Angel investing mechanics
Natty tries angel investing: Part 2
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Last time, we discussed how venture firms measure themselves, and a bit of the setup for knowing how much money we need to set aside for a diversified angel portfolio. Once you decide that you really want to start putting money into angel investments, unsurprisingly there’s a level deeper that you need to go to really understand what’s going on. So let’s dive in.
Are you eligible to invest?
In order to invest in “exotic” and “complex” assets like venture, you typically need to be an accredited investor. The actual definition is fairly complex, but for the purposes of individuals, this generally boils down to needing to be able to answer “yes” to one of the following criteria:
Your net worth, excluding your primary residence, must be more then $1M
You, personally, have made more than $200K in income in the past two years (through investment gains, W2, whatever), and expect to make more than $200K this year
Between you and your spouse, you’ve made more than $300K in income in the past two years, and expect to make more than $300K this year
If you’re in tech, there’s a good chance you qualify for one of these treatments, but in most cases, you’ll need to provide documentation to prove that you are accredited, so you can’t just lie and claim that you are. This type of stuff is pretty heavily regulated for financial institutions in accordance with KYC (Know-Your-Customer) requirements.
If you get into venture investing, you’ll probably also come across the term Qualified Purchaser, which has more stringent requirements, and is really intended more to cover activities by a fund. It generally won’t be relevant to an individual.
Personally, when I invest, I actually invest through a family trust (as a side note, if you’re married, have kids, live in California, it’s probably a seriously good idea to get a trust written up -- they’re definitely not just for high net-worth folks). The technical term for what I use is a grantor trust, or a revocable, living trust, which is basically just a legal replacement for me investing directly, which insures that my partner is entitled to partial ownership, and makes it a lot easier to deal with distribution of illiquid assets if something were to happen to either of us. For the purposes of investing and taxation, it’s effectively no different than if one of us were investing directly.
Using cash versus retirement funds
It’s not always an option, but when you’re investing through AngelList, and certain investment firms, you may have an option of investing using retirement funds. In many ways, it can be very advantageous to make angel investments using retirement funds, because these are typically going to be very long-term investments, and if you get lucky, you might get hit with a large capital gains bill. Using retirement funds like an IRA can help offset that by deferring tax liability until you eventually withdraw the funds at retirement age. In particular, some firms will allow investors to invest money via self-directed IRAs (SD-IRAs), which are specifically designed to allow holding illiquid and alternative investments (like real estate or art) with a retirement account.
There are pros and cons to either approach. Using cash means you’ll be locking up your money for a long period of time, so you need to be confident that you won’t need that money anytime soon. You ain’t getting it back for 5-10 years. However, one potential upside to investing with cash is that if the startup you invest in is a qualified small business, and you hold onto that stock for more than five years, the gains could be tax free (federally, not necessarily at the state level), due to qualified small business stock treatment. If you invest with an SD-IRA, you’re likely not going to be able to benefit at all from QSBS treatment.
The other thing to be aware of with SD-IRAs is that because they’re a bit out of the normal investment swimlane, you can’t just get an SD-IRA from any major brokerage. You typically have to go to a particular company to set one up, and sometimes the venture fund will partner with a particular SD-IRA provider (for example, AngelList partners with AltoIRA), and dictate that you have to use that provider. It ends up being a little bit of a pain in the butt to transfer funds into them, and there are usually setup fees and transaction fees to enter and exit positions, so it’s a little more cumbersome and costly. But it’s an option, and sometimes a good one!
The workhorses of the venture world: the SPV and the LP
The SPV, or Special Purpose Vehicle, is an investment vehicle commonly used for making venture investments. The concept of a “vehicle” for investment probably sounds a little weird if you’ve never come across the term before, but it’s safe to just think of it as a investment product. A bond, a CD, a stock, a mutual fund, are all different types of investment vehicles. If you start doing any angel investing, you’re going to be seeing this term a lot.
In reality, SPVs are kind of like shell corporations or holding companies. They generally don’t “do” anything, just sit around and own other stuff. In reality, SPVs can be structured in a number of different ways, as LLCs, or LPs. In the context of venture investing, they primarily exist to own stock of privately-held corporations, and are almost always structured as Limited Partnerships.
