* This is an excerpt from a special report. Download full report at “C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters.” Again, this is not legal or financial advice. Please consult with your lawyer and accountant.

Having only one class of stock means that equal rights must be given to all shareholders – no special rights or preferential treatments can be granted. For this reason, experienced investors typically require an S Corp. to convert into a C Corp. or LLC before backing the company.

C Corps can have different classes of securities while LLCs can have multiple classes of units. Both structures are free of the one-class stock restriction inherent in S Corps. Still, it appears that in this instance, at least, the C Corp. is the more favorable structure. Let’s see why.

Photo by: Podknox

Tax Implications Upon Exits

While LLCs offer short-term tax efficiencies with its flow-through ability, the C Corp. structure offers a number of potential benefits upon successful exits.

For example, you can “achieve a tax-free exit through a stock for stock exchange with another corporation,” ACEF reports. [3] “There can also be favorable capital gains in tax rates for early stage investors in certain C corporations that have raised less than US $50 million.”

In addition, if you hold the stock for more than five years, you may cut half of your tax payment upon a liquidation event. “If you think there is going to be big home run, paying 7.5 percent instead of 15 percent can be a huge advantage,” says Jeff Solomon of LKN+S.

Subject to specific conditions in the Internal Revenue Code (IRC) and the type of C Corp. you invested in, you may treat the losses as ordinary, rather than capital, losses, which may result in higher personal tax savings. If there are profits, you may roll them over into a future investment to postpone tax payments.

Talk with your tax specialist to see which (legal) tax minimization strategies you’re eligible to implement.

Because LLC members own membership interests rather than stocks, members aren’t entitled to the benefits tied to stock ownership, as discussed above.

However, in certain exits, the benefits of an LLC’s flow-through ability can be substantial. For example, in an asset-sale type of exit, the proceeds will be taxed only once as opposed to twice in the C Corp. structure, according to Adrienne Randle Bond, an attorney who specializes in partnership and securities law and mergers and acquisitions. [6]

* This is an excerpt from a special report. Download full report at “C Corps vs. S Corps vs. LLCs: Which Corporate Structure to Angel Invest in and Why the Form of Entity Matters.” This is not legal advice. Please consult with your lawyer.

Dr. Basil Peters

There are some dangerous misperceptions, myths, and outright lies that are commonly told in the industry that lead boards and startup management teams completely down the wrong path, Dr. Basil Peters, an exit strategist, technology angel investor, and angel fund manager for Fundamental Technologies II, tells Venture Hype.

He continues:

I’m dismayed by how often I see good boards make very bad decisions about the exits, primarily, in my opinion, because the information isn’t readily available. There’s not enough investor and entrepreneur education available about the things to watch out for when you’re thinking about designing and executing an exit.

Investing is easy; exiting is hard, adds Peters. That’s why he devotes most of his work time writing, talking about, and executing exits, with the goal of educating angel investors and entrepreneurs about the importance of designing a clear exit strategy. His motto: Exit Early, Exit Often.

His first book, Early Exits, challenges angels and entrepreneurs to take a serious look at exit planning. What the CEO of Cisco has started saying today is exactly what Peters had written two years earlier in Early Exits. When Peters talk exits, you better sit up and listen.

What You’ll Learn in This Interview

* Fit for beginners

• Why companies should have either angels or VCs as their funding source, but not both, and how the company’s decision would affect its angel investors.
• Why the multi-hundred million dollar traditional VC funds don’t work in the 21st century.
• Differences between venture capitalists and angel investors – some investors are calling themselves VCs but they really are angels.
• What are capital efficient companies and in which sectors do these companies exist.
• Why having a clear, written exit strategy almost from the earliest days is the most important goal for every externally financed company.
• Some of the important elements that make up a good exit strategy – it’s much simpler than you think.
• Myths, misperceptions, and outright lies about exits and mergers and acquisitions that often led boards and management teams completely down the wrong path.
• What companies really need to do today to have a successful exit.
• Why receiving an unsolicited acquisition offer is almost never good news.
• The type of exits current economy favors.
• New dynamics of the exit environment and the urgent requirement of having an exit coach.
• Pressing challenges for entrepreneurs in today’s economy.
• Whether angel investors should be optimistic or cautious about backing startups in the current economic climate.
• And more…

More About Basil Peters

While working on his Ph.D. in Electrical and Computer Engineering at the University of British Columbia in Canada, Peters started Nexus Engineering and went on to take home the Entrepreneur of the Year Award, Entrepreneurship Silver Award, BC Science and Engineering Gold Medal, and Business Leader of the Year Award.

