Wednesday, March 16, 2011

Investing PART 12: Angel Investing

“This is a land of confusion”

THE WALL STREET JOURNAL; (3/12/2011) had an interesting article entitled “An Easier Way to Bet on the Next Facebook.” As I read it, I thought: “There are too many men, too many people, making too many problems, …This is a land of confusion.” Angel investing may not be what Phil Collins was singing about, but it fits. Back in April, a series that started with “Angels, entrepreneurs, and diversification: PART 1” then again in June and July in a three-part series that started with “The discussion Congress should be having: PART 1 Angels, entrepreneurs, and diversification” The Hedged Economist made a reasonable argument for angel investing.

While the WALL STREEET JOURNAL article contains lots of interesting factoids, in total it just muddies the water. For example, it notes: “While the basic requirement is that investors be "accredited," having a $1 million net worth excluding the value of their primary residence….” That’s true, but totally irrelevant. Why should I care what the government thinks should be the liquid assets that an angel investor should have? Quite frankly, Government doesn’t have the foggiest idea what constitutes good financial behavior, and it certainly doesn’t have any insight into what constitutes a good investment- - except perhaps investing in pork. Angel investing is just one of many potentially beneficial financial behaviors the Government makes difficult. A more useful discussion would be when angel investing makes sense (i.e., under what circumstances) and how to participate in investments in startups without accreditation, topics discussed in the postings referenced above. Help on those issues would be appreciated.

The statement quoted above continues “….they also should have the stomach for blowups.” Again, true, but in this case redundant. Any investment can “blow up.” Investing inherently involves risk. Values go down as well as up, and some go to nothing. The notion that there is such a thing as a risk-free return is a fiction; a point noted before in The Hedged Economist (e.g., see the April 1, 2010 posting entitled “Beware the risk-free return”). While talking of blowups adds drama, the more useful info is presented when the article leaves the drama to the screenwriters’ guild and turns to reporting. At that point the article goes on to note interesting factoids. For example, one of the factoids references a study that found that one in four angels in a particular category goes bust. That’s interesting. I’ve seen other numbers. But, it leaves a legitimate impression.

If the author wants to imply that a million dollars makes sense, just quoting accreditation standards is a pretty weak argument. To add confusion, a million dollars is inconsistent with the implications of some of the “experts” quoted in the article. To illustrate, one advisor states, “angel investments should make up no more than 5% of a wealthy person's overall portfolio.” At a million dollars, that is $50,000. Another advisor states, “Only one or two of every 10 investments will generate any significant return.” Another states, "Don't do it unless you'll make 10 or 20 investments over time.” Then the article quotes another advisor who points out, “Since $25,000 is generally a starting point for angel investments, that requires plenty of cash to spread around.” But, you should note that 10 to 20 investments at a minimum of $25,000 each works out to $250,000 to $500,000. That’s a lot more than 5% of a million dollars. Somebody is wrong. But then, “This is a land of confusion.”

It’s interesting to note that angel investing as currently defined is a relatively new concept: not a new activity, just a new concept. If one reads studies of how wealth is made and preserved, one see terms like non-public companies, technology companies, startups, new businesses, non-traditional assets, and concept investments. All of these overlap with angel investments. But, angel investment is a term that doesn’t often appear. For what it’s worth, adjusting for differences in definitions, the older research seems to imply a higher portion than 5%.

It’s as if the concept of angel investing developed to accommodate regulation, as in “something’s going on so let’s give it a name so we can regulate it.” Meanwhile, the article provides some insight into angel networks and how angel investing works. That’s important. Many of the financial and social institutions that supported new ventures in the past have weakened or vanished in Western societies. Angel networks may be the substitute.

In fairness, the article wasn’t all confusion. It gave a ballpark feel for returns on successful investments and the probability that any one investment will succeed. It also pointed out, “Angel investors should be prepared to have their money tied up for seven to 10 years.” But, for The Hedged Economist, the section that describes some tax benefits was the most interesting. Not because of the tax benefit itself. Rather, the creation of the tax benefit is interesting because it implies that policy makers have woken up to the importance of startups. Now, if only policy makers would recognize the damage they do to investors by trying to “protect” them from the confusion that is angel investing. We can hope.

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