Angel investing sounds like an area of investing that is reserved for millionaires and billionaires. On top of that, it seems much too risky for regular investors. However, it turns out that if you apply the power of diversification and basic business principles, this asset class can be a great addition to your portfolio.
What is Angel Investing?
Every day in America, entrepreneurs have new ideas and are in the process of creating a product or service that they can sell to consumers. Investing in these early stage companies that have the potential for exponential growth is called Angel Investing. Typically, these companies have an idea, a product and potentially revenue. Because they are so early in their lifecycle, they are very risky investments that institutional investors will not fund. This is the niche where angel investors can fill the gap. They get the opportunity to buy a piece of the company at a low valuation. Many of these companies will fail, but those that succeed have tremendous potential to provide a large multiple on the original investment.
For example, Jim has created a new high-tech widget with the potential to capture a large share of a growing market. He started the company, secured a patent, and sold a few to friends and family using his own money. Jim’s plan requires $1,000,000 to carry the company to cash-flow positive. He offers Angel Investors the opportunity to buy into his company at a $4,000,000 valuation. Typically, there are multiple angel investors that each put up $50,000 or more to reach the one-million-dollar target. In industry jargon this would be a pre-money valuation of $4,000,000 and a post-money valuation of $5,000,000 (the value of the company is increased by the amount of money raised). If you invested $100,000 you would own 2% of the company ($100k/$5M).
If all goes well, the company grows rapidly and a year later is valued at $20,000,000. At this point, the company would likely raise funds from venture capital investors, thus diluting your 2% down to 1.5% because new shares would be issued to the venture capital investor. Another year later they get an offer to buy the company for $100,000,000. As a 1.5% owner of the company, you have grown your original $100,000 investment to $1,500,000 for a 1,500% return.
In 2016, The Angel Resource Institute studied 245 completed investments of early stage startups. They found that a large percentage of them fail to ever return investors capital (70%). However, they also found that the distribution of returns over the average 4.5 year hold period ranged from zero up to 30 or more times the original investment.
Obviously, it is advantageous to have stake in the company that provides greater than 30x the original return, but if we could all pick the next Google and Facebook we would have a lot more money than we do now.
Out of curiosity, I plotted the expected returns in a table and found that a diversified investment of $100,000 over the expected historical outcomes of early stage startups would receive a 2.7x multiple on the original investment after 4.5 years. For those of you who like calculating the time value of money, this is an Internal Rate of Return = 24.69%.
|Projected Returns from a Diversified Angel Portfolio|
|Capital Invested||$100,000||Expected Return|
|Internal Rate of Return||24.69%|
This was a surprise to me. I invest in many real estate deals where the expected IRR is less than 20%, but often these are concentrated in one asset class and sometimes in one set of buildings in a specific city. If I can achieve a higher expected return by investing in a diversified group of startups, it seems logical that I should consider allocating a portion of my portfolio to this asset class. Plus, this performance is likely to be highly uncorrelated with your other investments which provides additional safety to your overall portfolio.
Criteria for Investing in Startups
The next logical question is to determine what type of startups to invest in. I came to the conclusion that I wanted to invest into early stage companies that have a business model I can understand, a CEO I trust, have very high growth potential, that are scalable and have a strong competitive advantage.
Business Model: Use some basic business sense when evaluating these companies. If there isn’t a market for the product or the market is way too small, they will likely not be able to rapidly grow the company. If the product does not have a path to being profitable, this is not going to be a good company in which to invest.
Founder/CEO: The leader of the company will be a critical piece of the company’s success or failure. You want a leader who can grow the company, who is truly planning to sell the company, who can court investors and has a good track record. Having a CEO you trust is a huge part of the evaluation process as the company will rise or fall based on their abilities in the early stages.
High Growth Potential: Without a high ceiling for growth, you will never have a startup that falls into the 10-30x or 30x+ buckets. According to the Angel Resource Institute, those exits greater than 5x, represented only 10% of companies, but generate 85% of the return. To be successful as an angel investor, you need to maximize your chances of having a high multiple return. A company that projects to grow at 5% per year would not fit the criteria. In addition, the valuation of the company to invest in is important because it is a lot easier to 10x a 1-million-dollar company than a 50-million-dollar company. Pay attention to the valuation of the company when you invest.
Scalable: The company also must have the ability to scale. While fast growth can grow a company from 1 to 2 million in value, it will be much harder to scale up to a 10 or 100-million-dollar business. Often the companies that are successful in scaling up are technology companies because the marginal cost of adding another user is much lower than the marginal revenue that will be achieved.
Competitive Advantage: Last, you want to find a company that has a product or software that is either protected by a patent or by some other logical barrier to entry. If your company has a great idea and proves that there is a market for it, what is to stop a big player from copying the idea and putting you out of business? Without this, you would be very hesitant to invest in a company, even if some of the other criteria are met.
There are a few tax reasons to consider investing a portion of your portfolio into a diversified portfolio of early stage companies. First, you can potentially shield up to $10m in gains or 10 times your investment from federal taxes under Section 1202 of the Internal Revenue Code. Consult your tax adviser for more information on Section 1202.
Even without the section 1202 gains rules, your returns in a startup will be treated as long-term capital gains which are taxed at a preferential rate. Also, you can hold title to your shares in a self-directed IRA which provides additional tax benefits.
How to get started
A general rule of thumb is to hold no more than 10% of your net worth in this asset class. Also, you will want to invest in a diversified portfolio of several startups and not put all your eggs into one company. With a 70% chance of failure, you do not want to concentrate all your holdings into one company.
Often the initial minimum investment is $50,000. One way around this is to create an LLC with a few friends and invest into startups as a group. This provides the ability to meet the $50k minimums while providing all of you a more diversified portfolio. For example, if 5 friends put $100k each into the LLC, you could invest in 10 different companies at $50k each with only $100k of capital required of each investor. This provides a way to gain exposure to a wider variety of companies and this LLC can be funded through your self-directed IRA
A diversified holding of startups can provide a non-correlated asset class to your overall portfolio. The high expected returns and tax advantages provide a reason to at least consider why startups are not a part of your current portfolio. Overall, this is an important asset class that is often overlooked by traditional investors.
Peter Amico, PhD
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