After 10 years, my $60,000 investment in a private gin company finally paid dividends. Initially, given the company was sold for about $49M after expenses and I had invested in the company at a $10M post money valuation, I was thinking I had made a ~3X return ($180,000). Since over time shareholders get diluted with subsequent funding rounds, I thought that was a reasonable assumption.
Well it turns out I didn’t come close. Instead, here’s what I got:
Gross Proceeds: $98,425.88
Federal Withholdings: $0
State Withholdings: $6,523.82
Net Proceeds: $91,902.07
What the hell!? After almost 10 years, with $98,425.88 in gross proceeds, I only made a 64% return on my money (1.64X). Further, I had ZERO liquidity and lost hope for years that I’d ever get my $60,000 back. Doing the math, I only made a 5.1% IRR, barely better than my guaranteed 4.1% 7-year CD that just expired.
So where did all the money go since the company was sold for 5X what I bought in for? Based on an internal document I received, we had to pay a lot of banker, lawyer, escrow, accounting, and general administration fees. We also had to pay severance packages to all the employees (rightfully so) who were made redundant when the parent company took over. But there must be something else I’m missing, which I’ll investigate further.
Despite the missing money, I consider myself LUCKY to get any money back because most startups fail miserably. Before the buyer announced the acquisition, I had already written off the $60,000 because shareholders had never gotten a dividend and the growth target dates kept on getting pushed out.
My concern was the company would turn into one of those zombie companies with just enough growth to maintain EBITDA break even, but never enough growth to become an attractive acquisition target.
When the purchase price was announced, my write-off expectation transformed into greed. And now with the payout, my greed has turned into selfish disappointment.
Why You Should Not Angel Invest
Now that the stock market has gone up every year since 2009 (except for in 2020 so far), everybody thinks they’re investing geniuses. I’ve got so many people asking me whether they should invest in some random, moat-less private business. You just can’t lose if you put money to work, especially if you’re under the age of 35!
This is exactly what I thought in 2007 when I invested $60,000 in the gin company and bought a $715,000 condo in Lake Tahoe. Then the world came to an end.
Here are the reasons why you shouldn’t angel invest:
1) You have ZERO edge. The other day I had sashimi and sake with a Sequoia Capital partner. Sequoia Capital is one of the best VC companies in the industry. It has made billions backing Apple, Google, Oracle, Paypal, YouTube, Yahoo!, and Whatsapp. The partner said Sequoia shoots for a one win, seven loss hit rate. In other words, to follow Sequoia’s ratio you’ve first got to be willing to make eight bets of similar size. Further, you’ve absolutely got to be willing to lose money on 87.5% of your investments and hope that one deal is at least a 10 bagger!
The best VC firms get all the first looks. They have some of the brightest people spending 50+ hours a week reviewing company after company. Oftentimes they see information about competitor companies that enables them to evaluate who will likely come out ahead. They also talk to their fellow VC industry colleagues about what other companies and other VCs are doing. In comparison, you and I get no looks. Instead, we only get the companies that have been rejected by the VCs. Talk about an unfair advantage.
2) Your money is more sacred than other people’s money. Being a VC is the best job ever because you get to make a $250,000 – $350,000 salary and make investments using OTHER PEOPLE’s money! If your investments turn sour, who cares? You still get paid your base salary for the 8-10 year life of the fund. If your investments do well, you get to earn even more money off other people’s money in the form of carry.
As an angel investor, you’re putting your own money on the line. In order for me to follow Sequoia’s model, I would have to personally make an investment total of $480,000 at $60,000 each in eight unproven companies. Other VCs with worse returns have a 1:9 win:loss target, meaning I’d have to make a $600,000 investment to try and make money. Even if we’re allowed to invest only $25,000 per deal, most of us won’t be willing to risk $250,000 worth of capital in venture.
