Before you invest into any asset class, it’s important to understand the basic drivers behind why this asset class exists, and whether or not it will continue to play an important role in the future.
Without this basic understanding, you may find yourself in a position like the old saying: “If you’re playing a poker game and you look around the table and you can’t tell who the sucker is, the sucker is you.”
As an angel investor, you should intimately understand the dynamics driving the market you’re operating in. Let’s take a few minutes to go over private equity as an asset class.
Advantage #1 – Venture Capital is About Access, Not Stock Picking
Unlike investing into the stock market, investing into startups is about access, not “outsmarting the market.” This is especially the case for smaller investors who don’t have the authority or capital to decide the price of the round.
Anyone in the world can buy Tesla (TSLA) or Facebook (FB), and the fact that anyone can purchase these assets make the returns not as favorable. At any given time, the entire world is buying and selling stocks at a price that’s determined by supply and demand rules. In fact, at any given time 50% of investors (sellers) believe the price is overpriced and 50% of investors (buyers) believe the stock is underpriced. The price at which buyers and sellers converge on is what dictates the current stock price.
Unless you are privy to information that the market is not privy to (which is oftentimes illegal due to insider trading laws), you are simply gambling or betting against the wisdom of the crowd, which is highly inadvisable.
In startups, the price of a round is not calculated by virtue of millions of buyers and sellers. In startups, the price is calculated by a very small number of elite venture capital firms that place bids on a startup’s valuation. Normally, these price points are tailored to target a 100X return from early-stage companies, or a 10X return in later stages.
In other words, the price is derived by figuring out a possible future value and calculate what price may bring a 10X or 100X return for investors. Because there are so few top-tier venture capital firms, the final agreed-upon pricing is relatively favorable and the profits are not bid away by millions of investors as they are in the public market.
Advantage #2 – The Illiquidity Premium
Startup investing is a subset of the larger private equity field, which benefits from what is called an illiquidity premium – the extra return that companies must provide to investors in order to take stock that is not tradeable on a daily basis.
In other words, if I expect to get a 10% return on Facebook stock which I can trade at any time, I must be offered a 10% + X% return in order to invest in a comparable private investment that doesn’t offer me liquidity.
Academics place an illiquidity premium of 2-3% extra return on a yearly basis, which really adds up over time. For example, a $10,000 investment making a 12% return over 20 years will return $96,500, while an investment making a 15% return over 20 years will return $163,700, entirely thanks to the illiquidity premium.
Advantage #3 – Preferred Shares Come with Major Perks
If you thought higher returns and less efficient pricing were the best benefits for startup investors, wait until you hear about preferred shares.
Preferred shares in startups provide a 1X liquidity preference on any capital that you invest into a company. In other words, investors benefit from downside protection in any given startup. Let’s look at how this plays out.
Imagine you have a company that is raising $10 million at a $100 million valuation. Five years later, the company is middling and not showing much process and decides to sell the startup for $20 million, or a 80% lower valuation than your entry price.
If this had happened to a public holding like Facebook (FB) or Tesla (TSLA), your $10,000 investment would return $2,000 or an 80% loss. As a startup investor, your $10,000 investment would return $10,000, as preferred stockholders receive their payout even before the company’s management receives a single dime.
Of course, we don’t invest with the goal of getting our original money back. The goal is to invest and receive a 100X or potentially a 10,000X return. But keeping this in mind, all things being equal, owning preferred shares gives you more downside protection than owning common shares.
Bonus
Venture capital has made some of America’s greatest companies possible, including Apple, Facebook, Google, Intel, Microsoft, Oracle and thousands of others.
In fact, despite being a very small asset class, venture capital has driven a significant amount of net new job creation in the U.S. For this reason, a bipartisan political effort created a special tax code called Section 1202. This code makes startup investments held over 5 years (with some additional provisions) Qualified Small Business Stock (QSBS), which means they are tax free on a federal level.
On top of this, many states, including my home state of New York, have made startup investments tax free on a state level. This can have a huge impact on your bottom line. In my case, these tax breaks decrease my personal capital gains tax from ~32% to 0% on up to $10 million in returns per investment.
As an angel investor, you should consult with an accountant or financial advisor to see if you may be eligible for tax relief under Section 1202’s Qualified Small Business Stock code.
Many of my investments end up returning 1.32X more than a comparable investment in either the private or public market for tax reasons alone. Those outsized returns are one of the things I love most about investing in startups.
It’s also why plenty of angel investors treat it like a full-time job. After all, it takes a lot of legwork to find the best opportunities and to eliminate startups that aren’t up to snuff.
But it doesn’t have to consume countless hours of your time. Our entire team is here to do that legwork for you… so that all you need to do is choose from a portfolio of potential winners to make your decisions.
If you want a closer look at how the process works, check this out. It’s a recording of the latest Private Dealroom meeting, where Neil and the team analyzed three companies with massive upside potential. There’s a lot to learn here – not to mention three startup recommendations you don’t want to miss.
Thank you David, this piece was VERY informative. I’m new to ALL of this and every bit of advice means a lot to me. I am here to learn, there’s certainly lots to digest but I think I found a WINNER with Neil, you and the entire Team of ANGELS+Entrepreneurs Network. Again, thank you all, it’s appreciated.
Neil Patel is a successful entrepreneur and investor who has been active in the startup scene for nearly two decades. Born in London, England, he moved with his family to Orange County, California when he was two years old, where he was surrounded by entrepreneurs and innovators from an early age. Neil is the founder of several companies, including Crazy Egg, Hello Bar, and Quicksprout – companies that established Neil as one of the world’s leading digital marketers. But Neil spends more time these days on the other side of the table – as an angel investor. He has made some unbelievable returns backing early-stage startups. Now, he’s here to teach you to do the same. Neil launched the Angels & Entrepreneurs Network to pull back the curtain on the world of “pre-IPO” investment, because he believes everyone should have access to the same playing field – not just society’s high and mighty.
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Thank you David, this piece was VERY informative. I’m new to ALL of this and every bit of advice means a lot to me. I am here to learn, there’s certainly lots to digest but I think I found a WINNER with Neil, you and the entire Team of ANGELS+Entrepreneurs Network. Again, thank you all, it’s appreciated.
Thank you Phyllis!
Thanks for sharing. Again!
Thank you Florence!