In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. explains how angel investing works and how to use a Self-Directed IRA to invest in startups and other funding opportunities.
Invest like a Shark with your IRA
Hey everyone, Adam Bergman here, tax attorney and founder of IRA Financial. On today’s podcast, going to be chatting about how you can get involved in angel investing and invest like a shark, from the shark tank, using an IRA or Self-Directed IRA. So, angel investments have exploded over the last couple of years. COVID obviously accelerated lots of interest in startups, new technology companies and there’s been a big, big movement from investors looking to get exposure to new and exciting investments.
So, angel investing is getting the opportunity to get a first crack at a startup before it matures. So, it’s super risky, because the chances of the company faltering are much higher than if it was a more mature company that has been in operations for several years with some revenue stream or even profit.
Angel investors are basically investing, where you’re providing capital to a startup and usually the investor is receiving either equity or some type of convertible note which converts into equity. Angel investing is generally right, right at the beginning. Typically, it’s wealthy middle to upper class folks, who have money to invest, and either they have experience in that industry or it’s friends or family, or they have their own angel investment club or fund, and they’re looking to invest in the next amazing, great Google, Uber, Facebook, LinkedIn, whatever the case may be, where they can get in super early.
But as I mentioned, it is risky because obviously there is a high failure rate for startups. So, the beauty of angel investing is that the upside is huge, but obviously you want to make sure you understand the risk. Now, the average angel investor generally invests $15,000 to a few hundred thousand dollars in the investment, and generally, as I mentioned, they get equity in the investment or convertible note where they’ll get some type of option to convert that debt instrument, that note, into equity at some later point.
So, here’s some statistics and data on angel investors over the last couple of years. So, angel investment activity is totaled as much as $24 billion each year; contributes to the success of 64,000 startups. Angel investors with twelve angel investments over a period of five years or more, have a 75% chance of 2.6 times return. About 22% of all angel investors are women. Investments in black-led companies grew to 15% in 2020, five-fold increase. Angel investments obviously make up a huge segment of the startup capital community. Most cases, angel investors need to be an accredited investor; that means someone who has at least $300,000 of income, married file jointly or a million dollars in net worth, excluding primary residence.
Angel investments can take the role of a Reg A, a Reg D; these are SEC-type approved investments. When I say approved, I mean there’s a disclosure to the SEC, but less disclosure then obviously if the company goes public. So, it provides the investor some comfort, but at the same time, it also allows these companies to go out and raise funds. Now, there’s also something called a Reg CF, a reg crowdfunding. If the company’s raising less than $5 million, there’s easier ways to go about it, which a lot of the angel investment network operate in. There’s less SEC requirements and less SEC reporting requirements, which makes it easier for companies to operate.
Now, let’s get the IRAs right, because that’s a big part of this podcast. $13 trillion of IRA money out there; 60 million IRAs. We’ve seen, especially in 2022, as we enter 2023, companies are going to be looking for cash, right? Banks are not going to be as generous as they were over the last couple of years. There’s no; well, rates, as we know, much. much higher. So, banks are less eager to jump in and lend companies money, especially if they’re startups.
So, that leads to angel investors and a lot of angel investors don’t feel as rich today as they did last year, or in 2021 or 2020, I should say. Why? Well, markets are down. Crypto markets are down. Stock markets, NASDAQ, even gold and silver are down. Inflation’s up. Cost of living is up. Whether it’s food, whether it’s gas, whether it’s housing, whether it’s interest rates on mortgages, which have doubled over the last seven or eight months. It’s getting more expensive, right? We’re all feeling it. Guess what? Rich people aren’t immune either. We’re not talking, when I say rich, I’m not talking about billionaires. I’m talking about folks that may have a million to $20 million of wealth and they’re feeling it. They’re not starving to death, but they feel it; and what does it mean when you feel it? It means you don’t feel as rich, you don’t feel as generous with your money, and you generally may be a little bit more conservative.
So, a lot of startups are now having to turn to angel investor groups, communities rather than banks, rather than more traditional sources, because what’s happening, and I’ve seen it from clients, is that private equity, venture capital, even angel investors, they’re looking a lot, lot closer at numbers today than they did six, eight months, 12, 14 months ago. Before, I was just like, hey, you got a great idea. I like you. I’m invested. Now it’s like, hey, I want to see your business model, I want to see your projections, your budget. Can you really turn a profit? When are you going to turn a profit? That’s changed versus last year when it’s just like, oh, I like you. This is an amazing idea. Yeah, let’s do it. I’m going to invest $25, $50, $100 grand. Who cares, right? I have Bitcoin, I have Facebook, I have Tesla. Everything’s up. Peliton, everything’s up. Snap. I’m making tons of money. Who cares? I’ll invest $20-$30 grand in your startup like, big deal. Everything goes up every day.
