The modern venture capital (VC) fund structure dates back to the 1960s—but VC continues to evolve. A desire to cut the middleman and invest directly spawned the co-investment special purpose vehicle (SPV), which allows investors to make a single investment through a vehicle created for that sole purpose without investing through a fund. But are co-investment SPVs giving you access to quality investments, or are they utilized by fund managers to excess?
To avoid common mistakes made in venture capital, investors should first understand how co-investment SPVs work, the pitfalls to avoid and how to find a quality co-investment.
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 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 middleman, and a 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 at about the same time.
Credit must go to Naval Ravikant, founder of AngelList, for developing a product called “Syndicates” to fill this direct investing desire. These syndicates generally allowed existing individual investors in a company to offer new investors the opportunity to invest in that company’s upcoming financing round. Existing investors could use their right-to-invest, or ‘pro-rata right,’ to let other investors ride their investing coattails via their syndicate.
Each AngelList syndicate invested in one company through an SPV. An SPV is a venture capital “fund” with one investment — subject to all of the SEC regulations governing a traditional venture capital fund. These regulations include:
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.
The recently emerged class of small venture funds, the Micro-VCs, recognized AngelList syndicates’ popularity and began integrating SPVs into their models. Why? Two reasons:
Just as Wall Street took low-documentation mortgage loans to excess almost a generation ago, many small early-stage VC managers 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 AUM to excess by bringing in a pedestrian investment?
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?
Investing in venture capital is all about pattern recognition. After 25 years, nine venture funds, 150+ companies, 10 IPOs and over 100 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 for the hills.
Here are a few things to avoid when you invest in a venture-backed company because the best way to make money is first not to lose it.
1. The performance of the business is a well-kept secret.
This sounds simple, but a mere glance at the syndicates on AngelList will show you that most give little to no information about the company’s actual financial performance. Revenue, gross margin and operating loss are often missing. Why? Because most individuals who post syndicates on AngelList do not have access to this information. Instead, they want you to invest in the company due to its reputation or their personal reputation. Just say no to information-light companies.
2. The financing round is a bridge note to a larger financing round.
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 not just helping the company fill that hole; they are also helping themselves, as a prior investor in the company, to protect the money they already invested. If you invest here and help fill that hole, perhaps that is less they will need 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 a middleman.
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 likely the investment is not ‘in demand’ and thus 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 that lack brand-name institutional capital are often a signal of deeper problems with the company, the market or the entrepreneur. This 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 do we filter for those potentially great investments? Once again, pattern recognition can suggest a few things that most great investments have in common.
1. The company is the clear category winner or a close #2.
Think Uber/Lyft, Open AI/Anthropic or iPhone/Android Phone. 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 25% of the value of the market. Go big or go home.
2. The financing round is led by a top 50 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 $100 million into the company, but the company only wants to take $35 million. 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 right when their fund first deployed its capital. This aligns the interest of the fund and the LP, since they both buy into the company simultaneously. Apply the same rule to venture capital. Invest alongside your partner, not after your partner invests.
5. The company has product-market fit and is growing double or more 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 products that people are buying today.
A 2X growth also suggests they have been selling long enough to work the kinks out and grow even more quickly. Prioritize real products and real growth.
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This article has been updated from the original article, published in Financial Poise in 2021.
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