Compassionate Capitalist – Angel Investing When You Don’t Have Cash on Hand

Often I’ll hear investors say “That company has real potential.  I wish I had the cash to invest. My money is tied up in….”.

An investor’s cash can be tied up in real estate, traditional portfolio of stock, mutual funds, and bonds and/or 401K or IRA.   Investment real estate isn’t considered liquid because it is either income producing or a long term strategic location.  Although public stock can be sold at the investors request at any time, often an investor won’t want to sell their stocks for many reasons.   It could be that they are waiting for a period of ownership to pass to minimize capital gain taxes, or they are waiting for a market response to announcements that would increase the value of that stock.   Many other traditional portfolio holdings may have a longer holding period before they can be liquidated without penalty.  Furthermore, 401K/IRAs are generally considered to be illiquid because of tax penalties associated with the withdrawal of funds.

However, there are two ways that these investments can be used to make investments in private companies, with certain caveats.

  1. Self- Directed IRA:  By definition, the Self Directed IRA is an IRA that allows the account owner to direct the account trustee to make a broader range of investments than other types of IRAs.  The custodian of a self-directed IRA may offer a selection of standard asset types that the account owner can select to invest in, such as stocks, bonds, and mutual funds, but, by definition, permits the account owner to make other types of investments, including loans. The range of permissible investments is broad but regulated by the IRS.  Mostly the IRS regulates what an investor cannot invest in and leaves the “what can invest in” open ended.   For our purposes regarding private companies, here are the restrictions:
  • Not intangibles : art, alcohol, gems, collectables
  • Not an entity that is more than 50% owned by  the service provider who manages your IRA
  • Nor a partner or JT venture that is 10% or more with an entity that is 50% or more held by the service provider.

For more information regarding Self Directed IRAs, here are two good sources:
http://en.wikipedia.org/wiki/Self-directed_IRA

http://cdn2.hubspot.net/hub/319644/file-395650388-pdf/Email-Attachments/Article_Top10Mistakes.pdf?t=1386019713000&t=1386019713000&t=1386019713000

2. Portfolio Margin Loan:  Margin loans on an investment portfolio have long been used by sophisticated investors with high risk thresholds to expand their investment portfolio by borrowing against the value of a stock in order to purchase another stock that they believe they can profit from before they need to repay the loan.  Taking a margin loan out in order to purchase a private non-traded stock is not as common.   Only a few investment advisory firms have provisions for such uses of a margin loan.  Similarly only a few firms have provisions for securing a margin loan for personal use.   Investors that have substantial portfolio holdings and want to consider use of this asset to facilitate an investment in a private company should inquire about restrictions their advisory firm has on the use of margin loans.   There are  3 ways a margin loan may be used to finance an early stage company:

  •  Margin Loan on existing portfolio to directly invest in a direct public offering.
  • Margin Loan as a personal line of credit with authorized use by the CFO of the target company.
  • Margin Loan with the cash extracted as one time loan.  The investor can then provide that capital in a form of a note with warrants or as a convertible note to the company.

More info on Margin Loans: http://en.wikipedia.org/wiki/Margin_%28finance%29

Sample Rates: http://www.schwab.com/public/schwab/investing/accounts_products/investment/margin_accounts

What the SEC has to say: http://www.sec.gov/investor/pubs/margin.htm

Managing the High Risk

Using debt to finance an early stage company is highly risky.  Most often, if a payment is required, it is an interest only payment based on the loan rate and the principal loan balance.   If the margin loan remains in good standing and the portfolio retains or grows in value, the investor is unlikely to have a “margin call” where they must pay down a portion of the outstanding loan balance.  The typical margin loan cannot exceed 50% of the value of the portfolio and are closely monitored the relationship of the margin loan to the total value of the holdings.

Using a self-directed IRA to purchase non-trading private stock is very risky simply because no one can ever actually predict the success and how much success an early stage or emerging growth company may have.   You cannot declare any capital losses if the company does go out of business.

