Investing in startups

Angel investing—buying stakes in newborn companies—can produce substantial returns, but you’ll have to take on considerable risk to have a shot at those profits. If you’re extremely lucky, you’ll bet on a business like Google or Facebook; if you’re not, you could lose some or all of your investment.

As the startup scene continues to roar back from the financial crisis that began in 2008, angels are opening their checkbooks, hoping to cash in on the latest trends in tech, healthcare, fashion and even manufacturing. In 2014, angels invested $24.1 billion in 73,000 entrepreneurial ventures, approaching the 2007 peak of $26 billion, according to the Center for Venture Research at the University of New Hampshire, which counts 316,000 active angel investors in the U.S.

How risky is angel investing? Some 52 percent of angel deals result in losses because the businesses fail. Of the companies that don’t lose money, only 10 ­percent return angels’ investments more than 10 times over, says Marianne Hudson, executive director of the 13,000-member Angel Capital Association, based in Overland Park, Kansas. And as for Facebook-style success: that’s a lottery-odds long shot.

You can be an angel in the U.S. if you’re an accredited investor, as defined by the Securities and Exchange Commission (see page 28). Angels usually put $10,000 to $50,000 into an early-stage startup, typically after a friends-and-family round, which provides some comfort, Hudson says: “If they can’t get the people who love them to invest, why should you?” (Friends and relatives must also be accredited to participate; the difference is that they rely on their connection to the founders to give them confidence about the company’s prospects.)

Tax laws are designed to encourage angel investors to put money into risky ventures. If the business is set up as a limited-liability corporation and has losses, you can claim a portion on your federal tax return. For a C corporation, IRS Section 1244 allows for the deduction of up to $50,000 per year in losses for investors who are part of the first $1 million in qualified small-business stock, with some other requirements, Hudson says. In addition, the IRS and a few states exempt from taxes capital gains on qualified small businesses, and just over half the states offer some sort of tax credit to angel investors.

One increasingly popular way to make angel investments is through crowdfunding websites, which let you find and fund startups online. The largest of these, AngelList, helped fledgling companies raise $104 million in 2014. Part social network, part capital-introduction service, these sites allow you to screen many new businesses at once and create the diversified startup portfolio that experts recommend.

AngelList members—who join for free but pay 20 percent of any profits to the group—can buy shares in a fund that invests in companies the site lists. They can also follow people who list their investments on the site, paying those lead investors 15 percent of any profits after they make their money back, with another 5 percent going to AngelList. More sophisticated angels can comb through the website’s listings of startups, do their due diligence, and make investments through the site. AngelList counts well-known people like AOL cofounder Steve Case as members; the typical user is an entrepreneur who has sold a company, says Kevin Laws, chief operating officer.

For a startup, the angel-funding round is just one step on the road to growth. Sometime after that round closes, the company’s management typically takes on larger investments from venture-capital funds, followed by several more rounds, delineated alphabetically. If all goes well, each round carries a higher valuation. In a “series A” round, the founders may sell some 25 to 50 percent of the business to the venture capitalists, diluting—but also increasing the value of—their own stake and that of their early investors.

“If you owned 1 percent of the company, with new investors coming, you’ll own less of a bigger company,” says angel investor Alicia Syrett. Investors often have the right to maintain their pro forma percentage ownership by buying more shares in subsequent rounds; angel networks often ask for these rights, she adds.

If you intend to invest a significant amount of time and money in this asset class, you might consider joining a local network or club, such as New York Angels, where Syrett is on the board. The advantage is that the group sees a relatively large number of companies—about 120 a year at Syreet’s club. As a member, you might attend a monthly meeting at which startup founders, perhaps 1 percent of those who apply to the group, present their companies.

If you’re interested in a startup that presents, you can raise your hand to participate in the group’s due diligence research—analyzing the company’s financials, speaking with key customers and vendors, and scrutinizing the competitive landscape. If you write checks to four or five of the companies annually for five years, you’ll wind up with a diversified angel portfolio, Syrett says. If you have less time to spend on angel investing, consider that some groups, including New York Angels, have their own funds in which members can participate.

After a career in hedge funds and private equity, Syrett turned to angel investing full-time four years ago, setting up a vehicle to hold her own investments called Pantegrion Capital. Her portfolio includes stakes in some 25 startups and she sits on a half-dozen advisory boards.

So far, none of her startups has been sold or gone public, the coveted “exits” that angel investors use to harvest profits. That can take three to 10 years. She has learned to be patient, to do her research, and to offer help to the startups in which she invests, making introductions and providing advice.

“The two big things correlated with investment return are the time you spend [researching] the company before investing and the time you spend with them afterward,” Syrett says.

She advises looking carefully at the capital structure of a company—who owns what, and with what rights—before investing. Angels aim to own preferred stock, the most senior type of equity, which comes with the right to receive ­dividends before holders of common stock. Some startups begin by selling convertible debt, which can be converted into preferred stock. Have your lawyer look over the documents to make certain of what rights your stock or convertible debt would carry.

Another lesson from Syrett’s experience: make sure to earmark capital for follow-on investment rounds in the startups you’ve backed. You might need to double or triple the amount you’ve put into a startup as it grows and takes on additional investments, she says. That’s because new investors may need to see existing shareholders put in more money to signal confidence in the startup’s path before they inject their own capital. And if the startup has trouble attracting additional investors, it may have nowhere to turn but the current shareholders.

You should also insist on information rights, which allow you to receive regular updates on how a company is doing, says Scott ­Mollett, an associate at the law firm Baker Botts in Palo Alto, California. Mollett recommends that before investing, you have a frank conversation with the founders about the company’s business, how it has raised money, and how it plans to finance itself in the next year.

Asking tough questions is important. Remember, most startups never become successful enough to pay dividends or to sell for a significant sum. It’s crucial to diversify your angel investments by placing relatively modest bets on a multitude of startups, and to put only a small portion of your net worth into early-stage businesses, Mollett says. “If you invest in only a few companies, you are playing the numbers wrong,” he adds. 

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Who’s an Accredited Investor?

The U.S. Securities and Exchange Commission permits only accredited investors to buy stakes in privately held startups. You fit the definition if you made $200,000 or more for each of the last two years ($300,000 combined for a married couple) and expect to reach this level again this year. Alternatively, you can have a net worth of $1 million, not counting the value of your primary home.
A trust or another entity can be accredited as well if it has assets worth more than $5 million or is owned by accredited investors. The person in charge of an accredited entity has to be “sophisticated,” meaning that he or she is qualified to evaluate the entity’s investments. —C.S.

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Chana Schoenberger is a business journalist who has worked for The Wall Street Journal, Bloomberg News, and Forbes.