How to Pool Money to Invest in Startups

Back in 2017, after a decade of advising startups as a corporate lawyer, I wanted to invest in one.

I attended angel meetings, asked my network to send me deals, and cold-called VCs asking to see their decks. At founder meetups and tech conferences, usually crawling with advisors and consultants, I introduced myself as an investor and received some of the warmest welcomes of my professional career. It felt good to shake someone’s hand and say: I might give you money.

But I quickly discovered that the more attractive opportunities were looking for cheques for $50,000. Some VC funds wanted $250,000 minimum. I had faked it quite far, but I couldn’t fake this part. Sooner or later, I had to pull the trigger. There were deals – perhaps not my first choice – that would take $20,000, a workable commitment. But that would still leave me with one concentrated bet in one startup.

My solution was to find five friends in the same position. Each of us contributed the same amount and pooled the money through a new entity we created, a limited partnership. That allowed us to come to the table as a single, more credible investor. We even branded the new entity as a micro-VC and built a website. We did not pretend to know how to pick the winners, but our combined capital was enough to get us into most of the deals we were seeing. Better still, instead of placing everything into one lottery ticket, we invested across five startups, including competitive deep-tech financing alongside an established venture capital fund.

That was our first SPV, or special purpose vehicle, and it taught us almost as much about the practical realities of startup investing as the investments themselves.

Since then, we have used – and helped others establish – several different SPV structures for different situations. This article explains what worked, what did not and how a Canadian investor group can choose between a one-time SPV and a more flexible, reusable investment vehicle.

How a Canadian SPV is Usually Structured

Our first SPV used a structure commonly adopted by investment syndicates: a limited partnership, or LP, with a corporate general partner, or GP.

Under this structure, investors contribute capital to the LP and receive limited partnership units. The LP then uses the pooled money to acquire the shares, SAFE, convertible notes or other securities issued by each startup. A separate corporation acts as the GP and manages the LP. The GP, like any corporation, has directors and officers, who sign the investment documents, exercises the SPV’s voting and information rights, deals with amendments and follow-on financings and, eventually, directs the distribution of any proceeds.

The investors participate economically through their LP units, but do not appear separately on a startup’s capitalization table. From the startup’s perspective, there is one investor, one cheque and one point of contact. In the background, the limited partnership agreement of the LP determines how the investors behind the SPV share the costs, risks and returns.

The LP structure can be used for one investment or several. The investors may all contribute equally, as we did with our first portfolio, or the LP can issue different classes or series of units so that different investors participate in different deals and at different amounts.

The core documents typically include the corporate GP’s organizational documents, a limited partnership agreement governing the investors’ rights and obligations, subscription documents for each investor and the closing documents for each underlying startup investment.

Why Use a Corporate General Partner for the Limited Partnership?

A limited partnership must have at least one general partner. The GP manages the partnership and has unlimited liability for the partnership’s obligations.

The limited partners, by contrast, do not run the business directly and are generally liable only for the amounts they have contributed or agreed to contribute, subject to the rules governing limited partner participation in control of the business. Ontario’s Limited Partnerships Act sets out the provincial framework.

For that reason, the GP is usually a corporation rather than an individual. The corporate GP allows the organizers to manage the SPV through a separate legal entity instead of personally assuming the responsibilities and liabilities of the general partner.

The GP has its own directors, officers and annual maintenance requirements, but it can also become reusable infrastructure. The same corporate GP may be able to manage:

• a standing LP that makes several investments;
• separate LPs created for individual deals; or
• a combination of both.

Each LP will still need its own records, accounting and tax filings. Reusing the GP nevertheless avoids incorporating and organizing a new management entity every time the group invests.

Could the SPV be a Corporation instead of a Limited Partnership?

Yes. Instead of creating a Limited Partnership (with a corporate General Partner to manage it), the investors could form a new corporation and subscribe for shares of this corporation, which would then use the proceeds to acquire the startup securities.