3) Your stake will be diluted away. As a minority investor, you have no say in management decisions or funding rounds. If the company starts getting desperate for cash, they may offer sweetheart deals to future investors at your expense. One such sweatheart deal is called liquidation preferences.
For example, assume a venture capital company has a 2X liquidation preference after investing $1,000,000 for a 50% stake in the company. The founders own 30%, and you, the angel investor, owns 20% after investing $100,000. If the company is sold for $2,000,000, you might think you’d be getting $400,000 back. In reality, you’d get $0 back because the VC gets paid 2X their initial $1,000,000 investment during the liquidity event. Meanwhile, the founders also get $0 back as well!
Just realize that whenever your private company raises a new round of funding, your stake will get diluted by 20% on average.
4) You have zero liquidity. Goodness forbid you need the money to cover an emergency during a typical 8-10 year holding period. So sorry! You will never get your money back unless there is a sale or IPO. And given ~90% of companies fail, and 9% of companies end up barely staying alive, you will likely never get your money back even if you waited 50 years.
At least with public investments in stocks and bonds, you can get your money back within three business days.
5) The returns aren’t even that great! For all the sexy talk about angel and venture capital investing, for the typical VC and angel investor, the return is truly dismal. We’re talking median 0%-2% returns a year from 2001 until now. The mean (arithmetic average), however, is more like 8% during the same time period due to the massive success of the top VC firms.
Check out some great charts that demonstrate my point.
The top 20 firms (out of approximately 1,000 total VC firms) generate approximately 95% of the industry’s returns according to Betterment, the leading digital wealth advisor today. Further, nobody can participate because the funds are way oversubscribed.
Here’s an old chart that shows how VC returns were awesome in the 1990s, and have since fallen to ~0% in the 2000s due to too much money chasing too few deals. The lines continue to hover around the 0% return level until 2017.
Here’s another chart showing that 64.8% of US Ventures return just 0 – 1X your money over a 10 year period. In other words, best case scenario for 64.8% of the VC funds, you only get your money back (1X return)!
Here’s another chart that shows the top quartile and bottom quartile performance of micro-VCs, funds that are $50 million and less. Notice the wide range of performance, with the median performance coming in closer to 10%. Not bad, but nothing special compared to the S&P 500 return. With the global pandemic hitting in 2020, many more private companies will go bust due to a lack of cash flow and capital.
If you look at even “sure bets” like Uber, Lyft, and Airbnb, investing in these companies haven’t turned out so well if you did after 2015. Airbnb is the big shocker, when they had to raise money from Silver Lake Partners in 2020 at a $18 billion valuation after being valued over $50 billion at the end of 2019. Who would have thought there would be a global pandemic and months of lockdowns that would crush the travel and hospitality industry?
As investors, we just never know. Timing is so important.
Three Saving Graces For Angel Investing
Although my gross proceeds from my $60,000 investment is only $98,425.88, apparently I don’t have to pay the full federal taxes on my $38,425.88 gain under the Qualified Small Business Stock (QSBS) Act.
Beginning in 2015, for the first time since its enactment in 1993, Sec. 1202 allows noncorporate taxpayers to exclude from federal income tax 100% of the gain on the sale of certain qualified small business stock (QSBS), limited to the greater of $10 million or 10 times the adjusted basis of the investment.
To qualify for the exclusion, five criteria generally must be met:
1. The stock must have been directly acquired via an original issuance from a U.S. C corporation (Sec. 1202(c)(1))
2. Both before and immediately after stock issuance, the C corporation’s tax basis in gross assets did not exceed $50 million (Sec. 1202(d)(1));
3. The C corporation and shareholders must consent to supply documentation regarding QSBS (Sec. 1202(d)(1)(C));
4. The C corporation conducts certain qualified active trades or businesses (Sec. 1202(e)); and
5. The stock must have been held for more than five years (Sec. 1202(b)(2)).
Well what do you know? My investment in the gin company back in 2007 meets all these qualifications. All I have to do is pay California state tax, which I’ve done. But of course, there’s a catch. My investment needed to have been made after 9/28/2010. So in reality, I only get about a 43% tax savings (see chart), which is better than a dumbbell on a toe.
