News & Insights

An overlooked attraction of angel investing, compared to most other asset classes, are the fun tax rules around gains and losses on early stage investing. Sounds odd, but it’s true. As we discussed in our guide to angel taxes, the gains from angel investing are often tax free – thanks to the Dabo of the tax code. Following a lucrative 2021 for VentureSouth members, we have spent much of the last few weeks explaining to investors the tax consequences of their exits. We thought it might be useful to share a case study on a recent exit, as it covers the range of tax implications described in the guide. VentureSouth members made five investments in a company, as follows:priced preferred equity seed round in 2015a small purchase of common stock from a departing cofounder in 2017a convertible note in 2017; this note converted into the next round of equity in August 2018priced preferred equity Series A-1 round in 2018, and a further priced preferred equity Series A-2 round in 2029…and exited when a purchaser acquired our shares in 2021. Sounds complicated, but this is a typical journey for an early-stage investor. Each of these rounds is an interesting angel investing tax scenario, so let’s take them one by one. 1) Priced equity held more than 5 years We’ll start with the best. This first round was an investment in Qualified Small Business Stock (“QSBS”), as a a C-Corp running a real business with less than $50M in assets. This is the “base case,” a typical angel investment in a southeastern deal. As QSBS stock held for over five years, gains on this stock are exempt from capital gains taxes. (There are, of course, some limitations, like a max gain of 10x or $10M. There are also more…creative… methods (“stacking”, “packing”, and of course “peanut buttering” discussed here), which do not really apply to angel investors but make for interesting reading.) So the gains on this investment were tax free for our members. Not only was this the best pre-tax return (earliest money in, at the lowest price, so the largest gain); the returns are entirely tax free. What more could you ask for? 2) A purchase of founder’s common stock The next round was a similarly strong pre-tax return, but had a less favorable tax impact. QSBS only applies to newly-issued shares in a company. If you buy existing shares – as in this case where common stock shares held by a founder were purchased in a “secondary transaction,” or more generally, like when you buy shares in a public company – QSBS does not apply. QSBS is designed to encourage new investment. While active and liquid secondary markets make investing more appealing – it’s more palatable to buy stock (and found companies) if you can sell that stock one day – QSBS is focused on rewarding new funding of startup companies, and so is limited to newly-issued shares. Even without the benefits of QSBS, though, this is still fairly appealing as a long-term capital gain taxed at capital gain tax rates. 3) Later priced equity rounds held for less than five years Let’s disrupt the timeline by next tackling #4, the two recent priced equity rounds. Both these investments were QSBS: still a C-Corp with less than $50M in assets, still operating, selling newly-issued shares. So you might think QSBS / Section 1202 / Dabo applies. Unfortunately (from a tax perspective), this was, fortunately (from an IRR perspective), a quick win, with capital deployed and returned within five years. That means the stock was not held long enough to get the Section 1202 exemption. The good news, though, is that these proceeds are eligible for “rollover” under Section 1045 of the tax code. If the proceeds are redeployed into new QSBS within 60 days, no capital gains tax is due on the gains. Investors then face the decision: do we bank the proceeds (and pay long-term capital gains tax on the gain); or do we “roll the dice again” by reinvesting the proceeds into one or more (sensibly: more) QSBS companies? Letting tax treatment determine your investing has the tail wagging the dog, but recognizing the net, post-tax returns is a critical part of investing successfully. 4) The convertible note round The most complicated round of all is the convertible note round in the middle. If you’re familiar with VentureSouth’s soapbox, you know we are generally not fans of convertible notes. One reasons is taxes. The original investment in the convertible note was not into stock of a C-Corp, so QSBS doesn’t apply. The QSBS “clock” only starts when the note converts – which in this case was several months later, which is typical. There are other complications too. How much of the “gain” here was from the accrued interest on the convertible note (taxable as interest?)? How much came at the conversion event? How much should each be taxed? This is a bit beyond the scope of this post, but let’s just say the tax treatment might be murkier on notes than on priced equity. As one hypothetical, notice that if the exit had been in January 2022, a priced round in December 2016 would have been capital gains tax free under Section 1202, but a convertible note at the same time (but that converted in June 2017) would not. (It would have been Section 1045 rolloverable based on the date of conversion, which is good, but it ties up capital for more than six years total to get the treatment you might have received after five. Not so ideal. And no guarantee that the rolled-over money would not be written off!) Not a bad outcome, of course, but one tangible example of where equity would’ve been better (post taxes) and simpler than a note. To sum up: One company, five rounds, four different tax treatments. Fun stuff we hope you agree! We think VentureSouth members benefit from having access to early stage, QSBS-eligible deals; from a steady supply of Section 1045 rollover-eligible companies so eligible proceeds can be reinvested within 60 days; and a full-time team who love explaining the tax implications of investing before and after the investment. Perhaps you will join us for the next one! PS – Section 1045 in action! As an interesting aside, some of our members invested into this company using proceeds from a successful exit of another VentureSouth portfolio company. The prior exit was from a QSBS company held less than five years, and so the proceeds from that exit were eligible for rollover under Section 1045. The successful investors took those proceeds, redeployed them into Company A, and made a further multiple of gain on them. First company was held for two years; second held for three; added together they passed the five years required for QSBS to apply – so all the gains became capital gains tax free. This is Section 1045 working exactly as advertised!  Double win.

