Given the continued and growing interest in special purpose vehicles (“SPVs”) as a means of accessing private market investments, we are publishing a series of posts that examine different aspects of these structures. This is our second post in the series exploring how a single-investment SPV can be structured to obtain the economic exposure investors seek.
As discussed in our introductory post, an SPV’s primary function is to provide investors with economic exposure to a private company without those investors holding the company’s securities directly. An SPV may accomplish this objective by (1) acquiring securities issued by the underlying company, (2) obtaining indirect exposure through contractual arrangements with securityholders of the underlying company, or (3) creating synthetic exposure through derivative instruments referencing the underlying company’s share price or performance with no involvement by the company.
In our prior post, we introduced a fictional private company, TechCo. An SPV sponsor evaluating how to structure a TechCo SPV has several available alternatives depending on a range of factors, including TechCo’s stage of development, its willingness to approve secondary transfers, the sophistication and investment objectives of prospective investors and the extent to which investors seek actual ownership rather than purely economic exposure.
Direct Ownership of Common Stock
At one end of the spectrum, the SPV may directly own common stock of the underlying company. In that circumstance, the SPV itself may appear on the company’s capitalization table as the record holder subject to the transfer restrictions, voting arrangements and contractual obligations that apply to the securities. However, the rights associated with the SPV’s direct ownership of the common stock may vary substantially from those of other holders. The underlying company may or may not formally recognize the SPV as the legal owner of the shares. Additionally, the SPV may or may not possess direct contractual rights under the company’s investor agreements.
Shares held by an SPV are often subject to vesting provisions, repurchase rights or contractual transfer restrictions. For example, an SPV that acquires common stock from a former employee may receive only economic ownership of the shares without obtaining governance, information or registration rights available to larger institutional investors. If the transfer was not properly approved or documented, the company may decline to recognize the transfer.
Accordingly, SPV sponsors conduct diligence regarding capitalization records, stock powers, transfer approvals, securities law compliance and the applicability of transfer restrictions under company agreements. Sponsors also often seek legal opinions concerning title, authority and enforceability in order to reduce the risk of subsequent ownership disputes.
Preferred Stock and Associated Rights
In other transactions, an SPV may acquire preferred stock. Preferred stock frequently carries a liquidation preference, anti-dilution protections, dividend rights, information rights, voting rights, consent rights and participation rights in future financings. Whether the SPV actually receives the benefit of those rights depends on both the structure of the transaction and the company’s agreements. In many venture-backed companies, preferred holders are parties to agreements modeled on NVCA forms, including investor rights agreements, voting agreements and rights of first refusal and co-sale agreements. Those agreements typically provide significant rights but they also frequently restrict transfers and limit the ability of transferees to succeed automatically to the transferor’s rights.
As a result, an SPV may acquire preferred stock economically while receiving only some, or potentially none, of the associated contractual rights. The SPV may not even become a party to the investor rights agreement. As a consequence, information rights may not transfer automatically and anti-dilution protections may terminate on transfer. Board observer rights may also disappear entirely. Consent rights may remain with the original investor or cease to apply after the shares are transferred.
The transfer process itself may also be restricted. Contractual transfer limitations are frequently imposed through organizational documents and stockholder agreements modeled on NVCA forms. Those agreements often include rights of first refusal, co-sale rights, repurchase rights, drag-along provisions and investor consent requirements. Larger investors may negotiate additional transfer limitations through side letters, management rights letters or stockholder agreements.
These restrictions reflect several concerns. Companies seek to maintain control over their capitalization, preserve confidentiality, manage securities law considerations and prevent governance rights from becoming fragmented. Existing investors may similarly seek to prevent unknown third parties from obtaining voting influence or access to sensitive company information.
Options, Forwards and Other Contractual Exposure
In other structures, the SPV may not hold company-issued securities at all. For example, the SPV may enter into a prepaid forward arrangement, an option agreement, a total return swap or another derivative instrument referencing the economic return associated with TechCo stock over the term of the arrangement. The SPV will never become a stockholder of TechCo.
An SPV holding a derivative contract is not a holder of record, does not appear on the company’s capitalization table, does not possess voting rights and may have no contractual relationship with the company. Instead, the SPV’s rights depend on the enforceability of the derivatives contract and the creditworthiness of the counterparty. These structures have become increasingly common as private companies have sought to restrict direct secondary transfers to SPVs. However, a company’s governing agreements may define transfers broadly enough to capture indirect arrangements, synthetic exposure structures or changes in beneficial ownership. Accordingly, SPV sponsors and counterparties must carefully diligence the company’s organizational documents and stockholder agreements before implementing any such structure.
Proceed with Caution
Two SPVs marketed as offering exposure to the same company may provide materially different rights, risks and economics depending on whether the vehicle holds common stock, preferred stock with governance rights, stripped-down economic interests, options or forwards or purely synthetic derivative exposure. For that reason, the threshold diligence issue in any SPV investment is often not simply identifying the company referenced by the SPV but determining what the vehicle actually owns and what rights, if any, accompany that ownership.