April 23, 2019
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Angel investors are those people who make early investments in new high growth businesses – popularly called startups. Assuming you are already investing in stocks and bonds, the question then is, should you add startups to your portfolio? How are they different and what returns or risks do they add to your portfolio?
Startups are a form of alternative investment. Very broadly, alternative investments include things that are not publicly traded stocks or bonds. So real estate, hedge funds, venture capital and private equity are all alternative investments. Per financial theory, alternative assets (or alts, as they are called) are uncorrelated with the market. So it could make sense to have them in your portfolio, as it lends your portfolio greater diversification. But…these are not for everybody.
This is high risk investing. If you are contemplating early stage investing, you should consider at least three things:
- Do the regulations permit you to invest in startups?
- Do you have sufficient money to set aside and build a diversified portfolio?
- Are you able to stomach the high volatility and are you able to lose all of your invested capital without impacting your lifestyle?
Starting with the regulations – every country has its own regulations and you need to be aware of these. In the U.S., there is the concept of accredited investor. This means that you either have a high income or high net worth. Specifically, accredited investors are those that had a net worth of $1M, excluding primary residence. OR, they had an income of at least $200K in the past two years and expectations of the same in the coming year. If combined with a spouse, the income threshold rises to $300K. i.e., they should have had a household income of at least $300K over the past two years and expectations of the same in the coming year.
In August last year, the SEC updated the definition of Accredited Investor to include individuals who may not qualify on income or net worth, but who hold certain professional certifications – specifically, who hold the Series 7,63 or 82 licenses.
That is an important concept to remember because per U.S. law, only a limited number of un-accredited investors are allowed as shareholders for private companies. As a result, some of the best startups do not accept unaccredited investors at all.
However, there do exist other options for unaccredited investors – specifically, there are websites that offer investments for unaccredited investors – popularly called equity crowdfunding. You should check those out. On Propel(x), we only host accredited investors as of now. That is not to say this will never change! But for now, its accredited investors only.
The second consideration to become an angel investor is whether or not you are able to set aside sufficient capital to build a diversified portfolio.
Lets start this discussion with the concept of asset allocation, or, what percentage of your investable assets should you allocate to startups? Conventional wisdom has it that you need to take some risk to get some growth. So, if you are in your 20s and 30s, the good financial planner will likely suggest that you invest 70% in stocks, and 30% in bonds. Or thereabouts. This allocation changes when you add alternatives. Large asset managers such as endowments allocate 5%-15% of their assets to venture capital.
I recently read that for 2020 that the Yale Endowment was planning to allocate 21.6% to venture capital! That is not even including other alternatives like real estate, which had its own separate allocation of 10%. So these endowments are willing to take on much higher risk. As an individual, you should probably allocate a much smaller percentage of your investable assets – assume 5-10% of your investable assets. This will vary across individuals of course, and you are the best judge of your own financial situation. But that range seems sensible.
Then, you have to consider Diversification. Diversification is still relevant in the startup world. You should plan to invest in at least 20 startups, OR, none at all! Please do not start unless you are willing to invest in at least 20 startups! And this is not the gospel truth by far – its merely the opinion of one individual. You could have 21 investments or 51, or any other number. The important point here is that you must have a large number of investments to build a diversified portfolio.
So how much of a capital requirement does that work out to?
Turns out that the earliest stage startups usually accept a minimum of $25,000 investment. In some cases as low as $10,000 -15,000. But even these are large numbers if you are looking to build a diversified portfolio. Platforms like Propel(x) enable you to invest smaller amounts – as little as $5,000 per startup. And other platforms are willing to take even smaller amounts. So definitely check these out if you are planning to invest amounts in these neighborhoods.
So lets say you invest $5,000 per startup, and you plan to invest in a total of 20 startups over 2-3 years. That means you will end up investing $100K in startups. AND, per our earlier discussion, this should be about 5%-10% of your investable assets. So your net worth should be at least $1M – $2M to get started, not including your primary residence. OR, you should have an annual income that enables you to set aside this amount over 2-3 years, without impacting your liquidity needs or lifestyle. And, you should be ok with losing this capital as startup investments are very high risk.
Investing in startups is highly, highly risky. The fortunes of startups go up and down…by a lot. Startups could raise millions of dollars but shut down the very next quarter. You need to have the stomach to tolerate this volatility. And, there is a good chance that you could lose all of your invested capital. So you should only invest an amount that you are comfortable losing entirely.
To summarize, think of three things before you dive into the angel investment world:
- Are you an accredited investor?
- Are you able to set aside at least $100K over 2-3 years without batting an eyelid?
- Do you have the stomach to tolerate the volatility in these kinds of investments? And are you ok if you were to lose all of this money?
If your answer is a “yes” to all of these, you are a match. And you should get started – create a free account on Propelx.com for starters!