A corporate SPV may seem simpler to establish and easier to understand because the group creates one corporation instead of both an LP and a corporate GP. It can work well for a single investment where everyone participates on substantially the same terms.

But that simplicity erodes when the SPV is intended to make several investments and different shareholders want to participate in different deals or invest different amounts. The corporation would need separate classes or series of shares to track the economics of each investment. Under corporate law, the rights, privileges, restrictions and conditions attached to those shares generally need to be established in the corporation’s articles or through properly authorized share-series terms. The corporation will also have by-laws, resolutions, and require a shareholders’ agreement addressing governance, decision-making, transfers and the other relationships among the investors.

The result is that the arrangement may be spread across several documents and must operate within the requirements of the applicable corporate statute. Changes to the structure may require corporate approvals, amendments to the articles or other formal steps. Corporate share classes can also become cumbersome where investors opt for different deals and require separate allocations of expenses, losses and proceeds.

A limited partnership also needs an agreement governing how the vehicle operates. The difference is that the investor-level mechanics and economics can be placed in one document: the limited partnership agreement. The corporate GP of the LP needs only a basic set of articles, by-laws and organizational records.

That contractual flexibility makes an LP more naturally suited to a standing SPV in which investors may participate in different deals, contribute different amounts and join the group over time.

Apart from documentation and mechanics, the tax treatment of a limited partnership SPV versus a corporate SPV is materially different.

A Simple Tax Example

An LP is generally a flow-through vehicle for tax purposes. The partnership calculates its income or loss, but that income or loss is allocated among its partners (the investors) and reported by them. The CRA’s T5013 partnership reporting system is used to report each partner’s share.

Consider ten individuals who each contribute $10,000 to an LP. The LP invests the resulting $100,000 in a Canadian startup.

If the investment is later sold for $1 million, the LP realizes a $900,000 capital gain. But, the LP is not taxed at the entity level. Instead, the gain is allocated among the partners and reported by each of them personally for tax purposes. Assuming each investor has an equal interest, and the LP has no expenses or holdback, each investor receives $100,000 of proceeds and is allocated a $90,000 capital gain that this investor reports on his/her tax return.

Using one-half capital-gains inclusion rate for illustration, $45,000 would ordinarily be included in that investor’s taxable income. However, if the startup shares qualify and the investor has sufficient lifetime capital gains exemption available, the tax otherwise payable on the gain could be eliminated.

The result is different from a corporate SPV. The $900,000 gain belongs to the corporation, not directly to its shareholders. The corporation cannot use the individual shareholders’ lifetime capital gains exemptions, and the shareholders cannot claim those exemptions simply because the corporation later distributes the proceeds.

The corporation must account for the gain under the corporate tax rules and then distribute the remaining proceeds to its shareholders. The capital gains deduction in section 110.6 of the Income Tax Act is available to qualifying individuals, not to an intermediary corporation realizing the gain.

For a recurring syndicate requiring flexible allocations, deal-by-deal participation and flow-through tax treatment, an LP will often be the more natural choice.

What Does an SPV Cost?

The following relates to the costs of a limited partnership SPV.

The cost is not limited to forming the entity. An SPV may remain in existence for a decade or longer, so the group should consider both the initial setup and the expenses that continue throughout the investment.

The initial legal cost should reflect the complexity of the arrangement. Four investors participating equally in one straightforward deal should not require the same infrastructure as a syndicate with dozens of investors, several closings, management fees and carried interest.

Third-party SPV platforms provide a useful reference point. Based on materials we reviewed, platform pricing may include:

• setup fees of approximately $5,000 to $11,000;
• closing or administration fees of approximately 1.5% to 2.5% of the capital raised;
• annual administration charges;
• fees for follow-on investments; and
• carried interest or another share of the investment profits.

Platforms may help with formation, investor onboarding, funds handling, tax reporting and eventual dissolution. They generally do not replace independent legal or tax advice, however, and their standardized structures may not accommodate more flexible arrangements such as a standing LP used for several investments.