The previous posts in this series looked at investors that invested directly through VentureSouth. This included investments made through our VentureSouth Angel Funds. If the last posts were accurate, we would expect an automatically-diversified portfolio to lead to even fewer investors that have lost money overall.And, based on our two fully-invested sidecar funds, those expectations would be correct. None of the investors in those funds have lost money, and none are (we think) on track to.Fund I (2014/16 vintage) has already returned almost 50% of invested capital to members, from the realization of just the first three of its 18 investments. It has a TVPI book value approaching 2x ROI already (from exits and the residual portfolio value based only on later share sales, not marking-to-market the performance of its portfolio), and could be more if things continuing going well in the portfolio.Fund II (2016/18 vintage) has had its first positive realization this year, a TVPI book value of 1.1x ROI already, and is on track for similar results – though it is still too early to estimate precisely what the return will be.These fund investors (with no loss-makers yet) bring the average for VentureSouth down a little: those that are less diversified from their group investing have higher incidence of losses.Of course, no-one knows what the future brings. If many of these companies fail over the coming months it is conceivable that these fund investors could ultimately lose money. But with companies like Proterra, KIYATEC, Baebies, Spiffy, Emrgy, and others attracting national attention, VC funding, strategic partners, and acquisition interest we are optimistic.

One other point to note in this series: “losing money” in angel investing does not necessarily mean losing all the capital you invested in startups.Of the 10% of investors that lost / are losing money in VentureSouth-related investments, only a very few (less than 1% of investors) lost all their investment. In fact, the aggregate return for those investors is around 0.6x ROI – not great, of course, but far from a total loss. These unfortunate investors have, in total, in fact received back a majority of their invested capital!An individual angel investment can easily result is a complete loss of capital: when startups fail, there is often no residual value for equity investors like angels, whose claims at a liquidation come after lots of others have received their claims. Angels should only invest money they can afford to lose.But it’s very much less likely to hit a string of complete “zeros.” A few partial exits, dividends, or a successful investment along the way makes it quite hard to lose all your money. Diversification, again, is critical.

The last posts about the proportion of VentureSouth investors that have lost money in angel investing concluded that only a small minority (10%) of angels investing through our group have lost, or are on track to lose, money in aggregate.That’s not a trivial number – we don’t want people losing money on investments made through VentureSouth – so we wanted to dig deeper to understand why those individuals received, or are facing, overall losses.First, the obvious reasons:startups fail all the time: the five-year survival rate of all new businesses, let alone technology startups in the Southeast, is under 50%.50%-70% of individual angel investments result in a loss of some capital, according to the most authoritative academic data; the same is true for VC deals.and in any dataset there will be “unlucky” investors in the left hand tail of the distribution and some “lucky” ones in the right hand tail.But let’s dig further: what did those “unlucky” investors have in common, and what can we learn from their misfortune or mistakes?First, diversification. It’s a cliché – but it’s true – that diversification reduces risk. Of the investors that fall into the “loss” category, around 60% (of the 10%) invested in only one or two companies. It is not really surprising, therefore, that they lost money. Startups are risky and individual companies frequently fail.On the other end of the spectrum, only one of the unsuccessful investors made over ten investments, and that individual is on track (according to our best estimate of likely outcomes) to have a positive return in the end.So, if you’re diversified, you stand a much better chance of not losing money. If your angel investment plan is “one and done,” or you expect to generate 20%+ annual rates of return from a couple of angel investments (alone or through any group), you will be disappointed. VentureSouth’s biggest strength is the opportunity to develop a portfolio of well-curated investments quickly. We’ll come back to that, and how diversification affects returns overall, another time.Second, timing. Some of the loss-making investors have realized losses but still have paper gains that might result in a positive return overall; if their portfolios mature as we think, they would move out of the population. Fingers crossed – and noses to the grindstone.These individuals highlight the inescapable reality of angel investing: angel are “blessed” with early failures and (usually) long-term gains. If a deal is going to fail, it is likely to do so quickly, as its 12-18 months of runway from the angel round are exhausted; if it’s going to win, you might enjoy an “early exit” – a solid result quickly, which is a good rate of return – but it will likely take 3-5 years or longer for truly successful results. A 10x return in two years is a rare exception – but we have those in our portfolio, and others do too.So, the VentureSouth data supports what we tell members and potential members: angel investing is risky, but if you’re diversified and patient your probability of success is much greater.