That’s changed. That’s the past. So IRAs are going to prove to be a very important source of funding for angel investments because of the amount of cash out there, right? When you have money in your IRA, in most cases you’re looking to the future, right? You don’t need the money. Today you’re under 72, maybe even under 59 and a half. You can’t really take the money out without penalty. So, you’re looking to make IRA investments for the future, three, five, ten years down the road. And startups could be an opportune investment because of the fact that it is more hold, is more long term than, let’s say, just doing something that offers more immediate return.
So, I’ve seen it. Angel investment opportunities are springing up. There’s better deals, lower valuations, better convertible debt arrangements out there now, right? If you have cash, cash is king. Two years ago, I remember a banker told me, Adam, cash is trash. Guess what? That’s changed super fast. Cash is king. So, if you’re an investor and you have cash and companies need your cash, you’re going to get better terms today than you got two years ago, even more important than an IRA.
So, here are a few tips if you are looking to do an angel investment with an IRA. If you’re investing in a corporation, you don’t have to worry about a tax called UBIT or unrelated business income tax, which is an ugly four letter word tax that gets triggered if your IRA invests in a pass-through business, like an LLC or partnership that is business, like a tech company or a software company. So, if your IRA invests in an LLC, you may want to start with a convertible note. But when you convert it to equity, if there is net profits over $1,000 that’s allocated to that IRA, that could trigger the UBIT tax, which is a tax that can hit, the maximum UBIT tax rate of 37% and approximately like $15,000 to $20,000 of net income. So, very low threshold and a very high tax. Whereas again, if the company is a corp, C Corp, it blocks the application of the UBTI; that’s why if you buy publicly-traded securities or mutual funds or ETFs, you’re not going to have to pay UBIT tax because they’re all corporations.
Whereas if this startup is an LLC, partnership, there’s more than a $1,000 in net profits, which isn’t a huge deal for startups that angel investors are looking at. Why? Most startups don’t make money, right? They have a lot of R&D cost, especially if it’s tech, and they may not turn profits for three, four, five years. So it may not be an issue. Now, if you start off as a debt holder, you’re not going to have any UBIT, because UBIT only applies if you are an equity investor. Equity means you own an interest in that business, membership units or stock. If you have a convertible note means you’re just a lender, excuse me, and the interest you receive on that note is not subject to UBIT. So, it’s only when you convert it to equity from debt that you could be subject to UBIT if there’s more than $1,000 of net profit allocated to your IRA, okay?
However, in a lot of cases, angel startups will, at least startups looking for angel money, will be C corps because some, or many actually, startups don’t want the income to pass through to the losses. At least some angel investors don’t want the losses passing through and, especially if they’re looking for foreign investors, foreign investors do not want any connection, any effectively-connected income to the US. They don’t want to follow any tax returns. That’s why they’re going to force a lot of these startups to be corps. But again, it depends. Just a tip, if you are looking to use an IRA to invest, corp is safer because there’s no UBIT; LLC could trigger UBIT. S corps – no, IRAs cannot invest in S corps. It’s not an IRA rule. It’s an S corp rule. If an IRA does invest in S corp, it will likely blow the S election and that corporation will then become a C corporation, which could have other tax ramifications.
What else you should consider? Terms, right? You’re in the driver’s seat today. This isn’t 2021 anymore, okay? You have leverage, so seek better terms, do your research. Angel investment could be risky. There’s generally a holding period of three, five, even longer. Now, there’s probably a 50% to 60% fail rate within the first few years. So, you may need to make a number of angel investments and hopefully one out of five or six hits. And if that one hits, that hopefully is a home run.
If you’re doing an angel investment, you’re usually looking for home runs, right? You’re not going up to the plate looking to hit singles opposite field, you’re looking to park grand slam. That’s the whole concept. That’s what venture capital firms do. They’ll make 15-20 investments, and if they get two or three that hit, they’re good. They’re going to get their stated returns because those returns on the ones that hit are going to be enormous; versus private equity, we’re looking for more stable; they still want to do well, but they’re not looking for ten X returns in most cases, whereas angel investments are looking ten x plus. They want to hit home runs. So, that’s something you need to be careful about.
