact as multiple percentage points of up-front management fee.

I never invest in SPVs on a variety of platforms that charge fees annually and don’t have a cap. I don’t have an exhaustive list but generally in practice for me that means not doing SPVs on Carta. I have modeled fees in the past for Carta vs self-administered (for funds that have a trustworthy administrator) or AngelList, and the fee difference in the structures over just 10 years (many early stage SPVs take a lot longer than that to harvest) can be over 5x.

The Fee vs Management Fee Calculation

An AngelList SPV generally charges fees of between $4k - 12k depending on who the GP entity is and some other factors.

I’ve seen other platforms where in 10 years the fees can go north of $50k.

On a $500k SPV that’s approximately a 4% difference in the amount of your money that goes in to the underlying company.

If you wouldn’t invest in a company with 4% management fee why would you do it if their administrator choice charged you the same.

I view this two ways. Not only is it expensive, but the selection of an expensive administrator doesn’t necessarily signal stability (which we’ll talk about next) but it does indicate a disregard for fees, and in that a potential mindset mismatch for what I look for in managers I can trust with my money.

Next Level of Fee Risk

When administrators charged a fixed fee they take the long term tax and administrator risk. If the SPV has a liquidity event early they are making money, if it goes on long, they’re putting in work 10-15 years later for a check received a decade ago.

Early stage investing always take longer than expected. When this happens and your SPV is being charged annually, there may not be enough in the reserves to cover the administrator fees. When this happens the manager has a few choices, all bad.