Special purpose vehicles for SMB acquisitions

When acquiring a small- to medium-sized business (SMB), it’s common for the purchaser to form a special purpose vehicle (SPV) as part of the transaction. In the case of a stock sale, this SPV may purchase the stock from the seller and keep the existing operating entity running. Or, in the case of an asset sale, this SPV may set up a child entity to serve as the operating entity on a go forward basis. 

The benefit of an SPV is to separate the ownership structure and governance from the operating entity, providing parties with minimized legal risk and more streamlined operations. In this post, we’ll dive into SPVs, how they are used, and how much they cost to setup.

What is an SPV?

An SPV is a special purpose vehicle. It’s as simple as that – an entity formed for a specific purpose. The exact purpose can vary greatly:

In the venture capital market, it’s common for a group of investors to form an SPV to consolidate all of the individual checks into a larger investment into a venture company. By consolidating into one vehicle, they can increase their target check size and only occupy one entry on the cap table for the venture company (e.g., founders don’t want hundreds of investors as individual shareholders, so they like when investors pool together into one investment from an SPV).

In the SMB M&A space, it’s common for self-funded searchers and independent sponsors to form SPVs either as part of a roll-up or hold-co strategy or to own the operating entity of a single business.

The SPV will then shield the owners from direct legal and financial risk. It can also simplify the financial reporting for its owners.

What are SPVs used for?

Given the two goals of an SPV – (1) shield from risk, and (2) make it easier to work with investors, special purpose vehicles find lots of use cases.

Aside from the venture industry, special purpose vehicles are a key mechanism for how SPACs operate, where a special purpose vehicle is formed and funded before identify a target to acquire. 

In the real estate industry, a special purpose vehicle is often formed to own each property. Sometimes, there will even be SPVs representing the general partner of a deal as well as the limited partners of a deal.

SPVs can also be used to separate a company’s operating activity from their investing activity. Sometimes, this can lead to dishonest or unethical behavior. The most famous of which is the Enron scandal in 2001.

Enron created over 3,000 SPEs to hide financial risk from investors and regulators. In short, Enron took poor performing assets or placed risky bets and made sure to place those assets or bets in SPVs. Due to how SPVs work, the SPVs Enron created did not flow into Enron’s financial statements. Therefore, Enron was able to hide its poor performing assets and investing activities. Enron crumbled when creditors came for its assets because Enron did not have sufficient funds to meet creditors requirements.

How are SPV’s used in SMB acquisitions?

1. To separate the operating entity from the investing entity. Even in the simplest case, of a single SMB entrepreneur buying a single company as an asset sale, it is common for that entrepreneur to form an SPV to purchase the company. By forming an SPV, that entrepreneur is protected from personal liability during the transaction and has a buffer between themselves and the operating company on an ongoing basis.

2. To protect the holding company or roll-up vehicle from risk on a specific acquisition. As is evident above, it is common for entrepreneurs running a roll-up or hold-co strategy to use SPVs to own separate targets as they are acquired. As you can see, the SPVs shield their sister entities and the parent company from direct liability. Thus, the parent company is protected from claims on one of the operating companies. Similarly, the other “sister” companies would not impacted by litigation or financial difficulties of a specific operating company.

3. To purchase the stock in an stock sale. When working with investors to buy a small business, it’s common for an SPV to be formed to represent the ownership of the acquisition. That SPV will often outline the economics for the different stakeholders as well as the governance rights. This then simplifies transactions like a stock purchase. Rather than raising money and each investor and entrepreneur buying a pro-rata share of the stock, the money is raised in the SPV, which then purchases all of the stock of the seller’s company.

4. As the new operating entity in an asset sale. Lastly, SPVs are formed to operate the seller’s business in an asset sale. Because no stock changes hand in an asset sale, the buyer needs to decie how he or she wants to operate the assets as a going concern. She could decide to be a sole proprietor, effectively purchase the business’s assets personally, or she could set up a SPV solely to operate the assets and goodwill acquired. The latter is most common, as it provides her with a way of mitigating risk with the business.

What type of entities are used for an SPV?

Typically, SPVs are normally formed as a Limited Liability Corporation (LLC) and act as pass-through entities. SPVs do not need to have a physical office space. Given that many SPVs are formed for working with investors, they are filed in Delaware, which is most investors’ preferred state given their well-known and understood corporate law.

When should you form an SPV for an acquisition?

It’s common for searchers to form an SPV during the search. This allows them to enter into contracts on behalf of their entity, rather than individuals. If a transaction then went south, they have at least some protection through their LLC.

For those that do not form an entity during the search phase, they will typically form one after going under contract with the target. This entity will then be the “purchaser” of the company in the transaction documents and will be the entity that raises equity funding from investors and bank funding from SBA lenders.

To form an SPV for your acquisition, you can work with your legal counsel or a platform like Mainshares. We offer LLC and C-Corp formation services as part of our capital raising offerings and can ensure that the SPV is set up in the way expected by investors with the correct management structure (e.g., member-managed vs. manager-managed).

What are the costs of an SPV?

Initial Costs: The all important answer is that it depends on the size of the SPV and the purpose of the SPV. Each of those variables will affect the management fees and regulatory fees (state and federal) needed to pay for the formation of an SPV. 

In addition, if the owner or owners are using an attorney or a third-party service to help with forming an SPV, then the costs associated with that SPV formation may fluctuate.

An SPV formed for an SMB acquisition is typically on the cheaper end (e.g., less than $750 for the entity formation). The investor and governance documents can easily run into five figures, but typically these are not created when the SPV is initially formed and occur later during the financing process.

Ongoing costs: While there are no required ongoing costs besides tax filings and state registration filings, most SPVs have significantly more costs given their reporting and governance requirements to the investors involved.

In the real estate world, it’s common for independent sponsors and managers to use Juniper Square to manage SPVs associated with real estate projects and transactions. In the small business world, Mainshares is designed to support SMB entrepreneurs operating with investors.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.