A decade later, he sold the Nexus Group to its biggest competitor and is now part of Cisco. Through the process, he went from being a starving entrepreneur to actually having some nice coins in the pocket. Like many successful, cashed-out entrepreneurs, Peters started angel investing. He’s been investing in startups since the mid ’90s and has founded three technology investment funds. He now belongs to three angel groups and dedicates most of his time on exit transactions.

What You Get

• MP3: 34 minutes | 30.78 MB (refer to PDF for download instructions)
• PDF: 29 Pages (Edited transcript + Quick Recap)
• Word Count: 6,200+

Your Investment: $15

Download MP3 and PDF Report Now

Special Offer

+ $4 and receive “Angels and Startups, Don’t Play in China Until You Read This”

Original: $15, You Save: 73%

What You’ll Learn

• What foreign/Western startups must absolutely be aware of if they want to break into the China market.
• The type of companies that have a completely unfair competitive advantage over foreign/Western companies.
• The pros and cons of converting into a local company in China.
• What investors need to know before pumping money into the burgeoning country.
• The main configuration for angel or venture capital investment in China.
• The differences between pure local and offshore local companies and why they matter to investors.
• The easiest way to invest in Chinese startups.
• Several potentially profitable investment niches for angel investors.

Inside This Report

• MP3: 33 minutes | 29.75 MB (refer to PDF for download instructions)
• PDF: 24 Pages (Edited transcript + Quick Recap)
• Word Count: 5,500+

Note: To receive this offer, both reports must be purchased together.

Download Both Reports Now for Only $19

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Doing that is valuable for 2 reasons.

First, it urges him to figure out whether the price of the item is decent enough that he would be able to sell it for a profit, or at least break even.

Second, it forces him to consider the market and identify a potential buyer.

Buyer Access is Half of the Equation

Without performing this little bit of precautionary measure, he might overpay or he might wind up stuck with an obscure item that nobody else wants to buy once he is finished with it.

Thinking his way past the point of sale also makes him consider the kinds of enhancements he needs to add in order to increase the item’s attractiveness to the next buyer.

For items that are time-sensitive, like depreciating options or cyclical commodities, he would set a deadline for sale.

For those that would likely gain value over time, like baseball cards, first-stage ventures, or retirement account, he would calculate the items’ potential appreciation.

That’s a smart approach, because buying before pondering the other end of the equation is never a good investment strategy.

Life Cycle Relationships

In the world of angel and venture investment, that comes down to finding follow-on investors and potential buyers.

If you want to be a successful angel investor, you ought to hunt for and cultivate potential buyers with the same degree of diligence and attention that you apply to uncovering promising deals or putting together effective management teams.

As a smart angel investor, you would also develop solid relationships with potential buyers, who can crown your portfolio companies with success.

Investing in start-ups is a business of life-cycle management – from sourcing and coaching, to funding through various stages and collaborating with others to make co-investment and exit decisions. All of those phases require resourceful, trustworthy relationships. If you have those relationships, you will succeed while others stumble or fall.

Birds of a feather flock also together, so if you cultivate relationships within both the entrepreneurial community and among potential buyers, you will find yourself surrounded by the kinds of resources that ensure success across every stage in the investment process.

With just a few days away from 2011, the new year is a great time to start seeding and cultivating relationships. Go make some new friends and have a happy and prosperous new year, dear angels!

Image by: courtneyBolton

In this final installment of an 8-part series on royalty (or revenue) based investment — an investment vehicle that features “build-in” exits — we’ll report some final thoughts on the model that some investors hate to love while others love to hate.

Haven’t read all of the articles in the series yet? Please do.

