3 Reasons Why Accredited Investors Should Invest in Startups Today
The following post, written by CEO Charles Stack, originally appeared on Crowdfund Insider on November 26th, 2013. All photos are credited to Crowdfund Insider.
Angel investing involves accredited investors (millionaires) investing directly in the private stock of early stage companies. Millionaires are rare—they make up 1.5% of the world and 4% of the US. As most entrepreneurs quickly learn, angels are very, very rare. Only 3% of all accredited investors enjoy angel status. This is about to change.
The traditional angel model requires the almost serendipitous face-to-face meeting of a millionaire and a young startup entrepreneur (rather like The Prince and the Showgirl or a neutrino in a salt mine). Unless either party is actively and skillfully looking in the right places, these meetings are exceedingly difficult to accomplish. The two disparate groups simply don’t run in the same circles.
Angel groups, pitch nights, demo days, golf outings, and other entrepreneurial gatherings have been created throughout the 20th Century to increase the frequency of investor-entrepreneur collisions. These traditional methods were and are very time consuming, ineffective and inefficient process.
While the Internet has made other previously unlikely interactions efficient (ebay, match.com, Airbnb, etc.) and transformed the economy in the process, angel investing has been stuck in the past century, due to restrictions on advertising stocks and prohibitions on general solicitation. That changed September 23, with the lifting of the 80-year ban on general solicitation as directed by the JOBS Act.
Today, angels and entrepreneurs can perform the match.com version of investment dating. Now is the perfect time for the 97% of accredited investors who do not invest in early-stage startups to become angel investors.
Why bother you ask?
I’ll give you three reasons.
The financial returns on angel investing can be superior – particularly as part of an overall asset allocation strategy. The target return for most VC firms is 20% IRR, although the average actual returns are historically closer to 15%. Still, in an age of 1% interest rates, double-digit returns can be very enticing.
Modern portfolio theory posits that superior returns are more likely when you invest in different, uncorrelated asset classes. Without jumping further into the theoretical deep end of asset allocation, let me summarize by way of example. Some of the best financial returns in the past 30 years have been enjoyed by Ivy League University endowments: Yale, Princeton and Harvard. Since the mid-1980s these endowments have moved from investing in two asset classes (publicly traded stocks and bonds) into investments in numerous categories of ‘Alternative Investments’ like real estate, private equity and venture capital.
Spreading investments across multiple asset classes increases overall returns and decreases volatility because asset values move somewhat independently. Most of these alternative asset classes have historically been difficult for individuals to access. But the recent changes permitting general solicitation have made venture investing in early stage companies much more readily available. People way smarter than me (the people running the $30 billion Harvard University Endowment) allocate their money across a wide range of asset types. They now typically invest 10-15% in private equities like startups. So should you.
2. Tax Incentives
In addition to the possibility of superior returns there are also significant tax incentives at the Federal and often State levels for investors in startups. At the Federal level, capital gains from the sale of Qualified Small Business Stock (QSBS §1202) can be completely free from taxation. Most small business stock ‘qualifies’ but the timing of purchase and sale can affect the benefit.
Many states provide similar tax advantages. This is a complex and shifting space so you should consult a tax professional.
3. Angel investing is fun
Although it may seem ‘un-financial’ to mention the fun component, most angel investors find the process of betting on new ideas and new entrepreneurs to be quite enjoyable. Many angel investors were once entrepreneurs themselves and transitioning to angel investing is much like moving from parent to grandparent. Angel investors, like grandparents, get most of the joy without the day-to-day grind that comes with parenting their own company. Angels swoop in periodically to get updates, feel proud and later show off their photographs.
There is a great German phrase schadenfreude that means ‘joy in the misfortune of others’. There is a less well-known (possibly used here for the first time) German phrase mitfreude that means ‘joy in the success of others’. Angel investing provides the opportunity for experiencing mitfreude. There can be great joy in pointing to the latest and greatest new Internet sensation and saying, “I invested in that company when it was just 2 people and an idea.”
One key to angel investing is investing in multiple startups, simply because, while the returns can be high, the failure rates are also high. Spreading your risk across multiple startups is highly recommended. This can be accomplished by joining an angel group that invests together across multiple opportunities, or by participating in new platforms like Gust, AngelList or Flashstarts that provide different ways of spreading a single investment across multiple opportunities. (Full Disclosure: I am the CEO and co-founder of Flashstarts, and a member of Gust and AngelList).
Joining an angel group is another great way to experience the benefits of startup investing. If you are interested in joining an established angel group, the Angel Capital Association has anextensive list of groups around the world. If you are interested in learning more, here is an excellent introduction from MIT (PPT).
One final point. Embrace failure. Embrace your role as angel. Forgive, learn and move on to the next opportunity. Successful angels generally make many small bets. Time, circumstance and luck play a major role in the success or failure of a startup. Numerous entrepreneurs that I have bet on failed their first time, but succeeded wildly the second or even third time. Like angels, good entrepreneurs are rare – we need to nurture and cultivate them.