Angels Sometimes Need Help, Too
A Carefully Targeted Tax Break to Boost Innovation Could Be Worthwhile
SOURCE: Liberty Films
Early-stage investors in innovation companies—angel investors—and the founders of start-up companies they support financially, warrant investment support. Here’s one intriguing idea.
Clarence Odbody, the great-hearted but bumbling angel who saves George Bailey from himself in the post-war Christmas classic It’s a Wonderful Life, counted on Jimmy Stewart’s character to earn Clarence his “wings.” Angel investors, those wealthy individuals who bankroll the innovative entrepreneurs at the earliest stages of company creation, don’t drop from heaven like Clarence, but they do save entrepreneurs struggling to turn their new ideas into successful companies and in turn count on the entrepreneurs they support financially to get past the nearly suicidal hours required to create explosive new companies—think Google or Genentech—which create the majority of new and well-paying jobs in the United States.
Angel investors aren’t in this game to earn their wings, of course. Wealth is the goal, but so too is job creation for these mostly local serial entrepreneurs who thrive on the thrill of building companies that help their communities grow and prosper. Problem is, these and other very early-stage investors in innovation companies—including the inventors and founders of these new companies and their friends and family who put up their first rounds of cash—often don’t reap the rewards of their early risk taking. The reason: Once a young company reaches a certain point of success it usually stumbles as it tries to bring its new product or service to market—at the very time it needs lots more money to grow.
Enter the professional venture capitalists, who demand a big majority stake in the young company in exchange for the new cash, and then do the same again when the company needs a second and third round of venture capital. In fact, venture capitalists these days are by and large not doing what they once did for the U.S. economy—backing early stage innovation to create the Googles and Genentechs they once did. This job is falling more and more to angel investors.
According to the National Association of Seed and Venture Funds, “venture capital plays almost no role in funding basic innovation, and a relatively small role in funding true startups, with only about 3 percent of the $21 billion VCs invested in 2005 going to such firms.”[1] Long-time venture capital lawyer Joseph Bartlett, who also runs the website VCExperts.com, gives a great example of this problem in action in a forthcoming report:[2]
To illustrate, let me repeat an anecdote which I share with my classes at law and business schools, to wit: In real estate the three rules of successful investing are “location, location, location.” The gag is that they are all the same rule. Transposing that wisecrack to venture capital, I preach that the three rules are: “dilution, dilution, dilution.”[3] I draw an inverted bell shaped curve on the blackboard and show how the early capital, which is the highest risk and therefore should be entitled to the highest reward, can so often be burnt out or crammed down by subsequent rounds of financing, including (as the curve slopes downward to its nadir) the “down rounds” which dilute the founder and the angels to trivial interests in the company. Then, when the company, as companies often do, recovers and is sold or goes public, the result is all too familiar: The VCs who invested in the later rounds, having crammed down their fellow investors, wind up making out like bandits, but the earliest money is left bleeding on the shore.
Angel investors know this, as do the entrepreneurs they finance, and they all take their chances anyway. Such risk-taking is the lifeblood of U.S. economic competitiveness. But increasingly these angels are not stepping up, depriving the U.S. economy of the most critical stage of risk capital formation for the creation of globally competitive new companies and good paying new jobs for their employees. “The economic impact of the seed money gap is staggering,” says Bartlett:
At a conservative minimum, at least $4 billion is lost to the U.S. economy each year. More realistically, the economy losses closer to $100 billion per year because of the funding gap. Socially, the losses are just as great. Products and services that would improve the lives of our country’s people are either never developed, or significantly delayed.[4]
Here’s one way that Congress and the Obama administration could fix the problem, according to Bartlett in his forthcoming report. The United States, he says, needs a tax efficient structure by which angels and founders and other very early stage investors in young companies can mitigate the impact of dilution brought on by subsequent venture capital financings. His vehicle for doing this are what he calls “up-the-ladder” warrants,[5] which would enable early investors in young companies to participate fully when the company eventually goes public or is sold—because of the warrants that will make up for the dilution the angels and entrepreneurs encounter because of follow-on rounds of venture financing. Warrants are financial instruments that allow holders to purchase stock in a company when the shares reach a pre-determined price—stock that can then be sold or held onto for capital gains and wealth accumulation.
The exercise price—the price at which the holder of the warrant can purchase stock—would need to be set at a number that is well “out of the money,” says Bartlett, which in financial parlance means well above the current share price, hence the name “up the ladder.” This would keep the VCs content to leave the warrants in place when they invest. Assuming all goes well with the sale or public offering of a startup financed by angels and VCs, everyone can profit. Here’s how Bartlett thinks the structure would work:[6]
- Angels invest $1,000,000 for 100,000 common shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post-money valuation of $4 million ($1 million going into the new company in the form of additional stock); the founder and key employees own 300,000 common shares.