Previously…

1. 2 common investment models used by traditional equity investors
2. An emerging approach to achieve returns in a tough exit climate and an example of how it works
3. Debt and equity components of royalty based investment
4. The type of companies that are suitable for royalty based investment
5. What makes royalty based investment attractive to investors
6. What’s in it for entrepreneurs
7. Common complaints about the royalty based model, for investors and entrepreneurs

You might fall in love with the approach like some investors did. Or you might not.

Does it matter? No, not in our standpoint.

Each approach has its place in different settings. What matters is the understanding of each investment vehicle and the type of deals it serves best.

As an informed investor, you’d keep an open mind and widen the options in the way you invest. The knowledge will come in handy when you come across companies that suit perfectly for this model.

Royalty Based Investment Model Is Great for Diversification

In this regard, the royalty based approach is a great diversification device. It allows investors “to fund a much wider range of startups than just those that typically receive venture backing — the ones that have potential to grow huge, fast,” suggests Gregory T. Huang of Xconomy.

John Hamilton, managing director at Vested for Growth, expands on the suggestion:

I would also point out that investors do not need to stop offering equity, but simply add royalty to the array of deal structures that you offer entrepreneurs. The result will be better for both parties, whether its royalty or equity.

I don’t see royalty as disruptive – good equity deals will still get done. However when established businesses get turned down by banks and they feel like their only other choice is equity, they may feel forced into doing equity – this is a recipe for a “capital mismatch” which is bad for the entrepreneur and bad for the investor and hopefully market awareness of royalty will serve to limit that.

Royalty Based Investments Offer Partial Exits

Just like all other investment vehicles, the royalty based model isn’t for every deal and it probably will never resonate with investors who only live and die by the thrill of hitting home runs.

“[Andy Sack of royalty based investment firm RevenueLoan], for his part, doesn’t think the revenue-based model will take off in the Valley because the traditional flow of venture capital is too strong,” writes Huang.

But for those who are tired of waiting for a big payout that might never come and want to see some relatively immediate, albeit capped, returns in their portfolio, the royalty based approach can help.

Though, Brian McConnell of GigaOm stresses, “Of course, there will be complete failures, but companies that find some degree of success will also provide some return to their investors.”

In other words, this approach can, at the very least, provide partial exits for angel investors.

Royalty Based Investment Is Exotic at This Point

Huang reports:

[In any case], it’s too early to know how successful the royalty-based model will be. “It’s exotic at this point compared to venture or debt. It’ll take some time to prove it out,” [Jeff Schrock of Intel Capital] says. And he adds, “This is not a panacea. This does not solve all problems in venture. I don’t know if it’s going to solve the startup funding issue.”

Image by: judepics

Now, let’s turn our heads to the fanta-bulous entrepreneurs and find out how they can benefit from royalty based financing. We’ll deal with its downsides later in the series.

This is Part 6 of an 8-part series on royalty or revenue-based investment (or “royalty based financing”). Please visit Part 1 for links to the entire series.

More Control. Entrepreneurs aren’t forced to sell. They can maintain control and ownership of the company. This allows them to spend more energy on executing their business plan rather than chasing the all-important exit, writes Gregory T. Huang of Xconomy.

Minimal Dilution. Warrants give investors the right to purchase a certain amount of the company’s equity at a stated price so ownership dilution is minimal. This may give management more incentives to build a durable company with solid, profitable revenue streams — the most important criterion to qualify for royalty based investment.

Deductible Expenses. Just like debt, Rockwater Capital points out that payments exceeding original principal are deductible expenses for the company.

Obtain Growth Capital. Not only can entrepreneurs obtain funds that they mightn’t be able to obtain otherwise, but they can do so without requiring personal guarantees from management or equity owners, says Jeff Joseph of VenturePopulist.

“[Royalty based financing] offers growth capital to companies that can’t participate in debt or equity [financing],” comments Jeff Schrock, a VC at Intel Capital.

Andrew Clapp of royalty based investment firm Arctaris Capital Partners points out that the model is “better suited for the company needing debt to replace the bank line it may have lost or had reduced during the recession.”