Limited Partnerships, on their own, also have a handful of defining characteristics. Most notably there are two types of partners in Limited Partnerships: general partners (GPs) and limited partners (LPs -- I realize this is confusing if I use an abbreviation for both Limited Partnerships and Limited Partners, but you can generally assume that when I use LP, I’m referring to an individual partner). General partners are responsible for the day-to-day operation of the partnership, such as communicating with the LPs and the portfolio company, moving money around, and signing documents on behalf of the partnership and the LPs. Limited partners are the investors in the partnership (typically the general partners also have a stake in the partnership). LPs are usually thought of as the “silent” partners. They provide the initial investment, but don’t have any impact on day-to-day operations.
Limited Partnerships are particularly well-suited to venture for a few reasons:
The LPs are protected from lawsuits, and are only responsible and liable only for their own portion of the partnership’s assets. As an LP, you’re not responsible if the GP screws the pooch, legally.
Limited partnerships enable a contractual structure where LPs are passive investors, and you can sit back and let the GP handle all the heavy lifting of making future investments and so on.
Income taxes will pass through to the LPs (taxable gains are reported through an IRS form called the Schedule K-1), so you get taxed on your gains at your personal income tax rate. You don’t get taxed on the partnership’s overall gains, and the partnership doesn’t get taxed on your individual gains. Everybody’s happy.
Angel investing isn’t free
Given the fact that there’s all this setup associated with getting a limited partnership up and running, it hopefully won’t surprise you that angel investing comes at a cost. There’s a whole bunch of legal work that needs to happen at the very outset, and then the general partner has work to do to gather signatures, make investments, maintain relationships with the LPs and portfolio companies, etc. I’ve never managed a fund, so I can’t opine on quite how much work it is, and I imagine that it’s on an individual company basis, it’s not a huge amount of effort, but it’s definitely time.
If you’re familiar with how hedge funds work (or just watch Billions like me), you may have come across the phrase “2 and 20.” This actually refers to the compensation structure of funds, and is pretty much the same as how venture firms work. The 2 refers to a typical management fee structure of 2% of assets under management. If you invest $1000, you’ll pay $20 a year to the firm as a management fee. Since a typical venture fund is going to have roughly a 10-year life, you can anticipate that 20% of what you hand over to the fund as capital is actually going to get used for management fees, and not investments. The 20, on the other hand, refers to the 20% carry (more correctly, carried interest) that gets paid to the general partners as performance-based compensation. Carry is basically like commission for a VC, except that they only start accruing carry once the fund returns what you invested. Effectively, the partners split 20% of the profit on the original investment. You might also see something called a “hurdle rate” (probably not in any AngelList investment, but if you become an LP in a larger fund this might pop up), which specifies the minimum rate of return that the fund has to produce before the partners get any carry. This is a bit of an incentive both for investors who want a guaranteed return, and disincentive for partners to phone it in, and not shoot for the best possible outcome for their LPs.
To take a fairly simple example, let’s say you invested $10,000 into a limited partnership with a 2 and 20 structure and the fund buys equity in one company. Across all of the partners, the partnership has $125,000 in capital, so you end up owning 8% of the partnership. $25,000 of that is set aside as management fees for the life of the 10-year fund (including $2,000 of the capital you contributed), leaving $100K left to invest. The fund invests the $100K in the company via a seed round at a $10M post-money valuation, meaning the fund now owns 1% of the business. Ten years, to the day, later, let’s imagine that the company exits its investment through an acquisition of the company. The company gets bought for $100M, achieving an incredible 10x return on the investment. You don’t, however, get $100K back. You receive your $10K initial investment back in full, and then 80% of the remainder of the proceeds that are due to you. The partnership nets a $900K profit on its $100K initial investment, and since the game is over, begins distributing the $1M in capital that it now has.