Given the odds of using all of the investment amount, and having little to no recourse, this strategy should only be employed when the investor has a high level of confidence the company will succeed or the investment vehicle would be a revenue producing structure (see Investing for Residual Income Blog Post).   Consider these precautions when considering using either of these “illiquid” investment holdings to finance, either through debt or equity, a private company:

  1. Do the mental exercise….what if you lost the investment?  Would you be disappointed or devastated?   Disappointed is OK.  Devastated? – Then don’t invest.
  2. Company should be in revenue with a respectable back log of trailing revenue.  In the case of the Margin Loan, you could be the “private banker” to finance a transaction so the time the money is required is shorter than a straight equity investment.
  3. The management must have experience in running a company previously so you have a reasonable expectation that they know what to do to generate revenue and make operational corrections as needed to ensure continued growth.   You can’t afford to babysit or for them to get a life lesson on your nickel.
  4. Ensure they are compliant in every way with the SEC.   This includes legally reviewed offering memorandums, not paying finder commissions, and any registrations required with the state that you reside when making the investment.

 Summary

If you have been making an income that would qualify you as an accredited investor ($250,000 personally), then it is likely you have accumulated a portfolio and/or a 401K that is worth over a million dollars. You may have heard about “angel investing” but didn’t think you could participate because you simply were not liquid enough and you didn’t know much about how to make that investment because your Financial Advisor or Wealth Manager never talks about private offerings.  In the Podcast I go into some of the regulatory and market reasons for this: Listen Now. Typically only a Registered Investment Adviser who is not paid a commission on the placement of investments will explore how a high net worth investor could uses existing holdings to make investments in private companies.

Karen Rands, Host of the Compassionate Capitalist show, explored these two ways to make investments into private companies when an investor doesn’t have cash on hand but has ample accumulated wealth.

Listen to the replay:  http://www.blogtalkradio.com/karen-rands/2014/04/22/compassionate-capitalist–angel-investing-when-you-dont-have-cash

Sign up for all the news and learning opportunities….be a part of the new generation of sophisticated investors seeking to include private equity into their wealth creation strategy:

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Earning an Annuity as an Angel Investor- Yes, Virginia it can be done

Similar to other investment options, an investment in a private company can produce annuity type income.   When starting out as an angel investor an investor should plan on making multiple investments with diversification of industry and structure as a core principal.  Accredited investors with sufficient liquid capital to make multiple strategic investments over a period of time, will likely diversify their portfolio of private equity stock investments to include multiple types of investment structures.   Similarly to an investor looking to get involved in real estate investments with different targeted outcomes; short term return (flip), revenue producing (rental), and long term (raw land). An angel investor should seek to diversify into multiple types of offerings:  debenture with option to convert (flip); royalty or revenue cycle financing (rental); and traditional equity (raw land).

In this episode of the Compassionate Capitalist Radio Broadcast (REPLAY) http://www.blogtalkradio.com/karen-rands/2014/03/25/earning-an-annuity-as-an-angel-investor  Karen Rands shares her insight into the different types of angel investments and specifically how to identify private alternative investment opportunities that can produce a re-occurring revenue stream.

The conventional wisdom for angel investing is similar to venture capital investing— invest in 10 companies, wait 5-10 years to discover which one or two of the lot produced a big enough return on the investment to make up for the 4 that lost all of the investment and the 2 that broke even and the 2 others that gave you just a teeny return.   It doesn’t have to be that way.   When wealth men and women apply the same discipline they have learned when managing their public stock decisions and their real estate investment choices, and seek to have a long term strategy that calls for diversification of industry and investment type, they increase their odds of a higher rate of return because they have balance and load.

Diversifying by industry and into market areas that an investor already has an interest ensures some level of insulation from the natural economic ebb and flow industries experience.   Diversifying by product / investment type allows for shorter term results off set by long term hold.   For example, an investor just starting out could “loan” money as an investment secured against orders with the option to convert or to have it paid back but with warrants, then they get their money back, but have an option for discounted equity.   After a couple of those types of investments, they begin to accumulate additional liquid capital that could be invested in to an offer for royalty or revenue cycle financing.   This is a type of investment that is made but instead of an equity stake, the investor received a re-occurring revenue stream as a % of revenue until an agreed to multiple on the investment is paid back, usually 4X the investment.  Companies with the potential for long term growth and opportunity to go public are ideal for equity investments where the investor will have their investment capital tied up and illiquid for 5-8 years.   This type of equity investment is the most risky, because a lot can happen in 8 years to cause a company to not succeed, but if they do, then the results can be 10X to even 25X return on investment.    Early investors in Microsoft, eBay, Amazon and many others all experienced this type of return.    Keep in mind though… for every one of those, there are at least 10 that never got that far and never gave a return on investment.   There are some, like the companies that went public with a big splash… Web Van, even Facebook,  that did not hold its value after going public, but the initial angel investors made their money back and them some, probably at least 5X if they sold when it first went public.

