New(ish) Investor: “My group wants me to set up the SPV myself” or “We have an attorney who will set up the LLC pro bono.”
Us: “And who is going to manage it until it liquidates in ten years?”
Investor: “Me, I guess.… That’s not much work, right?”
In angel investing, it is often said that making the investment is easy; the hard part is getting your money back. The same is true about using an SPV (or “syndicate”) for your group’s investment: forming the LLC and closing the deal is the easy part. Most investors are so focused on getting the deal done that they forget to consider what happens next. In our experience, it’s the management over the next five or ten years that can be surprisingly hard.
What’s so hard about it? We have assembled a list of just a few of the things you need to think about if you are going to administer a syndicate:
Members change. Investors have this propensity to change titles. They get married, divorced, and sometimes die. They put their interest into or out of a living trust. They gift their interest either while living or at death to others. The interest was separate property when they made the investment, but now they want it to be community property or joint tenants with right of survivorship. They also move and change last names, phone numbers and email addresses—often forgetting to let you know. You get the picture: a large part of administering syndicates is administering the membership.
Tax laws change. We recently went through a significant change in the way partnerships (which is how LLCs are usually taxed) must be managed for Federal tax purposes. The Bipartisan Budget Act of 2015 (aka BBA) made changes to partnership audit rules and to what was formerly known as the Tax Matters Partner (TMP) effective for all LLCs for the tax year ending December 31, 2018. Some LLCs now have an option as to whether any audit adjustments are imposed at the partnership level or the individual member level. The old TMP is now the Partnership Representative with significantly different responsibilities. Our accountants and attorneys tell us we need to amend our clients’ existing Operating Agreements to account for these changes. Likely this will not be the last time the tax or other laws pertaining to LLCs change during the life of a syndicate.
Convertible notes convert. If there is accrued interest when the note you invested in converts to equity, this creates a taxable event to the LLC. We find a surprising number of companies fail to issue a 1099 for that interest, but this does not excuse your syndicate from reporting the accrued interest as taxable income. You need to be sure your books are set up to accrue that interest so you can meet your tax reporting obligations even if the underlying company does not.
Investment opportunities come and go. It’s highly likely the company in which your syndicate invested will have a subsequent offering(s). If you have participation or other rights, or must pay to play, you will need to work with the investors in the syndicate to figure out what the syndicate will do. If additional cash is needed, you can assume not all investors will be interested in or able to participate (see Capital Calls below). Even if your Operating Agreement allows for this contingency, you will have to get approval from all the investors and may have to change the sharing ratios. If your Operating Agreement does not allow for this contingency, the syndicate may have to walk away from a valuable opportunity. Either way the administrator is on the hot seat to alert the investors and implement what they want to do.
Capital Calls. Oh, the fun of capital calls! If you get into the position of requiring capital calls to meet expenses or fund a follow-on investment, sooner or later one of the members will fail to meet the call. It’s frustrating, time-consuming and expensive to chase people down. If the investment is languishing some investors may figure it’s better to cut their losses rather than to continue to feed the kitty. But your expenses will still have to be paid and obligations to the other investors must be met.
Reports and questions. Syndicates can go on for a long time. Your investors will expect to periodically know what’s going on with the underlying investments. You will need a system to keep them informed, and periodically you can expect individual investors to raise questions someone will need to answer. For example, if someone dies, expect estate administrators/heirs/attorneys/accountants to ask for help in valuing their interest in the syndicate.
Beware retirement plans. Many people prefer to invest through a self-directed IRA. In addition to extra forms and information required during formation, you can expect the retirement plan administrator to periodically ask for confirmation and/or valuation of the holding.
Zombies. It’s likely one or more of your syndicates will end up holding an investment that will not exit and will not die. This can result in a host of problems, not the least of which includes investors ghosting you as they lose interest (especially at capital call time). Conducting operations such as filing tax returns and renewing the LLC every year for an investment with little hope can be a drag on you personally and financially if you’re the one left with the responsibility.
Money changes everything. Sometimes you have an exit with a positive return, and sometimes it’s a significant positive return. Once the celebration dies down, all those syndicate members who couldn’t remember to update their address will suddenly want access to the books and records and have their voices heard about how the funds get distributed. As the administrator, everything you have done up to this point will be scrutinized.
If you are planning to use a syndicate for your group investment, think carefully about the long-term position you will be in if you agree to be the syndicate administrator, especially if you are not being compensated (which is the subject of another of our blog posts). Make sure you are prepared to handle these issues which will come up over the life of the syndicate. Or of course, you could hire a professional administrator like Loon Creek Capital who has not only the expertise but the staying power to take care of your syndicate throughout its life.
Loon Creek specializes in syndicate formation and management services for private investors (and for the companies in which they invest). You can learn more about our services on our website.