Flexible Repayment. Royalty based financing “is less onerous that debt because it is variable to revenues,” notes Joseph. Instead of paying a fixed amount on a strict schedule, companies have more flexibility in the amount they repay. The more sales they make, the more they repay, vice versa.

Valuation Avoidance. Because royalty based financing is a loan at its core, the company borrows money instead of sells equity. So there’s no need to put a price tag on the company, which eliminates the awkward and sensitive discussion on how much the company is worth.

Royalty Based Financing vs. Other Financing Methods

A table by royalty based investment firm RevenueLoan, comparing royalty based financing to other financing methods:

Next, we’ll study the drawbacks of the approach for both investors and entrepreneurs.

Previous articles in this series:

• Angel Investing: Exit Dependent Investment Models provides an overview of two exit-dependent investment models used by equity investors and addresses why some investors are testing a new investment vehicle that doesn’t depend on exits.
• Angel Investing: Royalty Based Investment Features “Built-In” Exits goes through the revenue-based model’s “build-in” exit feature and looks at an example of how the investment model works.
• Angel Investing: Components of Royalty Based Investment Model looks into the debt and equity components of the vehicle.
• Royalty Based Investment Works Best on These Companies outlines the repayment structures and some basic investment terms.
• Royalty Based Investment: What’s in It for Angel Investors breaks down why the approach may be beneficial to investors.

Image by: Juliana Coutinho

This is Part 5 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.

So what are the main features that turn some investors into a huge fan of the royalty based approach? Let’s take a look.

(Yes, we’ll go over the drawbacks later in the series.)

Before you proceed, we humbly suggest that you read these articles to put things into context:

• Angel Investing: Exit Dependent Investment Models provides an overview of 2 exit-dependent investment models used by equity investors and addresses why some investors are testing a new investment vehicle that doesn’t depend on exits.
• Angel Investing: Royalty Based Investment Features “Built-In” Exits goes through its “build-in” exit feature and looks at an example of how royalty based investment (or “royalty based financing”) works.
• Angel Investing: Components of Royalty Based Investment Model looks into the debt and equity components of the vehicle.
• Royalty Based Investment Works Best on These Companies outlines the repayment structures and some basic investment terms.

Royalty Based Investment: Benefits for Investors

Big Market. The kind of companies that fit this model are those “that have annual revenues of a few million dollars but have modest annual growth rates — 20 percent, say — that won’t attract VCs, who are searching for 10x home-run returns,” explained Andy Sack of RevenueLoan.

“We’re going after a segment that is today underserved by traditional equity like VCs and banks,” Sack said. “It’s a huge market.”

Built-In Exit. Rather than relying on an exit (M&A or IPO), royalty-based investment features a “built-in exit strategy,” according to Rockwater Capital.

“Royalty payments are typically made monthly, and begin shortly following the infusion of capital,” explains Rockwater Capital. “Companies pay as they go, paying more as they grow” until you’ve achieved a fixed multiple return on your investment.

“Instead of waiting five or 10 years for a startup to go public or get acquired, an investor can start seeing returns almost immediately,” says Gregory T. Huang of Xconomy.

Huang goes on to quote Arthur Fox, the god father of royalty based investment and the founder of Royalty Capital Management:

“When you invest in a company, buying stock and equity, you have no way of getting out unless they become significantly large enough to have a liquidity event.”

With the new approach, he says, “every month you get a check, and it doesn’t matter if they ever have an IPO, or get bought out.”

Early Evaluation. Huang continues with Fox’s biggest win and notes how this approach can get your foot in the door of promising companies:

His biggest win was Andover Advanced Technologies, a multimedia software startup that had no revenues when he originally invested $100,000 in 1993.

After two years, Fox had gotten back $125,000 in his cut of the revenues, and he invested in a second round with an angel investor, in which he took some equity.

The company (renamed Andover.net) went on to ride the dot-com wave with a successful IPO in 1999, and was acquired for $1 billion by VA Linux Systems in 2000. Fox’s stock ended up being worth $15 million.