You have an opportunity to get more information on this type of diversification by listening to the podcast or buying the Inside Secrets of Angel Investing.    This is the topic discussed in detail in Chapter 5.   You can also sign up for free excerpts from the ebook, Inside Secrets to Angel Investing.

Are you an investor that is tired of the volatility and unpredictability of the stock market? Are you frustrated that you have little influence to affect the management or operation of that public company? Have you realized that the public stock market is actually pretty risky and the overall return on investment isn’t that great?  The Join the New National Network of Angel Investors and be a part of the growing community of wealth men and women that want to master their wealth portfolio and learn how to be Compassionate Capitalists  – make money and contribute to the economy at the same time. 

Angel Investors tap Alternative Finance sources to mitigate risk

This is a common scenario for early stage companies.   They raised an initial round that got their product to market, got them selling, and now they have the orders, but they can’t deliver because they don’t have the capital to build the widgets or fund the salaries of their workers while the project is being implemented or software installed.   They can try to go back out to their existing investors to get more money by selling more equity, or try to attract new investors and sell equity.   The problem is that that want to sell it at a higher valuation so they can minimize the dilution of their own shares and their initial investors.  Unfortunately without the new revenue and completely proving the business model, they may find it hard to justify a significantly higher valuation and that means more time to raise the capital.   Time that they don’t have if they have a customer waiting on the product, service, or application to be delivered.   It is the proverbial – Rock and a Hard Place.

What are their other options?

  1. Offer a Bridge Loan to their private investors — go back to their most ardent investors and ask them to provide a 90 day or 120 day note secured by the order and earn pure interest – reg lender rates + .5%.  Roughly pay them 1.5% each 30 days on the loan.
  2. Seek Alternative Financing – Purchase Order or Contract Financing linked with Accounts Receivable Financing — In this scenario, an alternative lender provides a “letter of credit” for the “Cost” portion of the order.   It is  is tied to the order and the credit rating of the company issuing the order.   The company draws down on that letter of credit to pay the specific things related to the order.   When the order is shipped or delivered and billed to the customer, the financier flops the switch on the ‘factoring’ the receivable and pays off the letter of credit and advanced capital to company that is the difference between the letter of credit amount and the amount that equals 85% of the value of the full order.   When the customer pays, the remaining 15 % is paid to the company less their financing and processing fees, usually about 10-12% more.

Learn more about how this works from an Angel Investor who is also a source for Alternative Capital from a previously recorded Podcast on the Compassionate Capital Radio Show:

http://kugarand.podomatic.com/entry/2009-05-03T06_08_15-07_00

Get more of the Inside Secrets to Angel Investing at http://AngelInvesting101.com

Join the National Network of Angel Investors on Facebook

 

 

How do Angel Investors Find Deals?

Within the traditional private equity investment model, you start the evaluation process with an introduction. This leads to further evaluation and a commitment of time on the part of the investor to really get to know the management team and to learn a great deal about the business at hand. The due diligence phase and negotiation of investment terms follows, leading to the consummation of the investment.

Introduction Phase

An introduction can come from many different sources, each of which has its pluses and minuses.

Friends and Family Entrepreneurs are encouraged to pursue seed funding through “friends and family.” It is a generally accepted premise that the people most likely to provide seed capital are those who have some connection with the founders or key management of the company. Someone familiar with the founder(s) and management team will consider subjective factors such as work ethic, experience and character as part of the decision to invest in the company. Generally, they are making a subjective decision and want to find reason to invest rather than not invest.  On the other hand, a “stranger” to the founders and management team will rely much more on the business plan and financial statements as the basis for his/her decision.  They will be in more of a position to make an “objective” decision and decide to invest based on the business merits. Since they are considering many opportunities at one time, they will look for flaws that will be the cause of them to pass on the investment.

