Peter Adams, "Angel Investing is Not as Risky as You Think"
It’s a common misconception that angel investing and venture capital is extremely risky.
But when best practices for investing are followed, tax breaks and portfolio returns can consistently outpace even the best mutual funds. If you’re wondering how this can be true – read on!
Angel investing involves capital investments by accredited investors(people with a net worth of $1 million or more excluding the value of their primary residence, or with income of $200,000 or more per year/ $300,000 for a married couple). These investments are in startups, usually with less than $1 million in revenue and less than five years old. These startups have high growth potential and angel investors look to invest in companies that have a believable plan to be able to return 10X their investment or more within five years.
Yes, some of these companies will fail, but let’s compare two investors. The first one, Freddy Frugal, invests all of his money in mutual funds yielding a healthy 8% return. The second one, Andy Angel, invests his money in ten startups. Both investors hold their investments for five years. Let’s look at their returns.
Freddy’s returns are 8%, but he must withdraw $2,640 in the first year, and more each year to pay taxes, so the compounding is based on his after tax returns each year. After Freddy pays his taxes, his actual return is less than 5.93%. Not bad, given the relative lower risk of a mutual fund and the liquidity it provides when funds are needed.
Andy Angel’s returns are a bit more complicated.
First of all, because Andy is investing in a Colorado company he is eligible for state investment tax credits of 25%. (many other states have similar credit programs) This means that he gets $25,000 back immediately from the state government, so he actually has only $75,000 of his capital at risk. We’ve shown this below by adding the $25,000 cash returned by the state to the value of his portfolio.
Also, Andy’s returns for his portfolio match the HALO report of thousands of Angel investing deals reported, so in the second, third and fourth years one company totally fails each year, resulting in a complete loss of investment and another is liquidated and returns $.50 on the dollar. This results in a tax loss of $15,000 each year which he can take accelerated write offs against ordinary income thanks to IRS Code Section 1244. This results in a cash benefit to Andy each of these years in the form of reduced taxes which we’ve calculated at $4,500 per year.
In the fifth year, the remaining four companies have exits ranging between four and ten times the initial investment amount, resulting in a $295,000 positive cash flow. Because Andy made equity investments in early stage C-Corporate startups and held the investment for five years, he is entitled to a 100% long term capital gains tax exemption thanks to IRS Code Section 1202, so his tax bill for that year is zero.
There is a lot of mythology about how many startups fail on average.
So, how risky was Andy’s Investment?
The statistics about how many startups fail on average can be deceiving. Many of those statistics come from the SBA or local Secretaries of State who report failures of hair salons, restaurants and lawn mowing services along with other companies. But, companies that receive venture capital investment have to reach a higher bar than just registering with the state. They need to have gained significant traction and have gone through a lot of due diligence and had to jump the hurdle of convincing dozens of angel investors to write a check. These companies are far less likely to fail than the general population of company formations. In fact, HALOreport data shows that about 52% of these companies will return less than $1.00 for each dollar invested. Of that 52%, about 18% will be complete failures. So, we’ve been a little hard on Andy Angel and had him with three total losses and three returns of less than a dollar. On the upside, we’ve also been a bit conservative. About 5% of venture backed startups will return 30X or greater, and there’s a good distribution of returns between 10X and 4X. These winners more than pay for the losers.
Andy’s key to success was that he diversified his portfolio into ten investments. Smart angel investors know the value of spreading out the risk so that the winners can more than offset the losers.
Another point to observe is that we’ve valued Andy’s portfolio at the value of the investment only until the returns came in. Despite that conservative accounting, he barely dipped below his $100,000 investment amount in year four with a portfolio value of $93,500. This means that if the four remaining companies had returned only 1X, his loss would have been limited to $6,500.
But, his returns were a more typical 3X over the portfolio, resulting in a return of $295,000. We can add in the $25,000 state tax credit and his $13,500 in accelerated write-offs from the $45,000 loss, and his net cash return AFTER TAX is $333,500.
Andy was hardly more at risk than Freddy, and yet the internal rate of return on his investment was more than FIVE TIMES GREATER.
So, who is the smarter investor? Freddy Frugal with a 5.93% after tax return or Andy Angel with his 31.8% return and $333,500 in cash after five years? Angel investors have figured out how the system works and have been profiting handsomely from it for some time. Accredited Investors should consider contacting their local angel group, preferably groups that are members of the Angel Capital Association, like Rockies Venture Club, and consider membership so that they can benefit from great deal flow, a community of smart investors, group negotiation and high quality due diligence.
Visit www.rockiesventureclub.org to learn more.