angel investments case study unit 5

Angel Investing Taxes – A 2021 Case Study

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 2015
• a small purchase of common stock from a departing cofounder in 2017
• a convertible note in 2017; this note converted into the next round of equity in August 2018
• priced 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.

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.

CASE at Duke

Angel Networks In Emerging Markets

Entrepreneurship is a key driver of economic development – when new businesses launch and grow, they create jobs, address customer needs through market-based solutions, and drive demand for other products and services from a supply chain. With this knowledge in mind, the United States Agency for International Development (USAID) and other development institutions have increasingly dedicated resources to bolstering entrepreneurial ecosystems in order to fuel these economic ripple effects.

A critical component of strong entrepreneurial ecosystems are angel investors – individual investors who make relatively small, private investments to support enterprises through their more high-risk early stages. While angel investors often invest individually, they may collaborate with each other through angel networks , which bring together member investors for mutual benefit.

In 2018, USAID’s Partnering to Accelerate Entrepreneurship (PACE) Initiative engaged CASE to investigate angel network models to analyze strategies and best practices, as well as make recommendations for how development institutions can leverage angel networks to reach their economic development goals. CASE was happy to partner with Millbrook Impact and the Bertha Centre for Social Innovation and Entrepreneurship at the University of Cape Town Graduate School of Business on this initiative. The research team explored angel networks in parts of Latin America, Middle East/North Africa, and Sub-Saharan Africa.

The results of this project are:

• Angel Networks in Emerging Markets: A Guide For Development Institutions , which provides the framework and tools for USAID and other development institutions to assess angel investor networks, gauge their strengths and strategies, understand challenges they face, and identify how to support them.
• Five Angel Network Spotlights – case studies of angel networks to provide concrete illustrations of network variables, business models, strategies in action, and opportunities for support.

This work aims to go beyond simply sharing knowledge about angel networks. We hope this guide and case studies galvanize development institutions and other funders to select from a set of specific support mechanisms to help angel networks succeed.

Angel Networks In Emerging Markets: A Guide for Development Institutions

Provides five specific recommendations and three tools for USAID, development institutions, bilateral and multilateral donors, and other investors to engage with and support angel networks in emerging markets in order to leverage local, private capital to fuel early-stage enterprises. Read the full guide

Angel Network Spotlights

Angels Nest

Angels Nest operates one of the most active angel networks in Latin America. With no membership fees, an online platform for angels, and international partnerships that activate additional capital, it lowers entry barriers to angel investing and aligns its goals and revenue with the interests of investors and entrepreneurs. Read the case study

Colaborativo

Colaborativo runs several, connected entrepreneurial services to promote sustainable development in Latin America – an accelerator, an online community platform, an angel network, and a recently launched fund. Read the case study

Lagos Angel Network (LAN)

Lagos Angel Network was founded by high-profile Nigerian entrepreneurs and angel investors. With the help of development funding and key partnerships, they have leveraged their reputations and skills to build one of the most active angel investor networks on the continent. Read the case study

iungo capital

Born out of ViKtoria Ventures, a start-up supporter in East Africa, VBAN uses its deep networks to attract angel network members and build quaiungo capital’s innovative approach aligns the motivations of a for-profit fund, non-profit technical assistance provider, and local angel investors to meet the finance and support needs of East African Small and Medium Enterprises (SMEs).  Read the case study

ViKtoria Business Angel Network (VBAN)

Born out of ViKtoria Ventures, a start-up supporter in East Africa, VBAN uses its deep networks to attract angel network members and build quality pipeline for investors. With a dedicated Network Manager, VBAN provides hands-on support to members at every step of the investment process. Read the case study

How To Be an Angel Investor

If you want to become good at early-stage investing, you need to learn how to size up the fundamental elements of an opportunity. Many investors use checklists or think of evaluation as a process of judging an entrepreneur, or an idea, or a particular set of facts. Based on our experience in doing over 100 early-stage deals, we believe that an investment opportunity has four essential elements, that, when brought together in the right form, represent a high-potential opportunity to make money. If only one of the elements is out of sync, failure is predictable. The elements are represented by the Harvard framework ( Figure 11.1 ), which was developed by William Sahlman 1 and Howard Stevenson 2 is described in Chapter 12.