IntermediaryIf you are a serious investor who is or intends to be in the business of investing, you will increasingly rely on intermediaries and advisors to screen deals and assist with the due diligence and minimize the subjective, emotional part of the decision.  An intermediary may be a lawyer, consultant or other professional service provider. The capital seeker may choose a lawyer who is perceived to have access to funding sources as part of the “value add” for working with that law firm. Similarly, a consultant or other professional, who may be engaged to develop a sales strategy, financial models or any other aspect of building a company that can be outsourced, may offer to help in the funding process, as a value add. If you are introduced to the company through this type of resource, you can use your knowledge of that resource, the caliber of work he/she provides, his/her trustworthiness, your knowledge of his/her other clients, etc., which provides better knowledge from which to proceed in your evaluation of a particular private equity opportunity.

Deal Events: Sort of like speed dating for investors, fast pitch events are popping up all over. A room full of investors get to get a snapshot of what a company is all about in 90 seconds.  From there they are to make a decision to track down that company and make an appointment to see them.  For most investors, it is simply entertainment.  For the entrepreneurs it is a way to begin to create the buzz so that when a trusted intermediary or friend makes an introduction in the future, the investor can at least say… “you know I think I saw you at XY event.”

Venture Conferences on the other hand give a company an opportunity to take 10-15 minutes to describe their opportunity in greater detail.  Investors usually take the first 90 seconds to decide if they want to listen for the next 10 minutes, and in that time to decide to they spend another hour with the company or not.

GroupThink: Investors that are serious about angel investing, but may not have the resources to do the full evaluation on their own or value the input of others from other walks of life, experiences and knowledge of deal making, find value in joining an angel group.  Although there is usually a large ticket price to participate, they get the value of saving time and money in developing deal flow and in the initial vetting of the deal.   The group usually has a screening process to weed out the non-starters from the ones with some wings to fly.

WHY be an Angel Investor: High Networth men and women decide to get involved in angel investing for a variety of reasons…

1. personal success in building a company or being a part of a successful exit in a company gives them the burning desire to help another company succeed and participate in that process.

2. greed and desire to create untold wealth can only be realized through entrepreneurship and they realize they increase their odds by owning a piece of multiple companies that have the potential to be BIG rather than putting all their money and efforts into one dog that may or many not hunt at the end of the day.

Biggest RoadBlock for the Passive Investor: Ironically, although the SEC has a mission to protect investors by regulating the how information is shared by public companies when investors need to decide to buy that stock and by private companies in the information they are required to provide to communicate the inherent risk involved in making that investment.   Reality is that for the high networth person that has moved in sophistication beyond real estate investing or trading on options and creative margin trading in the public markets, or just wants to diversify into private equity investing as an asset class, they are VERY limited on who they can go to to get needed counsel on finding good deals and vetting those deals.   The person they have trusted to manage their money on the stock market, IRA, and retirement planning,  has been told by the SEC:  DO NOT advise your client on private equity transactions unless you personally stand to gain financially for that trade by collecting 5% or 10% of the money the investor invests.  And if we find out that you have been providing advice to your client about angel investment opportunities to help them protect their overall portfolio, then we will call that Selling Away and revoke your license and ability to make a living in your chosen field of work.

Learn more about that specific topic with this informative podcast:

Next Steps:

After the deal has been identified, then the courtship begins.   This is when you get to know the management, begin due diligence to determine if all they say is true or has merit.  Ultimately an investor decides to marry the deal because there are like minds, belief in success and the terms match the requirements of the investor from a long term wealth creation and preservation.

More info on the process of becoming an angel investor can be found at:

How to Be an Angel Investor

To get more content on this topic and to learn how to RUN with the BIG Dogs when it comes to building big companies, join the facebook community Business-Investor-Grow

Selecting The Right Employees and Building Strategic Partnerships Wisely

Karen Rands, during her Compassionate Capitalism show will engage her featured guests on a topic important to all start up and growing companies. When a start-up founder realizes he or her needs to build a team, bring on expertise to compliment their own skills how can they identify those people, confirm they will enhance their business and at the same time, protect the business they founded. They need to know what skills are needed on his/her team, identify the right resource, then negotiate for that person to join the company and protecting the company long term.

