Wednesday, July 22, 2020

How To Become An Angel Investor (Part 1)

Author: Sam Huleatt

There has never been a better time to explore becoming an angel investor. Angel investing continues to grow in popularity driven by increased access to private market deals (thanks AngelList and co!), greater transparency on how to evaluate companies, and regulatory tailwinds including crowdfunding legislation democratizing and expanding the total addressable market of potential angels.


Investor Accreditation: Very Helpful, Not Always Necessary


Most people assume that to be an angel investor you must be accredited.


What? Yes, according to SEC law, the majority of the population cannot legally angel invest. Instead only people who earn a certain amount of money or have a specific amount of assets qualify. Why is such regulation necessary? Without going into great detail, the answer relates to the perceived risk and susceptibility (to fraud) individuals seen as less sophisticated. I’d suggest Jason Calcanis’ book Angel as a good primer here. The SEC definition of an accredited investor can be found here.


However, assuming you must be accredited in order to invest in private company stock assumes you must invest to own private company stock. We will later describe ways in which non-accredited individuals can still come to be owners (i.e., investors) in private companies.


However, it’s worth knowing that not being accredited places you at an immediate disadvantage in terms of access to the best private deals. As an example, most investing platforms (ex: AngelList) and individual companies (accepting direct investment) will require investors to be accredited.


Why Private Company Equity Is So Valuable


First, let’s reframe the goal of becoming an angel investor to instead be a goal of owning a diversified collection of equity, or equity derivatives, in early-stage private companies with asymmetric upside potential. Let’s consider why equity in private companies has the potential to be so valuable in the first place.


Private company stock can provide asymmetric returns. This means that your upside is effectively uncapped, while your downside is limited.  Angel investors are compensated for the extreme risk they take investing in ideas and people, often before there is a true company vision and/or revenue metrics to produce an accurate valuation. As a result, unlike publicly traded stocks, for relatively small amounts of money you can achieve meaningful ownership levels and your returns can be many multiples of your initial investment. As a shareholder you reap the rewards of potential future successes. Many private companies (especially those who take angel or venture capital) aspire to liquidity events such as acquisitions or IPO which provide richer rewards the lower the basis of your investment. A classic example is Uber. Angel investors who invested $25,000 in Uber back in 2010 would have received $30,000,000 when Uber went public in 2018. There are very few investment opportunities outside owning private company stock that can provide such upside.



With Big Upside, Comes Big Risk


So perhaps now you’re thinking you are a total sucker for investing in public equities and ETFs when you should have been investing in private companies! Not so fast.


Money invested into early-stage private companies is often binary, meaning your equity is often worth zero, potentially a lot. But the odds are stacked against you investing in startups. With angel investing your probability of success is much less than 50/50. In fact, it’s highly likely the majority -- or all -- of your private company equity will ultimately be worth $0. In addition, investments in private companies are illiquid. Unlike stocks, you can’t sell positions on-demand. In fact, it’s quite likely if you see any return at all, it won’t be for 5-10 years after your investment. Doubling your money on an angel investment over 10 years is only a 10% annual return. That’s really not very good considering the risks and opportunity costs. Also, like the stock market, certain investors have major advantages over you that skew the odds in their favor.


If you are still not dissuaded, then there is some good news for aspiring angels. 1/ The most you can lose is your investment basis while still enjoying uncapped upside 2/ your successful investments may qualify for QSBS tax treatment and 3/angel investors often enjoy some additional non-financial benefits.

Ready to get tactical? Read More in Part 2

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