- The package includes 100 percent warrant coverage, meaning there is also a “call” on the company to issue another 100,000 shares of the company’s stock at a pre-determined exercise price.
- This exercise price must be based on pre-money valuations that are relatively win-win for subsequent venture capital investors so that these later investors do not require the warrants be eliminated as a price for future investments. So, in our example here, the warrants will be based on pre-money valuations which are in fact win/win, say at $30, $40, and $50 a share (33,333 shares in each case).
- Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the company—100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares.
- Subsequent “down rounds” of VC investment—a down round means an investment at a share price lower than prior to the investment—later raise $2 million and dilute the angels’ share of the company’s equity from 25 percent to 5 percent—their 100,000 shares now represent 5 percent of 2,000,000 shares (at a cost basis of $10 per share).
- The founder and key employees own 300,000 shares, or 15 percent and the VCs own the rest (1,600,000 shares at a cost basis of 80 cents a share due the down rounds).The company then climbs out of the cellar and a trade sale is scheduled for $100 million in cash, or $50 per outstanding share.
Absent “up-the-ladder” warrants, the proceeds to the angels would be $5 million. This is not a bad return (5 times their original investment) but nonetheless inconsistent with the fact that the angels provided the initial cash capital (the founder and employee contribution is largely sweat equity). The “up-the-ladder” warrants would add to the angels’ ultimate outcome as follows: 33,333 warrants at $30 per share are in the money by $666,660 and 33,333 warrants at $40 a share are in the money by $333,330. So the angels net an additional $999,999—call it $1 million—out of the purchase price.
The angels’ total gross returns have increased to 6 times their original investment while the returns to the VCs and the founder/employees have slid to $94 million. Even if the $1 million going to the angels comes entirely out of the VC’s share, that’s a relatively trivial result—a gross payback of 39.5 times their investment versus 40 times. If the company sells for just $30 a share, the angels get nothing because the exercise price is not above the actual share price, and the VCs still make out.
Now there needs to be a reason for venture capitalists to offer these warrants not just to angel investors but also to the founders, friends, and family invested in these new and innovative companies, and perhaps also to the employees in the company who are working so hard to make it a success. Bartlett argues that capital gains on the warrants should be treated as taxable under Internal Revenue Code Section 1202, which reduces by half the tax on the gain from the sale of securities issued by so called Qualified Small Businesses, assuming that the investment has been held for five years. And the capital gains would not to be subject to Alternate Maximum Tax.
For this to work, though, there need to be carrots and sticks to persuade venture capitalists to offer and then honor these warrants all the way to a profitable “exit.” One way would be to provide the same capital gains treatment to venture capital investors under IRS Code Section 1202—provided the venture investors offer these “up-the-ladder” warrants to the founders, the angels, and other early -stage investors in the company, and perhaps the company’s employees, too.
Remember, taxpayers will not be out any money if the company is not financially successful, as this tax break only applies after successful investing. And the tax break for venture capital investors would not apply unless they offered these up-the-ladder warrants to all early-stage investors in the company between the original rounds of investments and the final valuation of the stocks upon the sale of the company.
Broad-based wealth creation in the service of stronger job creation to boost U.S. economic competitiveness. Surely that’s a win-win-win.
Ed Paisley is the Editorial Director for Science Progress and the Vice President, Editorial at the Center for American Progress.
Endnotes
[1] NASF, “Fostering Innovation Capital,” Seed and Venture Capital State Experiences and Options, May 2006, p. 4.
[2] “The Great Debate: Half Full vs. Half Empty,” a forthcoming paper by Joseph Bartlett, to be published in early 2010, which will dissent from the idea there is too much investment in venture capital in today’s environment in the United States.
[3] See www.vcexperts.com, Buzz Archive: http://vcexperts.com/vce/news/buzz/archive_view.asp?print=true&id=78.
[4] Bartlett, Keller, Materfis, “An Initial Measurement of the Impact of the Seed Money Gap in the U.S. Economy,” Section 13.1.3, www.vcexperts.com.
[5] http://vcexperts.com/vce/news/buzz/archive_view.asp?print=true&id=109
[6] Summarized from the forthcoming paper, “The Great Debate: Half Full vs. Half Empty.”
Comments on this article
By clicking and submitting a comment I acknowledge the Science Progress Privacy Policy and agree to the Science Progress Terms of Use. I understand that my comments are also being governed by Facebook's Terms of Use and Privacy Policy.