It’s generally a good practice to do multiple smaller angel investments of $15, $20, $30 grand, than one for $100, okay? This way you get more cracks at the plate, right? You get more swings at the pitcher. Hopefully, you get to hit more balls. And that’s the goal versus just taking like one crack at it; better to get a bunch of cracks. It’s like throwing darts at a board. You have a better chance to hit a bullseye if you have four or five darts versus one. And that’s what angel investment is. It’s all about hitting a home run; hitting the bullseye, and again, if you do it in an IRA and you sell the stock, then it’s all tax-free, right? Roth IRAs, if you’re over 59 and a half, the Roth’s been open at least five years, it’s all tax free. If you do it in a traditional IRA, you can pull the money out without tax after five years, but the money grows without tax, which is known as the deferral
So in sum, angel investing is going to be super hot in ’23. Traditional sources of funding will dry up, have been drying up. Interest rates are high. Banks are getting more conservative. They’re spooked. And startups don’t have streams of revenue. They’re obviously more aggressive, more riskier than more stable traditional businesses that have historical financial position. So, banks are going to shy away from more aggressive, more risk entities, and that’s going to leave angel investment communities, angel investment funds, venture capital funds as last fund standing. And guess what? You’re going to be able to ask for better terms because you’re going to have leverage. People, start ups, entrepreneurs are going to need cash. They’re not going to be as confident to get these crazy valuations as they did years ago. They’re going to be happy for money, okay? And cash is king. So doing it in an IRA gives you the ability to diversify. But remember the risks. Probably 50% to 60% of these startups fail within the first few years. You probably want to do multiple smaller investments and one larger one. If you’re investing in an LLC, you got to consider UBIT, but that’s only if there’s a net income allocated to the IRA. And guess what? A lot of startups don’t have that income for several years. If you start out as a lender and then convert it to equity before a sale, or if the company then moves from LLC to a corp, the corp, think of it as a big box, it will box in all the UBIT, and you’ll have no UBIT. That’s why there’s no UBIT when you own stocks or mutual funds or ETFs in an IRA. But if it’s an LLC, there could be UBIT over $1,000. Highest UBIT tax rate in 2022 is 37%. That threshold is super low, around $17,000. So, that’s something you definitely got to be concerned about. But again, many startups don’t have profits initially. And if you start as a convertible note and you ultimately convert to equity, UBIT potentially only kicks in when you convert it to equity, not when you are a debt holder. IRAs cannot invest in s corps, so something to keep in mind, although most startups aren’t S corps who are looking for investors because S corps have very restrictive shareholder rules; less than 100 shareholders, only one class, no foreigners. So, startups looking for cash generally will be either LLCs or corps; they’re not going to do S corps; C corps, or LLCs. If they’re looking for foreign investors, generally C corps, which is a good thing for IRAs, but if it’s a flow through LLC, just be at least cognizant of the IRA UBIT rules; don’t necessarily need to refrain from doing the investment, but something you definitely want to consider.
But, wanted to do this. It’s exciting. I think if you’re a shark and you want to be, you know, the next Shark Tank host, you can be your own Shark Tank, right? You don’t need to invest a million dollars. If you watch the show you’re seeing, they’re not investing millions of dollars per deal. Sometimes it’s $50-100 grand because they’re doing multiple investments and all they want is basically 10 to 20% hit rate, that will make them rich. They don’t want a 0% hit rate. They don’t expect a 50% hit rate. They can hit anywhere from 15% to 30%; they’re going to do super well. It’s very akin to baseball, right? If you can hit .300, you’re a Hall of Fame hitter. Tony Gwynn, one of the greatest hitters ever, .330 batting average; that means he got out six and a half times out of ten, and that’s great. Most hitters are .250-.260 lifetime hitters; that means they only get hits 25% of the time. Tony Gwynn was able to do it 33% of the time.
So, if you can hit, as a venture capitalist/angel investor 25%, 30% of the time, you’ll be a Hall of Fame-type investor and you’re going to do really well. And again, if you do it in an IRA, Roth IRA especially, once you’re over 59 and a half, the Roth’s been open for at least five years, bang, it’s all tax free. It’s he ultimate tax-free grand slam.
So, there you go. More to come on angel investments, because I’m hearing a lot about it. It was popular last few years just because people had a lot of cash, but there were banks. Banks were out there lending money, too. That’s changed. Okay, so now angel investors actually have money, if you have it, and you have the leverage. Whereas, the last couple of years, the entrepreneurs have the leverage because there was money chasing them. Now, there’s not so much money. So, whoever has the money and IRAs have the cash, cash is king, remember that when you’re negotiating, whether you’re doing straight equity or convertible debt-to-equity, you have the leverage now and you should seek better terms because the entrepreneur is going to need you.
So, thanks for listening. If you’re watching on YouTube, really appreciate it. You guys are awesome and good luck investing like a shark. Remember, the more cracks at home plate, the more swings you get, the better you’re likely going to do. So generally, three investments of $20 grand is better than one of $60,000. It may not always work that way, but that’s what venture capitalists try to do. And if you’re going to be your own quasi angel investor or part of an angel investment community, that’s generally what is good practice, what typically takes place.
So, happy investing, good luck and I wish everyone enormous success. It’s fun. You get to be your own Shark Tank. You can look at deals, say yes, say no, but negotiate, especially today. 2022-2023, you’re going to be able to drive a much harder bargain than you would have a few years ago. So appreciate it. Have a wonderful, wonderful rest of your day and see you again next week. Take care, and don’t forget, this is a weekly podcast that drops every Wednesday. So, pick this up wherever you listen to your podcast, whether it’s Apple or Spotify or wherever, or you can check it out on our YouTube channel, where you’ll get videos of three podcasts and four to five videos, plus a YouTube Live, that generally drops every Wednesday at noon. So, have a amazing rest of your day and thanks again for listening. Take care.