The Basics of Angel Investing
Some people prefer the latter because they find it fun. Or they want to hit a home run. And I have no problem with that.
The only publicly traded individual stock I’ve invested in is Berkshire Hathaway, but I do have a little “play money” that I’ve used to invest in small businesses in the startup stages.
I currently have an ownership stake in a small craft brewery in the community in which I used to live in Michigan. I’ve also loaned money to help a small town Minnesota brewery get off the ground. Both are thriving and theyprovide me with plenty of liquid dividends (a.k.a. free beer). Things are going so well, I may be evaluating another brewery investment opportunity in the near future.
While angel investing may not be a focus of the majority of my portfolio, I am, in fact, an angel investor. Today’s guest post comes from Elizabeth Cho-Fertikh, PhD, a cancer biologist with much more experience than me in the realm of angel investing. Enjoy!
The Basics of Angel Investing
If you’ve ever watched an episode of Shark Tank or heard of tech investors of Silicon Valley making it BIG, leaving you wondering ‘how can I get in on that?’, then you were thinking of angel investing, whether you were familiar with this term or not.
So what exactly is angel investing? The term ‘angel investor’ interestingly originates from a time when wealthy individuals, known as Theatre Angels, provided capital to Broadway productions to prevent them from shutting down.
The term expanded to describe those who invested in startups, in general, in the 1970s. Following the market crash & downward tailspin of the economy in 2008, angel investor numbers shot up and now there are approximately 300,000 angel investors in the US according to the Angel Capital Association, the primary industry association (ACA).
As a group, angel investors tend to be highly educated, high net worth individuals who invest capital in startup ventures in exchange for equity or convertible debt in the venture. The hope of garnering significant profit with either the sale or other major liquidity event of the startup is a major goal. And yes, most of you, as Physician on Fire readers, would likely qualify to become angel investors. There’s no test or interview to become one; by virtue of investing in a startup, you instantly become one.
The SEC has defined accredited angel investors as those who satisfy a specified asset/income threshold. Don’t worry, accreditation is typically a self-check process, nothing bureaucratic at all. It’s recommended that startups go through accredited investors as they have the funds to “spare” and not at risk of losing the roof over their heads. (Crowd funders, you might be wondering, have a lower asset/income threshold to meet than accredited angel investors, as defined by the JOBS Act of 2012 that President Obama had signed into law. )
Why Consider Angel Investing?
So why angel invest and how can it help your investment portfolio? People are motivated to angel invest for the scintillating possibility of profiting significantly as well as a host of other reasons. Here are some common ones and how angel investing can become a valuable part of a well-diversified investment portfolio:
1. When done with some understanding of the process and a fair amount of research (due diligence) into a startup, angel investing has historically returned at rates higher than market indices such as the S&P 500. Take a look at the graphic below, which provides a comparative track record over nearly 30 years of returns by asset class. Simply put, angel investing can rocket past traditional investment classes boosting your overall portfolio returns!
If we dig deeper and peel away at an average angel investor’s portfolio, we see how the oft-used baseball analogies hold up: for about every 10 investments, 1-2 yield home runs that more than make up for the approximately 3-4 base hits and 3-4 losses.
According to a 2016 study published by the Angel Resource Institute, angel groups reporting from 1990 – 2016, showed a strikingly consistent trend in returns over the years (see graph below): the median investment was a loss, while the mean has been a 2.5X multiple of the original investment. Approximately 10% of all investments resulted in the 10X-30X+ homerun return on investment (ROI) and netted 85% of all cash returns.
2. A second major draw for angel investing: privately held startup companies are not subject to the price/value fluctuations of publicly traded companies. We’ve recently experienced another market drop with all wondering: have we reached the bottom? When will the market swing back up and by how much?
3. The tax benefits of angel investing tend to fall under the lower, long-term capital gains tax rate as the duration of investments in startups is typically much longer than the one-year holding period needed for the long-term gains tax benefit.
Compare this to the buying and selling of public market stocks in less than a year: capital gains here are subject to the higher, short-term gains taxes which can differ in rates from long-term tax rates by as much as 15%, possibly more. Consult with your accountant as the difference will vary based on income, the capital gains, length of investment holding period, and tax filing status.
Risk and Due Diligence
Now, angel investing is not without its risks. In fact, some 90% of startups are unfortunately bound to fail and average investment holding periods can be 5-7 years or longer. But the sophisticated investor will know to manage these risks and zero in on the remaining 10% of the more promising pool of startups. And there are several ways to de-risk around the remaining choices. Likely each seasoned investor has found on their own personal methods to add to these:
1. There is a positive correlation between the hours spent on due diligence — industry term for the ‘research’ that is conducted into a startup, its founders, the marketplace, etc — and ROI.
A study by the Angel Capital Education Foundation and the Kauffman Foundation for Entrepreneurship revealed a significant, near 6X difference in ROI between high versus low number of hours spent on due diligence. It’s been our experience as well that the greater the due diligence, the higher the likelihood of a satisfying ROI. Up to a point of course. No need for thesis-type research taking years and no guarantees of a home run. You get the picture.
2. With due diligence being so critical and the many criteria that need to be evaluated, even seasoned investors do better when they conduct due diligence as a group. Not many of us have the expertise to single-handedly conduct technical, legal, tax, market, financials, etc. evaluation.
3. One can invest in both the seed stage and later revenue-stage ventures. The former group will come with higher risk as these early-stage startups are just getting their bearings and may not have market traction. But if they eventually succeed, the investment bump will be highest.
The revenue-stage ventures will come with lower risk but less of the potential profit hike. Putting your investment dollars in both baskets is another way to de-risk and diversify your angel investment portfolio.
Getting Started With Angel Investing
So how does one get started, where can one find angel groups, how does one learn the basics of angel investing?
The Angel Capital Association, as mentioned, is a rich resource for those who want to get their feet wet. The Center for Venture Research at the University of New Hampshire is also a helpful, educational resource. Some of the others mentioned in the blog are also chock full of information, such as the Kauffman Foundation and Angel Resource Institute.
As for angel investor groups, there are many in the US and globally. Again, the Angel Capital Association is an excellent place to begin: it has over 400 US groups in their database, plenty to get anyone started.
Many groups hold regular in-person meetings and will have online platforms where startups will upload their material– the ‘deal flow’ — that members can access. Virtual groups, as mentioned, have also entered into the foray such as AngelMD.
Some groups are agnostic to the deal flow they accept & invest in; others may be sector-specific with quite a number focused solely on healthcare deals such as Life Science Angels and AngelMD. Nearly all come with an annual or quarterly membership fee.
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Do you have experience in Angel Investing? How have you performed due diligence? Tell us about your winners and losers in the comments below!