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Tracking Angel Returns - inflation, taxes, and fees

Paul Clark
Paul Clark
Last updated: January 17, 2024
Venture south fallback

Last week’s UBJ article tried to cover a complex subject – investment returns for angel investing compared to other uses of capital – in a short word limit, so didn’t do justice to some of the nuances. As promised, we’ll cover a few of them in posts over the next few days.

First: what about inflation? All data given was “nominal” – that is, actual data with no adjustments for inflation. Inflation obviously hurts returns: if you deduct 2% per year from the 7% annualized return for the S&P 500, for example, you get a 5% “real” return; 2% subtracted from 22% IRR for angel investments giving a 20% real return is again harmful. But now the relative real return looks even better for angels: 22%/7% = 3x vs. S&P nominal returns; 20%/5% is now 4x for real returns. (I used 2% just for example; choose your own “deflator.”)

Second: what about taxes? Here too, angel investments are generally helped by tax laws. Most angel returns are (lower rate) capital gains; most public market returns are too, but not always, if you have a quick sale or you pay (higher rate) ordinary income on dividends. In early stages, too, investments might pass through their losses to investors if they’re an LLC – which can be helpful to offset other income.

Governments sometimes encourage investment in early stage companies with other favorable laws. Some federal benefits (like QSBS capital gains exclusions) and local tax law – like the SC angel investor tax credit that can reduce your SC income tax liability by up to 35% of the amount you invest in SC-based startups – can have a materially positive impact on post-tax returns too.  (We’re not tax advisors – consult your tax advisor to learn more and judge if those paragraphs were accurate!)

Thirdly: what about fees? Here, public markets catch up a bit. Fees on a basic S&P 500 index tracker might cost you a few basis points (expense ratio of 0.16% on the Vanguard VFINX, for example), or perhaps 0.5% for more complicated trackers (small caps, particular investment strategies), plus another 1% for actively managed funds or the work of a money manager.

Fees for angel investments on your own can be “zero” plus cash expenses in diligence costs, tax preparations, state filings, etc., which can be significant; plus time and effort.

Angels in groups charge different fees depending on how they are organized. Professionally-managed groups like ours charge fees because of the greater input into decision-making, administration, and portfolio management. Fees might include annual membership dues, ad hoc levies, or “asset” or “management fees”. For now, let’s use the fee structure for the VentureSouth Angel Fund II of 2% management fee and 15% carried interest, which we expect to reduce gross returns by 3-4%.

So net of fees and taxes, and (not) adjusting for inflation, a reasonable comparison might be 4.5% for S&P 500 and 16% for angel investing – still at the 3-4x out-performance in the original article.