It’s an example, he says, of how “royalty investment lets you get your foot in the door, evaluate how the company is really doing, how management is doing, and you may have the opportunity to participate in a follow-up round with much more knowledge.”

Note: Though the royalty based approach got Fox in the door, it’s the traditional equity investment that gave him the significant upside. And let’s not forget that this happened during the dot-com wave.

As discussed in Angel Investing: Components of Royalty Based Investment Model, companies that sign up for royalty based financing are typically, though not always, those that don’t want to sell or give up ownership, or that aren’t IPO candidates.

If you want a home run or the potential for significant upside, you still need a conventional equity deal. The chance that these companies will exit via M&A or IPO is statistically less likely, says GigaOm columnist Brian McConnell.

More Stable Steam of Payments. Royalties are based on a percentage of the company’s gross revenue, not net profits. You’ll receive payments even if the company’s not profitable.

Higher Priority. Royalty based financing is a loan in its core. Because note/debt holders have a higher pecking order than shareholders in the event of default, you’ll be paid in full first before equity holders see a penny. Which means you’ll have a better chance getting all or some of your money back when the company liquidates its assets.

Upside Potentials. Through warrants, you can participate in the company’s upside if it does end up getting acquired or going public.

Warrants give you the right to purchase a small amount of the company’s equity at a stated price. The upside potential is much smaller than is the case with traditional equity based investment.

Valuation Avoidance. Similar to convertible debt, you’re loaning money to the company instead of buying its equity. This avoids the awkward discussion over valuation – a term that investors and entrepreneurs often have a hard time coming to an agreement on.

Next, we’ll examine the benefits of royalty based financing for entrepreneurs.

Image by: Sergei Golyshev

This is Part 3 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.

By now, you should’ve learned about the 2 exit-dependent investment models used by equity investors; understood why some investors are exploring a new investment vehicle that doesn’t depend on exits; and looked at an example of how royalty based investment (or “royalty based financing”) works.

Now, let’s get into the more intricate details of the royalty based approach.

Royalty Based Investment: Alternative to Traditional Debt and Equity Investment

In a traditional equity investment, you buy an equity stake in a company.

In a royalty based arrangement, you buy a percentage of the company’s future revenues. (Or more precisely, you lend money to the company against its future revenue streams.)

That’s the simplest definition of royalty based investment.

Going deeper, royalty based investment has features of debt and equity.

The investment vehicle has many features of a bank loan. The deal is typically structured as a senior or subordinated debt. And the debt can be secured or unsecured, explains Rockwater Capital, an investment fund specialized in royalty-based investment.

Just as payments are made to amortize a loan, you the investor are repaid via royalties — a regular stream of payments that are typically calculated based on a percentage of the company’s monthly gross revenue.

In some cases, “the royalty is based on a percentage of sales of a specific product or set of products” rather than on gross revenue, according to RockWater Capital.

Repayments can go up or down depending on revenue levels. So, unlike a creditor of a typical debt who receives fixed payments on a strict schedule, you’ll receive payments that fluctuate with revenues.

And unlike a traditional equity investor, who relies on a liquidity event (M&A or IPO) to cash out, you can receive, depending on the repayment structure, some return on principal almost immediately.

Randall Lucas of RevenueLoan writes:

So, the model is different: in theory, then, for certain types of businesses and certain situations, RBF should be better than debt or equity.  (Conversely, debt or equity may well be better in other situations.)

Equity / Warrants

The equity component usually comes in the form of a warrant, notes Gordon Empey of Cooley. “Hard for anyone to step away from that equity upside.”

Warrants give you the right to purchase a certain amount of the company’s equity at a stated price. Which means you can participate modestly in the upside if the company gets bought or goes IPO.

RevenueLoan, for instance, takes just 1% equity kicker in warrants.

Pocketing the capital gains from a sale or IPO would be a nice outcome, but companies that sign up for royalty based financing are typically those that don’t want to sell or give up ownership or that aren’t IPO candidates.

If you want a home run or the potential for significant upside, you still need a conventional equity deal. The chance that these companies will exit via M&A or IPO is statistically less likely, says GigaOm columnist Brian McConnell.

