Often I’ll hear investors say “That company has real potential.  I wish I had the cash to invest. My money is tied up in….”.

An investor’s cash can be tied up in real estate, traditional portfolio of stock, mutual funds, and bonds and/or 401K or IRA.   Investment real estate isn’t considered liquid because it is either income producing or a long term strategic location.  Although public stock can be sold at the investors request at any time, often an investor won’t want to sell their stocks for many reasons.   It could be that they are waiting for a period of ownership to pass to minimize capital gain taxes, or they are waiting for a market response to announcements that would increase the value of that stock.   Many other traditional portfolio holdings may have a longer holding period before they can be liquidated without penalty.  Furthermore, 401K/IRAs are generally considered to be illiquid because of tax penalties associated with the withdrawal of funds.

However, there are two ways that these investments can be used to make investments in private companies, with certain caveats.

  1. Self- Directed IRA:  By definition, the Self Directed IRA is an IRA that allows the account owner to direct the account trustee to make a broader range of investments than other types of IRAs.  The custodian of a self-directed IRA may offer a selection of standard asset types that the account owner can select to invest in, such as stocks, bonds, and mutual funds, but, by definition, permits the account owner to make other types of investments, including loans. The range of permissible investments is broad but regulated by the IRS.  Mostly the IRS regulates what an investor cannot invest in and leaves the “what can invest in” open ended.   For our purposes regarding private companies, here are the restrictions:
  • Not intangibles : art, alcohol, gems, collectables
  • Not an entity that is more than 50% owned by  the service provider who manages your IRA
  • Nor a partner or JT venture that is 10% or more with an entity that is 50% or more held by the service provider.

For more information regarding Self Directed IRAs, here are two good sources:
http://en.wikipedia.org/wiki/Self-directed_IRA

http://cdn2.hubspot.net/hub/319644/file-395650388-pdf/Email-Attachments/Article_Top10Mistakes.pdf?t=1386019713000&t=1386019713000&t=1386019713000

2. Portfolio Margin Loan:  Margin loans on an investment portfolio have long been used by sophisticated investors with high risk thresholds to expand their investment portfolio by borrowing against the value of a stock in order to purchase another stock that they believe they can profit from before they need to repay the loan.  Taking a margin loan out in order to purchase a private non-traded stock is not as common.   Only a few investment advisory firms have provisions for such uses of a margin loan.  Similarly only a few firms have provisions for securing a margin loan for personal use.   Investors that have substantial portfolio holdings and want to consider use of this asset to facilitate an investment in a private company should inquire about restrictions their advisory firm has on the use of margin loans.   There are  3 ways a margin loan may be used to finance an early stage company:

  •  Margin Loan on existing portfolio to directly invest in a direct public offering.
  • Margin Loan as a personal line of credit with authorized use by the CFO of the target company.
  • Margin Loan with the cash extracted as one time loan.  The investor can then provide that capital in a form of a note with warrants or as a convertible note to the company.

More info on Margin Loans: http://en.wikipedia.org/wiki/Margin_%28finance%29

Sample Rates: http://www.schwab.com/public/schwab/investing/accounts_products/investment/margin_accounts

What the SEC has to say: http://www.sec.gov/investor/pubs/margin.htm

Managing the High Risk

Using debt to finance an early stage company is highly risky.  Most often, if a payment is required, it is an interest only payment based on the loan rate and the principal loan balance.   If the margin loan remains in good standing and the portfolio retains or grows in value, the investor is unlikely to have a “margin call” where they must pay down a portion of the outstanding loan balance.  The typical margin loan cannot exceed 50% of the value of the portfolio and are closely monitored the relationship of the margin loan to the total value of the holdings.

Using a self-directed IRA to purchase non-trading private stock is very risky simply because no one can ever actually predict the success and how much success an early stage or emerging growth company may have.   You cannot declare any capital losses if the company does go out of business.

Given the odds of using all of the investment amount, and having little to no recourse, this strategy should only be employed when the investor has a high level of confidence the company will succeed or the investment vehicle would be a revenue producing structure (see Investing for Residual Income Blog Post).   Consider these precautions when considering using either of these “illiquid” investment holdings to finance, either through debt or equity, a private company:

  1. Do the mental exercise….what if you lost the investment?  Would you be disappointed or devastated?   Disappointed is OK.  Devastated? – Then don’t invest.
  2. Company should be in revenue with a respectable back log of trailing revenue.  In the case of the Margin Loan, you could be the “private banker” to finance a transaction so the time the money is required is shorter than a straight equity investment.
  3. The management must have experience in running a company previously so you have a reasonable expectation that they know what to do to generate revenue and make operational corrections as needed to ensure continued growth.   You can’t afford to babysit or for them to get a life lesson on your nickel.
  4. Ensure they are compliant in every way with the SEC.   This includes legally reviewed offering memorandums, not paying finder commissions, and any registrations required with the state that you reside when making the investment.

 Summary

If you have been making an income that would qualify you as an accredited investor ($250,000 personally), then it is likely you have accumulated a portfolio and/or a 401K that is worth over a million dollars. You may have heard about “angel investing” but didn’t think you could participate because you simply were not liquid enough and you didn’t know much about how to make that investment because your Financial Advisor or Wealth Manager never talks about private offerings.  In the Podcast I go into some of the regulatory and market reasons for this: Listen Now. Typically only a Registered Investment Adviser who is not paid a commission on the placement of investments will explore how a high net worth investor could uses existing holdings to make investments in private companies.

Karen Rands, Host of the Compassionate Capitalist show, explored these two ways to make investments into private companies when an investor doesn’t have cash on hand but has ample accumulated wealth.

Listen to the replay:  http://www.blogtalkradio.com/karen-rands/2014/04/22/compassionate-capitalist–angel-investing-when-you-dont-have-cash

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