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

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How Angel Investors can Reduce their Taxes with Tax Credits

Slowly but surely, our Federal and State Governments are recognizing that most new job creation comes from small to medium size companies.  As entrepreneurs launch their businesses, get funding to bring innovation to the market and grow into bigger companies, jobs are created.   Furthermore, they have realized that the primary source of capital to start and grow those businesses are private investors…not the local bank.  Therefore, to provide an incentive to the very wealthy to “give back” to their local economy by investing in local businesses, they provide a tax incentive. By putting their wealth back to work in providing capital to early stage companies, the investor receives tangible benefit in the form of a tax credit against earned income, but they also receive intangible benefits from knowing they have contributed to the creation of jobs and the delivery of innovative goods and services to the market place….ie Compassionate Capitalism.

The Compassionate Capitalist Broadcast covering this topic can be replayed by clicking this link:

http://www.blogtalkradio.com/karen-rands/2014/04/01/compassionate-capitalist-saving-taxes-as-an-angel-investor

This podcast reviewed the various options that investors have to reduce their tax basis by investing in companies that have not yet gone public.   Investing in companies with tax credits associated with them offers two wins…reduced paid in taxes during the term investment tax credit, and return on investment at the point of sale of the equity to a public market or another company.  Twenty-one (21) states now offer tax credits for angel investment.  The Angel Capital Association maintains a list with links for each state to learn what is available in that state.  http://www.angelcapitalassociation.org/public-policy/existing-state-policy/ .

The movie and gaming industry is also a big contributor to local economies.   States have implemented multiple programs to attract companies to produce movies and develop gaming software.  Forty-Four (44) states offer “production incentives” and twenty-eight (28) states offer tax credit incentives to investors in those endeavors.  http://en.wikipedia.org/wiki/Movie_production_incentives_in_the_United_States

For the most part, tax credits are applied against earned income.   If the investor doesn’t earn a “w2” income, the can still gain benefit by selling the credits.  A number of financial firms and legal firms exist to advise investors with tax credits and broker those credits for sale.   This is just one firm that offers good information about selling of tax credits. http://www.taxcreditsllc.com/

It is important to understand the options that are available to you to reduce your tax basis while diversifying your investment portfolio.   As you seek to increase your wealth, it is important to also protect that growth with a reduction in taxes whenever possible.  In most cases the states require paperwork to be filled out in advance by the company to eligible for tax credits.   Some industries may be excluded.   Therefore it is important to become familiar with the programs available in your state and as you look for companies to invest in, take the potential for tax credits into consideration when calculating the Internal Rate of Return (IRR).

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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?  Then learning how to invest in private companies, purchasing shares in a company before it goes public, while the valuation is still low, could be the wealth creation strategy for you. Join the National Network of Angel Investors and sign up for the educational newsletter and free excerpts from the “Inside Secrets to Angel Investing”. http://NationalNetworkofAngelInvestors.com

Angel Investors, down but not out — some bright spots

There is so much discussion and knashing of teeth about the void of angel investors in the market right now.   Frankly, I think it is a convenient excuse for those investors that weren’t actively investing in 2008 and therefore continuing to not invest in 2009, but were still “in the game” attending events, considering deals, requesting business plans, but ultimately being an empty suit.   We saw this a lot right after the dot.com burst.   It took probably a year and half before those “walking dead” finally faded away or got to the point of making an investment.  Unfortunately, you can never really know who these decoy investors are (see my blog on that topic on www.entrepreneurblogspace.com) until you have fully engaged and wasted time and probably some money with them.   Likewise, a company that is struggling to raise capital, but has a fundamental flaw that they are unwilling to address, either out of arrogance or ignorance, can use the current economic climate as their excuse…”oh woe is me, nobody wants to invest, boo hoo, because the economy is bad!”   We talked about the available capital in my radio interview yesterday with Bank President, Chuck Lewis of One Georgia Bank and Angel Investor and Fund Manager, Ian Adlington of Newport Capital and the Kereitsu Forum.    These gentlemen are two of the panelists will be kicking off the second day of events at the SE Private Equity & Capital Conference (SPEC) on April 14th & 15th…..hurry if you are a company seeking capital or investors seeking innovative companies to consider investment with.

 

Some Highlights of Positive Indicators in the Angel Capital Markets:

Angel investments dropped in 2008 by 26.2 percent over 2007, but the number of deals was relatively unchanged, with 55,480 entrepreneurial ventures receiving funding, according to the 2008 Angel Market Analysis released by the Center for Venture Research at the University of New Hampshire.  Full Report:  http://www.newswise.com/articles/view/550514/

Also Angelsoft, as the software used by hundreds of angel investor groups, keeps excellent statistics on trends. http://angelsoft.net/industry/index.seam  We have been hearing of companies getting funding in odd places…mid west, southwest, of course the west coast.   Although the due diligence process may have taken a few more months than usual, they still closed on funding when the regular capital markets and stock markets were at their all time worst.   Just take a look at this impressive list: http://angelsoft.net/funding-stories/ 

This news in encouraging to us.  It should be encouraging to entrepreneurs out there seeking capital….good companies with good business models and good management team, and appropriate valuations, get funding.   We are more committed than ever to make the upcoming SE Private Equity & Capital Conference (SPEC) more successful than ever with exciting innovative companies on the agenda and a convergence of angel investors, VC, fund managers, and investment bankers from accross the US.   We believe we can be Economic Architects by creating a rich environment for deals to get done, jobs to be created, and delivering innovation and wealth to the market.