This is important for investors considering an investment in a private company.   When a company first starts out, they have limited resources and limited management structure, but as the organization grows, they add people, skills, resources.   Building effective teams and the leadership of those running the company is critical to the company’s success.   In the case of a key person coming on board, either as an active investor — an “Exec with a Check”, or when a key resource is brought in that may share in the equity as part of their compensation, it becomes all that more critical to make sure that there is a good mix for the personalities and to protect the company legally in the event it doesn’t work out as planned.

Guests are Kenneth Darryl Brown of E3C (www.BetterSalesandProfitsNow.com) and Hugh Massie, CEO of DNA Behavior (www.BusinessDNAResources.com) to discuss how a CEO can learn about their leadership and communication strengths and understand what to look for in potential team members. Bob Van Rossum, President of MarketPro, (www.marketproinc.com) the nation’s leading executive search and contract staffing agency specifically focused on marketing, interactive, creative and advertising talent will discuss identifying and qualifying a potential candidate for the management team. Glenn Garnes, Relationship Marketing Center, will discuss protecting your interests when bringing on partners…the subject of his new book:”Let’s Not Be Partners, Things you Must Do Before You Tie the Knot (“not”). Sure to be a dynamic show for all aspiring entrepreneurs.

Listen Now!

Check out these investment websites: Karen’s twitter page: @Karen_Rands, www.kugarandholdings.com, www.launchfn.com, www.nbai.net, www.kyrmedia.com,  www.entrepreneurblogspace.com and www.dothedeal.org

Listen, Learn, Enjoy and Share with a Business Associate!

How does an Angel Investor Mitigate Risk?

Risk in private equity investing is inherent in the process.   Often the greater the Risk, as in early stage the company, the great the Reward…if the terms are right.   Lots of “ifs” involved in angel investing.   You get the greatest return when you invest and the company has a low valuation.   But that is often based on not accomplishing many milestones yet.   Without the milestones to show a company can execute, the risk is greatest.   So what are some key milestones a company should have at the major stages of development?

Start Up or Seed Stage:

  1. Has a working business plan that delves into key areas of the business so they know what they don’t know and what they will need to get help on.   For example:  Figuring out the actual cost of goods when manufacturing.  Or will they hire sales reps or outsource sales etc.
  2. Has protected the product and offering with patents, copyrights, or at the very least explored it and determined trade secrets are best.
  3. Fully understand who their target market is and why they want to buy that product or service and what are they willing to pay for it.
  4. Have assembled a good advisory board, even if they don’t have the funds for a management team.   They should be people that have relevant experience.
  5. Has been able to raise a “friend and family” founders type round to at least get the $100,000 to $200,000 needed to build the balance sheet, pay for the patents etc, allow the CEO to actually be a full time CEO, and ultimately do the things that validate the business.

Early Stage:

  1. Building upon the seed start up stage, as a company enters into Early Stage they should have a finished product and either customers already buying or at least have a serious pipeline of customers they have been courting and will be buying.
  2. The money that comes in at this round should get them to cash flow positive.  
  3. They should be expanding management to include “execs with checks” or at least management that believes enough in the project to share risk through compensation from shares.  No Hired Guns.
  4. They should have analysis on the exit….do companies such as theirs get bought or go public.  Who in their industry has done either?  Who has bought companies like theirs.   Because if they know what they are going to grow up to be, they can put a plan in place to get there.   This is where you get your return, so this is important.

Expansion Stage

Angel Investors really don’t play at the expansion stage, and at that point the risk is still greater than a public company borrowing money from a bank, but not near the risk associated with Early Stage or Seed Start up Stage companies.  

 At just about every stage, you can also mitigate risk though the use of key-man insurance to protect in case something happens to the inventor/founder etc.   Also you can mitigate risk in the structure of the deal so that if the company has to go to a firesale, you can get all or most of your investment back when the company is liquidated.  

Angel investing can be very rewarding if the risk is appropriately mitigated.