Where the platform is built around a separate SPV for each deal, the setup and administration fees may apply again every time the group invests.

For a small and straightforward investor group, the legal setup can be simplified. The GP incorporation, LP registration, core partnership agreement, subscription documents and closing process can be standardized into a fixed-fee formation package, with customization only where the investors, economics or underlying deal require it.

A reusable GP and standard closing package can reduce duplicated work. In appropriate cases, a standing LP can go further by allowing the same group to make several investments without creating a new entity every time.

Three Ways We Have Used LPs to Pool Capital

Over the past decade, we have used LPs in three different ways:

1. a pooled portfolio SPV for multiple deals, where every investor contributed equally and participated in every deal;
2. a single-investment SPV used to meet the minimum investment in a single venture capital fund; and
3. a standing SPV that allows different investors to participate in different deals and invest different amounts.

Each model solved a different problem.

1. An Equal-Commitment Startup Portfolio

Our first SPV was formed approximately ten years ago by five lawyers and accountants who had spent years advising founders and emerging companies but wanted to participate as investors rather than remain solely on the advisory side.

Each person contributed the same amount to an LP with a corporate GP. Over approximately two years, the LP invested across five startups. Because everyone contributed equally to one common pool, each investor received the same exposure to the entire portfolio.

Two investors acted as the directors and officers of the GP. We opened one bank account in the LP’s name, obtained a credit card for expenses and handled the legal, accounting and tax work internally.

The group reviewed each opportunity together and decided by majority vote whether the LP would invest. Because the capital had been committed in advance and everyone held the same economic interest, the group was effectively in or out of every deal together. After the original capital was deployed, the partners made smaller additional contributions to cover ongoing expenses. When decisions needed to be made, such as follow-on investments or whether to sell early (we were offered to be bought out on a recent financing), the group was consulted but the GP dealt with the startups directly as the point of contact.

Approximately ten years later: two investments have been largely written off; one investment has returned the capital invested; one is expected to produce a meaningful exit in the near term; and the final investment may generate a decent return but take several more years. The story of this portfolio SPV is still playing out. We were right about the value of diversification but somewhat naive about how long the investments might need to be held.

2. A Single-Investment SPV

Our second structure was created for one opportunity.

Four investors, some of whom did not know each other that well, wanted to invest in a venture capital fund, but the fund’s minimum subscription was higher than any one person wanted to commit. They formed a new LP, pooled their capital and used the LP solely to acquire the fund interest.

The group reused an existing corporate GP rather than forming a new one. This reduced some of the duplicated setup work while keeping the fund investment and its investors separate from the earlier startup portfolio.

The fund dealt with one subscriber, while the four investors divided the economic exposure among themselves.

The trade-off is that the LP must be maintained for as long as the fund interest remains outstanding. It has its own records, annual tax filings and accounting costs, even during years when very little happens. For this entity, the group uses an external accounting firm to prepare the financial statements of the LP and the tax forms for each limited partner, which is the only major ongoing cost.

This is where the conventional one-investment, one-SPV model makes sense. The investor group came together for one distinct opportunity, the economics are straightforward and the benefit of separation may justify the continuing cost.

3. A Standing, Reusable LP

Our third structure was designed for repeated deal-by-deal investing where we did not know in advance which opportunities the group would pursue, who would participate or how much each person would invest.

No one is required to participate in every investment or contribute the same amount as the others.

One partner might invest $10,000 in one startup and $40,000 in the next. Another might skip the first deal but invest in the second. A third might participate in both at different amounts.

The LP issues a separate class or series of units for each investment. The capital contributions, gains, losses, and distributions from that startup are tracked for the investors holding the corresponding units.

The structure can also accommodate new investors. Someone joining for a later opportunity can be admitted to the LP and subscribe only for the new class or series, without receiving any interest in the existing portfolio.

