As part of the Compassionate Capitalist Radio Show where Karen Rands revealed the insights gained recently on why so many wealthy people don’t know about or participate in angel investing. Podcast file is include in this posting….
Interestingly enough, if you were to ask the average millionaire that you encountered on the street (not that any millionaires are actually average) their thoughts on entrepreneurship, capitalism, and creating wealth; you would likely get comments such as the following:
“Entrepreneurs are the backbone of our society. They create jobs and bring innovation to the market.”
“It is only in creating wealth that anything gets done or paid for.”
“I’d rather give my money to an entrepreneur with half a brain and the gumption to go out and do something with it, than some government empty suit that is just going to give it away. ”
“The people who solve problems make the biggest bucks.”
“Buy low and sell high!”
“The free market – capitalism – gives you personal freedom – to choose your future destiny.”
“I seek to invest my money where I can get a return on investment…the greatest reward relative to the risk.”
So with thoughts and feelings like this, what keeps millionaires with the capital on hand to make alternative investments and invest in early stage private equity opportunities? It is estimated that 10% of the American population has the means to qualify as an accredited investor, that translates to millions of potential investors, yet only a few hundred thousand participate in angel investor type deals.
Our investigative team has determined that the very regulations intended to keep fraud out of the process and protect high net worth individuals is actually creating a situation where misinformation abounds. Further, greed and fear actually limit the free market access to information about investment opportunities into private companies these potential investors should have to be able to become “angel investors”.
The Securities and Exchange Commission (SEC) regulates the sale of securities. What this means is that for entrepreneurs to be compliant in their sales of equity in their company, they must adhere to rules regarding selling those securities as a non-public company.
1. General rule of thumb is that they sell to only accredited investors, with a few exceptions.
2. They must provide documents that clearly state the risk, typically in a Private Placement Memorandum
3. They cannot do a public solicitation through an online posting, email blast, advertisement or anything that will offer the security to the public and therefore they must have pre-knowledge of the investor, or if they work through a licensed broker the broker can sell their security on their behalf.
4. If they are to pay a commission for the sale of that security, they can only do that with a licensed broker, with few exceptions.
This leads into the Broker side of the equation which is regulated by FINRA. FINRA, the Financial Industry Regulatory Authority, is the largest independent securities regulator in the US whose chief role is to protect investors by maintaining the fairness of the US capital market. They regulate the brokers that are authorized to sell and take a commission on private placement opportunities. Typically brokers/dealers charge large upfront fees and large back-end fees for the sale, and assuming the liability, of selling that security. They have a due diligence fee, retainer, commission and stock options. To justify those fees, they typically want to work with companies that are raising $5M or more and have revenues to manage to the upfront fee, or have cash on hand from their friends and family round of financing.
Broker/Dealers (BD) often have affiliate brokers, financial planners etc, that hang their license with them. The brokers, according to the FINRA guidelines, create fear with these affiliate brokers if they are caught “Selling Away”. So if an affiliate broker sells anything to their clients, the people whose money they are managing, that is not offered and approved by the managing BD, then it is considered selling away from the brokerage.
When a broker solicits you to purchase securities not held or offered by the brokerage firm. As a general rule, such activities are a violation of securities regulations.
Typically, when a broker is “selling away,” the investments are in the form of private placements or other non-public investments.
On the surface this is all good because the investor only gets products, securities, investment vehicles that have been fully vetted by the brokerage house. They sleep well at night believing that they have placed their money in solid investment vehicles, whether private or public offerings, they really don’t focus on the difference.
As with any private equity transaction, this does not guarantee that they will not lose money in that investment. We’ve seen that all over the place even in reputable firms like Stanford or in public stocks like Enron.
But in reality, how this plays out is that the Broker will only promote private offerings that they are being paid to promote. And investors that want to participate in angel investing, want to “own a piece of a company” don’t get the benefit of having their financial counsel to help them in evaluating the deal, they don’t get quality deal flow from other sources, and they don’t gain insight into how to make wise investment decisions in that area and manage to the tax implications on the return on investment.