You probably noticed a few italicized words in that last post. Different cuts of data tell different stories, so in the interests of full disclosure here is more explanation of the data I used.Through VentureSouth. This excludes any investments individuals made on their own, either before or after being VentureSouth members, or while members but outside of VentureSouth deals. You could argue that I’m cherry-picking the best data by only including VentureSouth performance, when wider data would be more appropriate. If you argue that, you’re saying that people make better investments through VentureSouth than on their own – so the logical conclusion is you had better visit our enrollment page to sign up…Still, it is a reasonable objection. We have a bit more insight into some of these investors’ portfolios, as we have some data from them about their angel investing experience, and we sometimes see their names on other cap tables, but not enough to be certain about full track records. Nevertheless, it would take a lot of investors making wrong decisions outside of VentureSouth to change the proportion materially.in aggregate…. I think David means his angel acquaintances have lost money in aggregate, not on any given deal. Of course, we all know angels that have lost money on a particular investment – it’s happened plenty of times here and will happen plenty more – but I’m sure a single deal loss isn’t what David meant.…so far. I’ve included here (a) investors who have lost money on realized investments but still have active investments in play and (b) investors who have made money so far but whose portfolios include some active companies that seem unlikely to generate a positive return. Several of the first group are on track to “rescue” their positions with a payoff from their remaining portfolios, and things might improve for those in the second; but as future payoffs are estimates, I’ve included both of those groups in our data as a “worst case” proportion.(before fees). I excluded fees (for us, membership dues and carried interest) from this data. These are small relative to the invested capital and returns, so while they might reduce the net aggregate return, they are unlikely to move an individual from the “made money” category to the “lost money”– and certainly not enough individuals to impact the proportion in each group materially.

Following from yesterday: as of writing, 389 angel investors have invested in one or more companies through VentureSouth since the first investment in 2008.Of those 389 angels, only 40 investors (10.3%) have lost money in aggregate (before fees) over their VentureSouth investments so far, or seem likely to lose money based on their portfolios’ trajectories.So, have the majority of angel investors we know lost money in startups? Definitively NO: 90% of angels we know have not lost money investing in startups with VentureSouth.Of course, life is more complicated than the short answer, so we’ll add some nuances in a follow-up post.

David Cummings’ post are always thought-provoking. His post a few days ago (about revenue-based financing, followed-up last week) started off in an interesting way.“Investing in startups is a great way to lose money.”“The majority of angel investors I know have lost money investing in startups.”Is that really true? Can that be true and the studies of the returns for angel investing (like those described by us here) be accurate? And what about me: have the majority of angel investors I know lost money investing in startups?I don’t know the same angel investors as David, so I can’t answer the first two questions. But the introduction made me wonder if data are available on the proportion of angel investors that lose money. I don’t know of, and haven’t found, any studies specifically about that.So, to try to quantify the “risk” of angel investing in a new way, here are some data from the first decade at VentureSouth to answer the last question: have the majority of angel investors we know lost money in startups? Posts coming over the next few days will answer that.And if you would like to share your results with us, publicly or privately, we would love to help add this dataset to the expanding data available on other aspects of angel investing.

In a follow up to this post, we need to explain why the 22% annualized rate of return for angels in groups is possible – and doesn’t get “competed away” when everyone finds out about it and piles in. My theory is that it’s very hard to “pile in” to early stage investments.1)      If you’re an individual, you probably aren’t even allowed to invest in early stage companies – so large “retail” investors likely can’t impact the asset class. (This may change as equity crowdfunding kicks in – but I doubt it, at least for a while.)2)      If you’re an institutional investor, how do you deploy $100 million into early stage capital? There is basically no cost-effective or logistically feasible way – even though, in total, angels invest $25 billion in early stage companies each year.3)      If you’re in California, how do you evaluate and invest in early stage companies in North Carolina? You don’t. Angel investing is a local activity: 93% of VentureSouth’s deployed capital has been here in the Carolinas. Even despite technology, angel investing remains an in-person and localized pursuit.It’s likely impossible for one unified market to generate 20%+ returns consistently over time. But hundreds of illiquid, hard-to-access, opaque, and highly-localized markets could keep generating, on average, such results.At VentureSouth, this our target – a portfolio return of 20% net to investors – and we are on track to get there.