For now, the LP’s general expenses are divided equally among all partners. That may not be ideal if one investment eventually creates significantly greater legal or accounting costs, but it has kept the administration manageable.

This creates a middle ground between a traditional pooled fund and a new SPV for every deal. Each investor chooses which deal to pursue and how much to commit, while the group continues to invest through one standing vehicle.

There is an administrative hurdle to this one. Every investment must be tracked separately, and accounting becomes more complicated as the portfolio grows. Separate classes or series also do not legally isolate the investments: all of the securities remain assets of the same LP. But, for a small group whose members know and trust one another, the model has worked well and avoided repeatedly forming and maintaining new SPVs for every deal. It also allows our group to approach founders and VCs as a recurring source of pooled capital with an identity and brand, rather than as a loose group of individual investors.

What are Some Key Considerations for the SPV Group to Decide?

As part of setting up the SPV, the group needs to consider a practical process for running it. These points should be addressed in the partnership agreement and reflective of how the group intends to operate in practice.

For a small group of friends, these arrangements do not need to be elaborate. However, the core rules governing control, capital contributions, expenses, economic allocations and distributions should still be documented. Less consequential matters can be left to the GP’s discretion or addressed as they arise.

Self-Administered SPV or Third-Party Platform?

The group can operate the SPV itself with support from its lawyers and accountants or use a platform to handle some of the formation and administration.

A platform can be useful where a larger or unfamiliar investor group is coming together for one deal and the organizers do not want to manage subscriptions, funds collection and long-term administration. Where the platform operates through a registered dealer, such as an exempt market dealer, it may also handle regulated investor onboarding, know-your-client reviews, suitability assessments and verification of the prospectus exemption being relied upon. That provides useful compliance infrastructure, although it does not eliminate the legal, tax and administrative obligations of the SPV and its organizers.

Self-administration may be more attractive where a small group expects to invest together repeatedly; the cost of using a third-party platform may be prohibitive in such a case. The trade-off is that someone within the group must remain responsible for the vehicle long after the initial investment closes.

A straightforward SPV with a small number of Canadian investors, one investment and equal economics may be suitable for a standardized formation process. More specific legal and tax advice becomes important where the SPV will admit investors over time, use multiple classes or series, charge management fees or carried interest, include non-Canadian investors, make cross-border investments or solicit participants beyond a small existing group.

A Brief Securities-Law Caution

An SPV involves a few main securities law considerations.

The partnership units issued to the investors are themselves securities, so each participant must qualify under an available prospectus exemption. In Ontario, that may include the accredited investor exemption or the self-certified investor exemption.

An SPV should not be assumed to create investor eligibility merely by interposing an entity. Depending on the prospectus exemption being relied upon, the startup may require the syndicate to identify its beneficial investors and demonstrate that each of them satisfies the applicable conditions to utilizing a particular prospectus exemption in Canada.

Registration issues may arise as the arrangement becomes more commercial. A small, closed group investing its own capital and making decisions collectively is different from an organizer who regularly sources deals, solicits investors, makes investment decisions for others or charges management fees or carried interest. These activities may trigger registration requirements and should be considered under National Instrument 31-103 and the applicable securities laws. There is no single number of investors or investments that determines when the line has been crossed. The analysis becomes more important as the group grows beyond a small circle and begins to operate like a business.

Putting It All Together

The best structure depends on how the group intends to invest.

For a straightforward Canadian SPV, the legal formation process can often be scoped on a fixed-fee basis to include the corporate GP, LP registration, limited partnership agreement, investor subscription documents and initial closing. Structures involving multiple investments, customized classes or series, carried interest, cross-border participants or ongoing syndication require more tailored advice. Our firm works with startup investors, angel groups and emerging fund managers to structure both single-investment SPVs and reusable investment vehicles.

This article is for general information only and does not constitute legal, tax or investment advice. The appropriate structure depends on the particular investors, proposed activities and investment terms.