You got that itch to invest in some early stage companies. Maybe a former colleague founded a company and you know they’re Super Smart and their idea is So Good. Or you just love the cause that this one company is supporting.
But also, $25,000 (or more) is a lot of money to just hand over to this One Company that is, let’s review, in a very early stage. How do you evaluate this choice?
I know many of our clients have at least expressed interest. A handful have actually made investments.
And most of them <cough> yes, I’m lookin’ at you <cough> have even sought out our thoughts on the idea before investing the money.
Angel investing is investing in early-stage, privately owned companies. You know, that stage when no one has any real clue whether or not this thing is even going to last a year, let alone be wildly successful? (What company founders do probably have, however, is lots of confident sounding opinions and projections.)
Here is what I know about private-company—especially early stage—investing.
Own the winners. DUH. (AKA, the Challenge of (No) Diversification.)
Much like in public-market investing (the kind you get when you buy an S&P 500 fund), most of the returns come from very few of the investments. Like, 10%ish of the companies generate all the returns.
We can easily see this in the public markets. If you didn’t own Netflix or, surprisingly, Domino’s Freaking Pizza in the 2010s, you got way less return than “the market.”
This means we have to own those 10% winners.
How do we solve this in the public market? Diversification! Whoo! We own everything, so by gum we own that 10%.
[As an aside, mutual funds and ETFs have been such a blessing to individual investors. Before them, you simply couldn’t get diversification in a simple, low-cost way. It was either complicated (keep track of your stock ownership in 200 different companies!) or expensive (hire a stock broker to do it for you!). And sometimes both. With funds, you can pay almost nothing to own a part of literally every publicly traded company in this country. Isn’t that amazing?]
How do we solve this in the private market? Ooooh, mmm…that’s a little harder.
I recommend you tune into an interview with well-respected investor Meb Faber on Morningstar’s “The Long View” podcast, in which he talks about investing. (Yes, you’ll probably find it boring. But if you can’t bring yourself to listen to an experienced investor talking for 30 minutes about something directly relevant, do you think you are well positioned to risk $10ks or $100ks of your money?)
He addresses most public market stuff and, at minute 56, he starts talking about private-market investing. The TLDR is that he invests in private companies…and he invests in hundreds of them. And venture capitalists invest in hundreds of them.
Even they—professional investors who spend their entire career and receive specialized training dedicated to this topic—can’t figure out ahead of time which companies are in the 10% that will bring them the Big Money. (I sure as hell know I can’t predict the future of any company, public or private.)
One perhaps extreme-sounding reason that diversification is important? Fraud. Private companies are a lot less transparent than public companies are required to be. I don’t want all your money ending up in a company that maybe won’t succeed…and fraud is a guh-REAT way of not succeeding.
If this sounds impossible to you, I encourage you to listen to a recent Equity podcast episode, in which they recount stories from several private companies committing fraud of one stripe or another. If you think this couldn’t happen to you because you know the founder or truly believe in the company…I ask you: Do you think the investors in Theranos would have done so had they thought there was fraud going on? And yet there was.
So, if you’re investing in only one (or hell, only 10 or 20) early stage companies, you have very little diversification and are, sadly, very likely to not get one of the Big Ones. And furthermore therefore likely to lose much or all of your money.
I Can’t Invest in 100 Early Stage Startups. Does That Mean I Shouldn’t Invest At All?
Is this me saying “Don’t do it!”?
No, it isn’t.
There are reasonable reasons to invest beyond “I’m totally gonna strike it rich”:
- You believe in the company or cause and really want to support it. An almost philanthropic attitude.
- You want the thrill of early-stage investing. Knowing that it could be 10x or 100x is exciting.
How to Invest “Safely” in Early-Stage Companies
(Ha ha! Pretty sure I just gave my Compliance consultant a heart attack with that heading.)
Even if you can acknowledge that you likely won’t get your money back, or better yet, even though you do acknowledge that (because if you’re not acknowledging that very real risk, you have no place investing your money in this way)…
Okay, let’s start over:
After you acknowledge that you likely won’t get your money back, you can still make a plan that will enable you to do angel investing while still protecting your finances. This boils down to:
Don’t invest money you can’t afford to lose.
Pretend you had a suitcase with $25,000 cash in it. Light it on fire à la Angela Bassett in “Waiting to Exhale” (minus the jerk husband).
As you sit there, watching your money turn to ash…are you worried that you might not be able to live the life you want? Are you worried that you’ll have to push off achieving some of the goals that you hold so dear?
Then Don’t Invest The Money.
If your response is, “Mmmmph. That’d suck and all, but I’m still on track.” then great! That means you’re more a candidate for this (repeat it with me) Highly Risky Form of Investing.
% of Net Worth
The above consideration is kinda squishy. You could do some projections, calculate your savings rate, etc. to bring some structure to it.
But if you want a rule of thumb measurement, use this:
How much are you planning to invest? What percentage of your liquid net worth (basically, all your cash + all your investments, not including home equity or the value of your car or anything else you couldn’t use to buy bananas tomorrow) does this represent? Though rules of thumb aren’t remotely personal:
If the investment represents > 5% of your liquid net worth, I lean towards “That is a bad idea.”
If the number is < 5%, well, then, that’s generally not a big enough part of your wealth that it could meaningfully hurt you if it goes awry. (Evidently I have no advice if it’s exactly 5%.) Of course, I have no idea about you and your finances, which is why this is a rule of thumb and not advice!
If you were my client, and you started making a habit of this sort of investing, you could definitely expect to hear me pipe up (“Um, Jane? Yes, darling, we need to talk…”).
Technical Considerations If You Do Invest
If you’ve read through all of this—and honestly probably much more—and have concluded that angel investing is right for you, then I will leave you with a couple of technical considerations that can make this choice even better for you:
Qualified Small Business Stock (QSBS). QSBS is simply startling. At its simplest, a company is a “Qualified Small Business” if its assets are under $50M. If you invest/buy stock at that stage and hold the stock for at least 5 years, then any gains in that stock are exempt from federal capital gains tax (up to a really high number).
Imagine you had a gain of $1M from an early-stage investment. You’d save possibly $238,000 in taxes under current tax law. (That’s 23.8%: 20% long-term capital gains tax + 3.8% Net Investment Income tax.) (This Investopedia article gives more details about QSBS requirements.)
If you’re investing early stage, then it’s likely the company will be a Qualified Small Business. Often companies don’t offer up any QSBS information. And you’ll need that if you want to eventually claim the stock as QSBS. So, ask the company about this and get whatever documentation you can. Oh, and work with a CPA who knows about QSBS.
By the way, there is a chance this tax goodness will be smaller if the House’s tax proposals are passed into law.
Documentation in general. Gather as much documentation as you can about your stock ownership and purchase activity, and also about the company. The company might be an awesome t-shirt or software company, but often these companies know very little about financial…stuff. And it could all come in very handy later on, especially for your taxes, if the stock becomes worth a lot…or worthless!
Let me conclude by saying that:
You absolutely do not need to invest in private companies to build a strong financial life.
In fact, statistically speaking, you’re more likely to worsen your financial situation by doing so. So, please, please, don’t feel FOMO. Or at least don’t act on it.
Boring old low-cost, broadly diversified, public-market investing is a great life choice.
Angel investing is one of a 1000 things you can do with your money. Let’s make sure to secure the core of your finances and then we can talk about “fun stuff.” Schedule a free consultation or send us an email.
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Disclaimer: This article is provided for educational, general information, and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Meg Bartelt, and all rights are reserved. Read the full Disclaimer.