In essence, a stable, regular stream of royalty payments is the primary focus of royalty based investment; exits are just icing on the cake.

Coming Up

Next, we’ll go through the repayment structures, terms, and the kind of companies that are suitable for royalty based investment.

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Sophisticated angel investors strongly favor equity over debt. We already know that.

* This is Part 2 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.

These angels are predominantly equity investors who live by the exit-dependent investment models. No exits, no returns.

Having barely survived the depressing exit environment in the past years, some investors are experimenting with a new investment model that doesn’t depend on exits and that would help them achieve some returns even in a tough exit climate.

The approach, called royalty based investment (or “royalty based financing“), isn’t new. It’s been successfully used in “mining, intellectual property, film, theater, music and other industries,” Rock Water Capital, an investment fund specialized in royalty-based investment, comments on its website. But the concept has only been applied to earlier (not startup) stage technology companies by a handful of people.

The idea is simple. Instead of buying equity, you buy a percentage of the company’s future revenues.

So, rather than having to rely on an exit, which could take years to (or might never) occur, you receive royalties (typically between 1 and 10 percent of the company’s revenues) from the company every month until a negotiated multiple (e.g. 3x to 5x) of your original investment has been returned to you.

That is, you can recoup some of your investment almost immediately.

Eager to test out the model, Andy Sack of TechStars and Founder’s Co-op recently raised US $6 million from Voyager Capital, Summit Capital, and Founder’s Co-op, and founded RevenueLoan to specifically make investments using the royalty-based model.

Royalty Based Investment: An Example of How It Works

Here’s a hypothetical example from RBF Central:

Tom is the CEO of a promising Software as a Service (SaaS) business. He’s built the business with no outside capital and is operating close to breakeven. He sees an opportunity to ramp up sales by investing in business development. He doesn’t have enough cash in the bank to make this happen.

Most banks won’t lend to a company like Tom’s because his isn’t an asset-intensive business. Tom doesn’t want to raise venture capital because he doesn’t want the dilution and he isn’t sure his business has the potential to scale as quickly or or as big as most VCs would expect.

Tom learns about Royalty Based Financing. He lines up a group of angel investors willing to invest $500,000 for a royalty rate of 10% of gross revenues. The royalty payments don’t begin for a year – giving him time to invest and build the business – and have a 3x cap (limiting Tom’s total royalty payout to a maximum of $1.5 million).

With the help of this additional capital, Tom builds a profitable small business with revenues of $3 million a year — and still owns 100% of the equity. The investors get their 3x return paid back over 5 years — without having to force Tom to sell his company or buy their shares. In this scenario, everyone wins.

The innovation here lies in bringing the Royalty Based Finance approach to riskier, earlier-stage investing, while receiving the expected return in the form of cash flows. The fact is, most well-run businesses look more like the firm in this example – growing, profitable, but not a shoot-the-moon success – than like the Google and Amazon.com rocket rides that the traditional venture industry is geared around.

Royalty Based Investment Series

While supporters swear by the model’s “built-in” exit and non-dilutive feature, those against it simply think it’s a bad idea as it caps investor returns and taps into the cash that should be reinvested in the company.

The royalty based model isn’t for every deal, that’s for sure, but it doesn’t mean that you can’t diversify your portfolio by funding some of the companies with this approach.

Let’s examine the model’s merits and challenges closely and objectively.

In a new series, we’ll break down the benefits and drawbacks of the royalty based approach for investors and entrepreneurs, and the type of companies that are suitable for royalty based investment. You’ll find comments from people who are in favor of as well as against this investment vehicle.

Is the royalty based approach an Advil for tough exit pain? Stay tuned.

Image by: griffithchris

They’re called private equity investors for a reason.

In the world of angel investing, the sophisticated bunch are predominantly equity investors — investors who make money on exits. If they don’t see an exit, they don’t get in.

Legendary angel investor Ron Conway, for example, said he won’t invest if he can’t think of five potential acquirers for a company within 10 seconds.

“Equity investors can’t sustainably invest in startups without exits, because exits are how those investors get paid,” notes Thomas Thurston, president of Growth Science International.