Not all high net worth individuals think of investing in private companies as “angel investing”. If they are readers of Robert Kiyosaki’s books (Rich Dad, Poor Dad or Cashflow Quadrant) then they likely are working on their financial IQ and working toward being Business Owners and Investors so that their money works for them rather than working for their money. Angel investing in effect is the entire scope of the right side quadrant….business ownership through investing in private businesses. Yes you have the greatest likelihood to lose all the money invested in an early stage private company, but you also have the potential for greatest return on investment. Private equity investing at the early stage produces greater returns than real estate or stocks or any other asset class.
Angel Investing has the potential to create more wealth than any other asset class…at multiple levels. It can create wealth for the investor that directly invests. It creates wealth for the entrepreneur that is bringing the product to market and building a successful company. It creates wealth for the newly hired employees in their earned income. It creates wealth for all the businesses along the supply chain that service the company, build the products, and so on.
On the other hand, most real estate investment only creates wealth for the seller and those that assisted in the sale and the investor who gets a return from rental income or the upside when it is sold the next time. Public stock investment doesn’t create wealth for anyone except for the person who is able to sell the stock for more than they paid for it. There is a commission paid to the broker for handling the transaction. The money used to buy public stocks doesn’t go into the company’s coffers to invest in R&D or hire new people, it goes to the seller of the stock.
So for those millionaires that “get it”….there isn’t a lot of guidance on how to determine if an early stage private equity opportunity is a good investment nor how to decipher the terms of the investment and if the return on investment will come in the best format for the tax implications and so on for that investor’s overall investment strategy. The tax implications from a convertible note that has accumulated interest may be different from an investment that shared in the revenue (and losses) of a company; the investment made as a straight purchase of equity that is held for 18 months vs one that is held for 5 years. And what would the impact be if you purchased the equity through your self directed 401K or as an investment made through a ROTH IRA.
Entrepreneurs that think they are doing the right thing, creating a PPM that even allows for a broker commission and only selling securities to accredited investment has NO idea that a whole source of potential investors are not available to them, actually blocked from them getting access to them. It is crazy to think they would go to one broker to get access to their investors, pay the fees, then go to another one, pay their fees, and so on. They typically will work with one broker for a while and then forge out on their own trying to find the individual investors. If they go the broker route, they typically can’t go back and work with angel groups because the structure of the stock offering is set in stone. The greed of the brokers won’t let the entrepreneur just pay the broker a commission or to have the affiliated broker take it to one or two of their high net worth clients that have expressed an interest private placement opportunities. And because of the fear that the affiliate broker has in losing their license if they are accused of “selling away”, they won’t even tell the client about the investment opportunity and NOT take a commission. When the licensed financial adviser knows the client wants to make real estate investments or buy a franchise, they will refer them to a source for those deals and help them to understand the implications on their financial diversification and asset allocation, and any tax and estate implications. They don’t collect a commission, they don’t think of this as selling away, they think of it as providing full service to their client based on the client’s interest in different investment options.
So what is the solution?
For investors, that want to be involved in angel investing and they don’t have the benefit counsel from their investment adviser they should do the following:
- Buy the series Learn to Be an Angel Investor…it is concise look at the history, process and structure for angel investing taken from 5 years of working with successful investors and their secrets to success and countless industry reference materials. 5 books, or one compiled “Secrets….”
- Join an angel investor group or find a group of other angel investors that can mentor you and co invest with you.
- Attend an angel investor meeting or forum and start to be familiar with the types of deals out there and the structure of the offerings.
- Form a team of advisers that will help you and protect you…this includes a lawyer accountant and financial planner/wealth manager. They should all have made angel investments in the past or at least counseled others in that arena, either entrepreneurs or investors in early stage capital.
- Attend a seminar that can teach you how to be an angel investor or be a better one if you have not achieved the results you hoped for in your previous investments. Investor Workshop July 15: How to Be a Better Angel Investor.