A Blog by Jonathan Low


Apr 7, 2015

VCs Create Insider Track for Investing in Hot Startups

SPVs, otherwise known as special purpose vehicles, are a sort of innocuous sounding investment mechanism designed to provide advantages to everyone but regular investors.

If they remind some with long memories of an ostensible financial engineering 'solution' from another time, well, they may be on to something.

Enron is now so ancient a scandal that it may be too old to be useful as a business school case study cum cautionary tale. One of the factors that brought the multi-billion dollar corporation with exquisitely correct - if fraudulent - financial statements to grief was the liberal application of outside investment funds known as...Off-Balance Sheet Vehicles or OBVs (sometimes known as OBEs or off-balance sheet entities).

This allowed for the parking of money of use to the corporation but technically beyond the purview of accountants or regulators. The latter day venture capital, legal and banking practitioners of this sleight-of-hand are too clever to do anything overtly illegal, at least by their definition, but they are pushing the same envelope. Startups get fast money without all those bothersome reporting requirements, VCs, bankers and lawyers get juicy fees, and insiders get what are politely called 'excess' returns.

The larger question, beyond sorting out the soundness - or legality - of this approach, is whether tech really wants to remind anyone how closely allied to financial services it has become, what an insiders' game it is - and how far its founders have strayed from the industry's original market premise. JL

Douglas MacMillan reports in the Wall Street Journal:

Venture-capital firms along with a cast of prominent entrepreneurs and executives, have each raised tens of millions of dollars for impromptu funds that give institutional investors, friends and business associates exclusive access to highflying companies.
Silicon Valley insiders are taking advantage of soaring values for technology startups by creating a potentially lucrative side business.
Venture-capital firms such as Andreessen Horowitz and FirstMark Capital, along with a cast of prominent entrepreneurs and executives, have each raised tens of millions of dollars for impromptu funds that take a direct stake in a single startup.
These funds, which often come together in a matter of days, give institutional investors, friends and business associates exclusive access to highflying companies. The funds also let the venture capitalists invest far more money in a company than they otherwise could. In many cases, the funds are blessed by the startups, which see them as a way to raise big sums quickly.
While the investments are usually billed as exclusive, can’t-miss opportunities, the funds aren't without risk. Their investors—which include fund of funds, family offices and pension funds—are usually offered limited financial information about the companies. They are also charged a performance fee that is typically about 20% of any investment profits on top of already rich prices.When image-bookmarking site Pinterest Inc. set out to raise more than $500 million in February, one of its earliest investors, FirstMark Capital, wanted to take part in the round.
But the venture firm couldn’t invest a big enough sum from its $225 million fund to keep pace with Pinterest’s steep proposed valuation of $11 billion, more than double the price from May. Venture firms typically spread out their bets and avoid allocating too much capital in one company.
So Rick Heitzmann, FirstMark’s managing director and a Pinterest board observer, struck a deal with the San Francisco company to create a special fund that would pool capital from other investors and take a direct stake.
In just three days, Mr. Heitzmann rounded up $200 million from seven of FirstMark’s investors and included a small of amount of capital from its main fund, according to a person familiar with the deal.
He sweetened the deal by waiving fees typically charged to manage a fund, usually about 2%. FirstMark will get the same “carry,” or a cut of the investment profits, as its main fund should Pinterest hold an initial public offering or get acquired at a price higher than $11 billion.
In the eyes of some investors, the wager is easy money: Pinterest has the potential to follow a similar trajectory as Facebook Inc., which became a social destination for hundreds of millions of people and a top place for advertisers. But Pinterest is no surefire bet as it only officially began selling advertising on its site in January.
A Pinterest spokesman declined to comment.
The deal illustrates how startup investors are increasingly using an emerging funding structure that helps them defend their most promising bets. They are employing a type of fund called a special purpose vehicle, or SPV. Unlike venture funds that invest in dozens of startups over several years, an SPV represents a bet on a single company at a specific point in time.
These funds let investors write bigger checks to compete with the billions of dollars pouring into later-stage startups from mutual funds, hedge funds and banks. Venture firms are finding they don’t always have enough funds reserved to retain percentage stakes in startups as valuations rise quickly.
In the past 12 months, at least 70 private companies world-wide raised capital at a valuation of $1 billion or more, according to Dow Jones VentureSource. Many companies, including Pinterest, have been valued at more than double their previous valuation in that time span.
Further down the chain, a small but prominent group of entrepreneurs and executives are capitalizing on their access to fast-growing startups by raising SPVs for companies such as grocery delivery service Instacart Inc. and bitcoin processor Coinbase Inc., people familiar with the matter said.
Elad Gil, a former executive at Twitter and Google, raised tens of millions of dollars from current or former employees of Google, Facebook and Twitter for Instacart’s $220 million January round that valued the company at $2 billion, said a person familiar with the matter. Mr. Gil couldn’t be reached for comment.
A spokesman for Coinbase confirmed the presence of an SPV in its January round, saying it represented less than 3% of the total $75 million investment. Instacart didn’t respond to a request for comment.
With the connections already in place, these deals happen quickly and further narrow the exclusive club that gets access to prime startups. But these funds pose financial risks. A venture capitalist gets a detailed look into a startup’s revenue, costs and financial projections before they make a decision to invest. Buyers of SPVs are usually only offered a high-level view into the potential performance, not detailed financial metrics, according to both investors who have arranged these funds and firms and individuals who have considered investing in them.
“There are going to be some bad outcomes,” said Brad Garlinghouse, a former executive at Yahoo Inc. and AOL Inc., who has invested in some SPVs and passed on others. “When you’re the last money in coming at the top, you’re going to be disappointed with the financial returns.”
There are going to be some bad outcomes. When you’re the last money in coming at the top, you’re going to be disappointed with the financial returns.
—Brad Garlinghouse, former Yahoo and AOL executive
As more startups go this funding route, some investors question whether the companies are losing out on a chance to bring aboard more strategically valuable investors.
“Entrepreneurs should focus on investors that deliver value to them,” said Jeff Clavier, managing partner of venture firm SoftTech VC. “When you crowd out experience just to get an SPV going, then that’s a problem.”
SPVs gained popularity around Facebook Inc. and Twitter Inc. as those companies headed toward mega-IPOs. Chris Sacca, a former Google Inc. executive, helped popularize this trend when he bought up hundreds of millions of dollars in private shares of Twitter from executives and early investors over several years preceding the company’s 2013 public offering. Those shares, bought on behalf of J.P. Morgan and investment firm Rizvi Traverse Management, would be valued at about $4.2 billion at today’s Twitter stock price.
Investment banks have also given their wealthiest clients special access to hot deals, such as Goldman Sachs’ creation of an SPV in 2011 to market shares of Facebook to its clients at a $50 billion valuation, a year before the social network went public at about $100
But many of the earlier SPVs bought shares from employees or early investors. Startups such as Uber Technologies Inc. have attempted to prevent the trading of so-called secondary shares, and regulators have tried to crack down on a market of middlemen trying to buy such stock and reap big fees.
The newer breed of SPVs involves primary shares issued by the companies, which are giving express permission to invest.
Since its site launched in 2010, Pinterest has raised more than $1 billion, much of that through SPVs. Besides FirstMark, another earlier Pinterest backer, Andreessen Horowitz, recently arranged its own special fund, people familiar with the matter said.
The firm shopped the fund to its limited partners and “friends and family,” said one of these people, and waved its management fee and charged a 15% carry, smaller than what it normally takes from its main funds. A regulatory filing from Andreessen Horowitz for a fund called PinAH LP disclosed it raised $37 million in mid-March.
A spokeswoman for Andreessen Horowitz declined to comment on the funding round.
Last year, SV Angel, the seed-stage fund headed by San Francisco financier Ron Conway, led a $200 million round in Pinterest at a $5 billion valuation.
Other companies have turned to SPVs for large sums of capital in recent months.
Data analytics provider Palantir Technologies Inc., which was valued at $15 billion last September, turned to an SPV arranged by Founders Fund, a San Francisco firm headed by billionaire investors Peter Thiel, according to people familiar with the deal. In March, ride-sharing service Lyft Inc. included an SPV of more than $10 million from GSV Capital for its $530 million round that valued it at $2.5 billion, a person familiar with the matter said.


Post a Comment