He continues:

They must be able to sell their equity (i.e. stock) at a higher value through a merger/acquisition or IPO.  No exit, no returns.  There must be a “liquidation event.” Startup funding is hooked on exits.

Angel Investing Home Runs

According to ACA [PDF], “the most sophisticated angels make at least 10 investments to make a return on their investment, counting on one or two to provide nearly all of their return.”

Case in point: Dave McClure, whose biggest exit to date is Mint.com, the financial website that Intuit Inc. bought for US $170 million in 2009, told WSJ that “he tends to make dozens of small start-up bets and can comfortably make money if just a few of the start-ups are bought by larger acquirers for less than $100 million.”

Brad Feld, managing director of Foundry Group, explains the concept of home runs:

Understand the difference between 0x and 100x: I’ve had two of my angel investments return over 100x each.

Since I had a strategy of investing the same amount in each company, all I needed was one 100x to allow me to have 99 companies completely flame out and return 0 and I’d still break even.

With two investments at over 100x, I now have a built in gain of significantly over 3x across all of my investments since I’m [sic] made about 75 of them and I’m now deliciously “playing with house money” on all of the rest.

As Scott Shane points out in his book, Fool’s Gold?: The Truth Behind Angel Investing in America, sophisticated angel investors know that many startups will fail so they use a portfolio approach to balance their risks. These angels make at least 10 investments and only invest in companies that have the potential to generate at least 10x their invested capital. This way, despite that many companies will fail, the handsome returns generated from the home runs will not only recoup investors’ losses but also fatten up their bank accounts.

Some critics argue that these angels are emulating VCs’ “ill-fated” investment model and question whether their approach would sustain.

“We have a whole different set of exit criteria [than those of VCs],” McClure stated matter-of-factly.

VCs require much bigger home runs to generate satisfactory returns for their limited partners; angels don’t.

Angel Investing Early Exits

Not everyone’s out searching for a home run though.

No doubt, home runs are still by far the most desirable outcome. But a number of angel investors are getting impatient with the expanding exit timeline and have opted for Basil Peters’ Early Exits approach.

In vast majority of the cases, angel investors, even super angels, make bets that are much smaller than traditional VCs. It’s easier and quicker to generate a good return on angel investors’ say, $50,000 to $500,000 investment, than on VCs’ $5 million to $50 million investment. Angel investors have a higher chance to exit earlier if their portfolio companies haven’t raised money from VCs.

Rather than hunting for “home run companies” that have the potential to generate exceptional returns, but likely require raising additional money from VCs to prove their business models, Peters’ strategy is to invest in pre-revenue, capital efficient companies that

• don’t require follow-on financing from VCs
• need only US $0.5 million to US $3 million to prove its business model
• have the potential to become an attractive acquisition target that can be sold for around US $20 million to US $40 million
• have the potential to generate 3x to 5x returns to investors in 3 to 5 years

Exits Are Scare

Angels and VCs have different set of exit criteria, but without a doubt, all equity investors, be they angels or VCs, or whether they embrace the home run model or early exits approach, all depend on exits.

“To the extent that economic vitality depends on innovation, innovation depends on equity investment, and equity investment depends on exits… there is a problem.  Exits are scarce,” Thurston laments.

Despite the improvement of the exit environment, some investors, having barely survived the depressing exit climate in the past years, are experimenting with a new model that doesn’t depend on exits, a model that’d help them get some returns even if the company isn’t a huge success in the traditional way.

Can you guess which investment model we’re talking about? Stay tuned. We’ll reveal our new series next week.

Update

The entire series is now available:

1. Two common investment models used by traditional equity investors (this article)
2. An emerging approach to achieve returns in a tough exit climate and an example of how it works
3. Debt and equity components of royalty based investment
4. The type of companies that are suitable for royalty based investment
5. What makes royalty based investment attractive to investors
6. What’s in it for entrepreneurs
7. Common complaints about the royalty based model, for investors and entrepreneurs
8. Diversifying your angel portfolio with the revenue-based model

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In Angel Investing as Asset Allocation Strategy: Risks, Returns, Homeruns, we reviewed why angel investing isn’t for the faint of hearts. The risks involved can be quite overwhelming.