The other saving grace of this deal is a performance bonus. If the gin company achieves several sales targets over the next several years, investors get to earn a 50% bonus on our returns equivalent. For me, that equates to an additional $49,213 of upside. I won’t count on it, but it’s nice to know it’s there.
The final saving grace is that locking up $60,000 saved me from potentially wasting my hard earned money on something wasteful like a fancy car or an even more expensive vacation property. I had a lot more desires as a 29 year old than I do now.
Despite these benefits, I still don’t think anybody should angel invest. If you absolutely must, you can take 5% – 10% of your investable capital and make some unwise investments to help friends and family. Just expect your money never to return.
Brushes With Angels Of Death
As I reflect upon my investment, I was foolish to invest $60,000 in a 28-year-old first-time founder with no experience in the spirits business. But he was my friend and I admired his drive and hustle. He told a great story: “We’ll do to gin what Skyy did to vodka and blow the category up!” A more risk appropriate amount for me at the time would have been $25,000.
Now my friend, who is 38, is worth $5,000,000 – $7,000,000 before taxes and is taking a well-deserved break before starting a new venture. If you are a founder, and people are throwing money at you, take it! Just make sure there are no nasty covenants in place. It’s so fun to get rich off of other people’s money. No wonder I like real estate.
To conclude, here are a couple more venture investments I was so close to making, but didn’t, thank goodness:
Circa 2011, I could have invested $100,000 in a company called Triggit, a Facebook ad retargeting company that was growing like crazy. I played poker with the founder all the time and at one point, my investment would have been worth ~$1,000,000. I was kicking myself in 2014 for not taking the risk in a business I knew pretty well as an online media business owner.
Then out of the blue in 2015, Triggit got taken UNDER by Gravity4. Employees got zilch, and I’m not even sure the founders got anything. Facebook decided to change the rules and made third party ad exchange providers irrelevant. Then the founder of Gravity4 ended up getting kicked out due to domestic abuse.
Then there was a company called Bento Now, an Asian food delivery company I was considering investing $25,000, also in 2015. I wanted a deal in exchange for helping promote their product, but they said demand was too great for them to negotiate. It was run by an ex-blogger I knew who ended up raising ~$1.5M from several well known angels. Then one day in the fall of 2016, I was listening to the Gimlet Media Startup podcast (which eventually sold for big bucks to Spotify) and heard they had spent $70,000 more than they realized in one month! How do you do that? A few months later, the company shut down.
Given I didn’t lose $125,000, does that mean I gained $125,000 and can therefore splurge on whatever I want?! Please say yes! Venture investing is seriously risky business. Don’t risk anything you can’t afford to lose. With my gross “windfall” of $98,425.88, I plan to do some more landscaping and save the rest for my Hawaiian dream house fund.
If you want to invest in VC, try and invest with a top tier VC fund instead. Funds like Andreesen Horowitz, Sequoia, Kleiner Perkins (new vintages), Benchmark, and so forth. The difficultly will be getting an allocation. These guys have much better track records and much better access to capital.
Angel Investing Alternative
I’d much rather invest in real estate, where there’s actually a tangible asset that provides shelter and generates income. Real estate is stickier on the way down and is often a defensive asset class during times of uncertainty. Fundrise is the leading real estate crowdfunding platform today that is free to sign up and explore.
Another good real estate crowdfunding platform to check out is CrowdStreet. CrowdStreet primarily focuses on real estate investment opportunities in 18-hour cities, those cities with lower valuations and faster growth due to demographic shifts.
Thanks to technology, remote work from home, and high cost of living on the coasts, I expect there to be a multi-decade demographic shift towards the heartland of America. As a result, I have invested $810,000 in commercial real estate across the country and plan to continue investing more over time.
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Updated for 2020 and beyond.