$125,000 goes back to the limited partners, of which you receive $10,000 for your initial investment
Of the remaining $875,000, your 8% stake in the partnership amounts to $70,000 of profit, but you also owe 20% carried interest on all of these gains to the partners
After the carry is taken out, you receive $56,000 in profits
Your total take is $66,000 on an initial $10,000 investment
On the other hand, if you’d invested $10,000 directly into the business at the same valuation, you would have owned .01% of the company outright, and the $10M acquisition would have realized a 10x return, netting $100,000 at the acquisition. So the cost of going through the partnership ended up being $34,000. That’s certainly a non-trivial cost, but it’s still a 6.6x gain in 10 years, which is pretty incredible for most investments, and far better than the 2x gain you more likely would have seen from investing in the broader stock market. You can also see the clear lucre of being a successful VC running a syndicate, because that 10x outcome results in a $175,000 payout to them, in one fell swoop.
In reality, AngelList is a little bit cheaper than this, because the setup costs for a fund are typically one-time fees, and are lower than 20% for the life of a fund, but you are definitely still paying 20% carry through AngelList investments, which ends up being the bulk of where the money goes.
If angel investing is so expensive, why not just invest directly in companies?
The biggest problem is deal flow. Good VCs see hundreds of deals per year, probably even per month. Pitches on pitches on pitches. And they have staff -- principals and associates -- who sift through the bad pitches to try to find the gold. I hear about direct investment opportunities sporadically, often through my own network, but not nearly frequently enough to generate a high-quality pipeline of investment opportunities. Also, as much as I have perspectives on certain opportunities in certain spaces, I haven’t spent years honing my ability to sniff out a winning team or spinning space, so it’s hard to say if the direct deals that I see are actually good deals.
And again, investing directly in a company is often more capital intensive. Typical angel checks are around $25,000, with $10,000 being on the very low end of the spectrum. You simply need a lot of capital to generate a diversified portfolio of $25K checks. Also, in a lot of cases, companies actually prefer dealing with partnerships or SPVs for the purpose of handling family-and-friends funding rounds, because it makes it easier to get signatures for future funding rounds and communications. An SPV can stand in for a large number of investors, and give the company the option of having a single name on their cap table, rather than having all of the underlying investors individually on the cap table. It reduces complexity significantly for the business.
Picking stocks versus picking funds
If you’re anything like me, which is to say, I have enough money that I feel comfortable putting some into venture capital, but I lack the millions of dollars of investable capital to be an LP in a serious fund, there are a couple options for how to build a portfolio of angel investments.
Become an LP in a fund that allows small checks: I have a suspicion that we’ll start to see more funds letting in smaller LPs, especially as the government starts to open the floodgates of crowdfunding for venture’s purposes. While there are a number of sites with sketchy-looking deals on the internet, one example of what I’m thinking about here is Alumni Ventures Group, which has a variety of funds (some focused on alumni of specific academic institutions, although AVG doesn’t have an affiliation with any of those schools) with minimum check sizes ranging from $50K to $100K.
Join a syndicate (or seven): The easiest way to find syndicates to join is through AngelList. When you sign up to invest through AngelList, you’ll need to join a syndicate in order to see deals. Technically, you’ll need to apply to join a syndicate, and craft a message to the administrators, though I’ve generally found that these syndicates are happy to accept you. If you consider the fact that more potential LPs means a faster route to filling an allocation in a deal, there’s limited incentive for them to not accept you. The more syndicates you join, the more deal flow you’re likely to have. There are also a number of standalone syndicates out there, such as Jason Calcanis’s “The Syndicate.” These syndicates function very similarly to how an AngelList syndicate functions, but since you’re dealing with a well-known investor, you may see higher-quality (and more consistent) deal flow than what you might get in a randomly-selected AngelList syndicate.
The upside to handing a check over to a fund is that it’s a quick way to get a diversified portfolio over stage and sector, but you sacrifice a lot of control by handing the keys over to a fund manager. This is also generally going to be a more expensive approach, since you’re likely going to pay fund management fees, as well as carry. Syndicates will generally be cheaper to invest through, since there are likely no management fees (although you’ll still pay carry), but you have to be much more comfortable with picking and choosing investments. You’ll also need to do more work to ensure you have substantial high-quality deal flow, but because you’re writing smaller checks as you go, it’s less capital-intensive upfront. There are pros and cons to both approaches (and these are not the only ways you can angel invest). Mix and match, or choose what works best for you!
Next time, we’ll look at the anatomy of a deal and break it down to talk about how you can evaluate a potential opportunity for investment.