For the ambitious bunch, though, it’s difficult to resist the attractive payoffs offered by angel investing. If we want to tap into the lucrative potentials and make sure our bottoms are covered, we need to understand the importance of personal asset allocation decisions and strategies.

This installment deals with the typical time required to exit an investment and the easiest way to determine how much to allocate to angel investments.

Liquidity Timeline

Angel investments are illiquid assets; you can’t just sell your positions like those in the public stock market. Angel investors primarily make money through liquidity events (e.g. M&A or IPO), which can take years to occur.

Lisa Lambert, Vice President at Intel Capital, said:

It just takes a long time to go from startup idea to a liquidity event. [...] During the boom days, it was like 2.6 years to get liquidity. And today, the latest average from NVCA, the National Venture Capital Association is 8.7 years.

Some suggest you should angel invest the money you don’t need for another three to seven years or longer. But the safest bet is to invest the money you can afford to lose forever. That is, only play with the money you can lose without affecting your lifestyle.

Even if you have a sharp eye for picking promising entrepreneurs, there’s no guarantee as to when a liquidity event will occur, or if it’ll even occur. There are too many factors that’d affect the evolution and progression of a startup.

Joshua Schachter, an entrepreneur-turned angel investor, states, “I’ve been investing since 2006, in 38 deals so far, and I’ve seen exactly one exit so far.”

Thealzel Lee of VANTEC notes, “One angel investor lamented that some of his investments are in their second decade and he has no way of liquidating his initial investments.”

Having said that, there are great exits that have put a huge smile on angel investors’ face too. Otherwise, no one in their right mind would angel invest!

Mint, a consumer SaaS startup, had raised a total of US$32 million over 3 venture rounds before getting acquired by Intuit for a handsome US$170 million. At a mere age of 3 at the time of acquisition, Mint went on to become “The 2009 Poster Child of Early Exits” for angel investors.

Problem is, even the most sophisticated investor can’t say for sure how long it’ll take to get to an exit. Thus, having an asset allocation plan helps you stay on course and understand how much you’re putting at risks.

Asset Allocation Pie

David Hehman, former chair of North Bay Angels, says that the easiest way to determine how much you want to allocate to angel investments is to create a percentage of your total asset allocation:

If you have X dollars [in investable capital], you indicate that Y percentage will be for angel investing. Then, Stick to that!

To come up with the percentage, you might want to meet with your financial advisor, and discuss with him (and your spouse) how much you can afford to lose. Angel investment money is often called mad money, as it is always high risk.

Let’s say John Doe Jr., Jane Doe, and John Doe Sr. each has $2,000,000 to invest.

John Doe Jr., who’s risk-adoring, allocates his capital this way:

Asset Class: % Allocation ($ Amount)

Public Equities: 20% ($400,000)
Bonds: 0% ($0)
Alternative Investments (Angel Investing): 80% ($1,600,000)

Jane Doe, who’s less risk-tolerant but not exactly conservative, allocates her capital this way:

Public Equities: 40% ($800,000)
Bonds: 20% ($400,000)
Alternative Investments (Angel Investing): 40% ($800,000)

John Doe Sr., who’s the most conservative among the three, allocates his capital this way:

Public Equities: 0% ($0)
Bonds: 100% ($2,000,000)
Alternative Investments (Angel Investing): 0% ($0)

Your asset allocation pie will likely look different. How much you allocate to each asset class would depend on your risk tolerance.

But as you can see, asset allocation isn’t rocket science. You may come up with a percentage yourself to keep things simple, or discuss with your financial advisor if you have a more complex portfolio.

Having an asset allocation plan helps you understand how much money you’re allocating to high, modest, and low risk investments.

Now, let’s hop over to Angel Portfolio Strategy of Brad Feld, Will Herman, Sim Simeonov, Et Al. This article goes over some of the reasons why you should reserve funds for follow-on investments; takes a quick look at the portfolio strategy of these noted angel investors; and discusses the minimum number of angel investments you should make to reduce risks and increase potential payoffs.