IRRs of 20%+ sound unlikely. If angels were really doing that, wouldn’t they have followed hedge fund managers to Puerto Rico or the Caymans?Maybe - although a 3x return on a $10,000 investment, which is the median investment made by an investor in VentureSouth groups, might not get you all the way there.But it does seem unlikely that the returns are truly this good. This isn’t because angels are (or aren’t) “beating the market.” The efficient market hypothesis says beating the market is impossible, as prices reflect known information (all public, or all including inside information, depending on your strength). On this, EMH is definitely correct – which is why Buffett is winning his hedge fund bet so easily. But angels aren’t beating the market – they’re investing in a different market.Still, if 22% was a consistent return, everyone would pile into that asset class, drive up deal valuations, and therefore eliminate the “excess returns.” (Or invest in more “marginal” (or nutty) companies and therefore bring the median return down.) So can it be true?There are two approaches here: either the 22% is wrong, or we need to explain why it can be true. This post tries the first; a follow-up post with tackle the latter.So let’s try to knock some holes in the 22%. There are likely several sources of exaggeration, because the data is (generally) provided voluntarily. Two are:Self-selection bias: in general, people only report information if they think it’s notable (which would suggest greater reporting of big wins or big losses, less reporting of 0.5x-2x returns) and much prefer to report their winners than their losers.Survivor(ship) bias: similarly, it’s likely that angel groups or funds that did poorly weren’t around to report their data, while successful and sustainable groups did.How much of an impact do these biases have? In a 2012 study of hedge funds, funds that did not report to commercial databases had alpha (outperformance vs. the market) 60% lower than funds that did report – from a “truncated left tail” in the returns distribution. Commercial databases of hedge funds likely miss the worst performers. That is true for mutual funds and VC and PE (though perhaps less so as public pension fund investors have to report their data – good or bad); and it likely applies to angel too.The authors of the angel studies are obviously aware of these biases, and try to control for, or at least analyze, them. Their tests suggested angels reported honestly (the data for syndicated deals was generally consistent between the different syndicate respondents, for example); sampling through groups makes it more likely the “failures” are included; and comparing “high response” groups with “low response” groups showed very little difference between the returns declared, suggesting “low response” groups were not just supplying their best results. And it may also be that as positive results take longer to achieve the “achieved” returns underestimate the eventual return – this “locked up” capital bias possibly offsetting the others. (It’s the opposite of “instant history bias.”)So, yes, 22% is probably not exactly right. The lack of data relative to hedge funds, PE or VC makes definitive conclusion impossible. My view is that 22% is probably a touch high to be the median result, but I don’t think they are much lower than that – which is why I’m an investor in the Palmetto Angel Fund (VentureSouth's first “index fund”) and will be in the next one too.

Continue the “tracking angel returns” series… Another objection might be that the S&P 500’s performance over the last 15 years is not the appropriate benchmark against which to judge angels' returns. Fair enough – I just used that for simplicity. Here are some alternatives.Different time frames: The original Wiltbank study was over the 20 years to 2007. The same time period for the S&P (1987-2007) has a total annualized return (including reinvestment of dividends) of 6.3%. Not much difference vs the 7% in the original.Different index: S&P 500 obviously has different companies (the largest of the large caps – you need a $5.3bn market cap to be in the S&P 500 today), so it’s not obvious to compare with angel investment returns. Fair enough. Choose any public index over the similar period, and I’ll wager it looks pretty similar. The S&P 600 small caps, for example has a 10 year return of 6%; the NASDAQ returned 0-11% IRR depending on your timing since 2000 (ignoring dividends: I couldn’t easily find NASDAQ total returns, but assuming dividends don’t add more to NASDAQ returns than the S&P I think we’re on solid ground…).Different timing: If you compared the return from when the S&P bottomed at 676.53 in March 2009 to its current value, you’d have enjoyed annualized returns of closer to 19% including dividends. The NASDAQ enjoyed an IRR of 11% from the trough in September 2002. Well, yes, if you can consistently “time” the market you can outperform the averages – but if you can do that you’re in a very small minority…Correlation? We don’t have enough granularity to determine whether angel investment returns follow those from public markets – whether timing matters. Perhaps they do and therefore if you timed your angel investments well you could beat the “22% market index”? The general belief is that angel returns are not correlated with the economy or public market indexes, and that timing doesn’t matter in angel investing.So here’s a request: can anyone supply a public market benchmark that makes the returns look poor?