Good judgement comes from experience and experience comes from making bad judgments. So it is with evaluating early-stage deals. If you made a single investment in one of the big Internet wins of the late 1990s, you may not know a thing about early-stage investing. By the same token, if you had 10 failures in multiple industries, you might not know anything either. But you will if you keep paying attention. Reading business plans, studying in business school at angel seminars, learning an industry by working in it; these are all ways to develop expertise that will promote your success in investing. But in both entrepreneurship and angel investing, there is nothing like doing it. Nothing.

The evaluation stage is the great time killer of all the stages and you will do well to manage your time carefully. Some angels think that evaluation starts with the first meeting and continues right up to the moment of writing the check. In order to structure this book effectively, we address evaluation as a single isolated entity, but bow to the correct idea that evaluation occurs throughout sourcing, valuing, structuring and negotiating. Given the potential time drain, the best angel investors are careful and strategic in their approach to evaluation.

Angels take a variety of approaches to this stage, with some doing substantial due diligence before a meeting (reading the plan, talking to people they know ) and others granting a meeting without looking at the plan at all. Some angels rely on their intuition while others crunch a lot of numbers. Almost all angels source carefully, make good use of co-investors, and focus on the entrepreneur and the team. Evaluation success will come in doing deals, emulating winners, and not making the same mistakes more than two, three, or four times.

Case Study AOL: The One That Got Away

Frans Kok shares with us the story about his decision not to invest in America Online (AOL).

"In about 1986 I was asked to take a look at America Online. My recollection is that they had about 10,000 subscribers at that time who were paying a little less than $20 per month. That gave them a running rate of $2.4 million in gross revenues per year. I thought that that was impressive. In addition they were adding more subscribers every month.

The system was extremely complicated. Computers were not using the same operating systems so there were a lot of protocol compatibility problems. There were no databases that could be accessed. So the "nerds" would establish a connection and ask each other how "things" were and what was up. The connections were terribly slow. My reaction was why don't these guys pick up the phone if they want to talk to each other?"

Evaluation success will come from doing deals, emulating winners, and not making the same mistakes more than two, three, or four times. —David Amis, Howard Stevenson

AOL was in the process of raising $5 million on a $20 million valuation. Based on revenues and subscribers I told them we could work with them and raise maybe $2 million based on a $6-$8 million valuation. AOL management was not interested and the rest is history.

Recently, I heard from a third party that at about the same time the technology guru at Alex Brown had the same reaction with respect to the superiority of the telephone. I guess I can stop kicking myself."

Chapter 12 The Harvard Framework

Rather than judge entrepreneurs or their business plans as winners or losers, it is most productive to look at the investment opportunity as an interconnected combination of four elements: people, context, business opportunity, and deal. The right combination, which is often manageable, means a high-potential opportunity. A bad combination, or the lack of any single element, is a recipe for failure. Most important, within any investment opportunity, there is usually some potential for a win, if only the right investor would join it, or if the right changes would be made. If you integrate this philosophy of investing into your thinking, you will be a far better investor.

A Short Lecture On Entrepreneurial Evaluation, Harvard Style

Bear with us while we explain the framework developed by William Sahlman and Howard Stevenson at Harvard Business School. This is one of the areas in the book where you need to be mentally engaged and really look hard at incorporating this methodology into your evaluation process. At the very least, if you decide to discard it, you will do so having a much better awareness of your own framework.

Figure 11.1

You have seen the framework (Figure 11.1), let's review each of the elements:

People The people in the deal, including the entrepreneur, team members, investors, advisors, and any significant stakeholders.

Business opportunity The potential business opportunity, which includes the business model, the size (which implies the potential returns), the customers, and the window within which it can be seized.

Context The macro-situation, which includes external factors, such as: technology development, customer desires, the state of the economy, industry trends, etc.

Deal The structure of the deal, its terms and pricing.

Not only is each element critical by itself, but the way they interact is also crucial. For example, in one opportunity at Capitalyst 3 , a Web developer with $5 million in sales was raising its first round of capital on a $10 million valuation.

Two comparable companies in the marketplace were worth over $1 billion each, despite having $300 million and $20 million in sales respectively. Most companies in the industry were valued at $1 million per employee, and this company had 40. However, NASDAQ had just dropped about 20% (April, 2000), and voices predicting the end of the tech stocks' ride were appearing daily in the press.

Therefore, the context was that the potential existed to sell the company soon for a substantial return to one of its competitors. However, if the market turned in a big way, the potential valuation could come screaming down. The business would not fail, as it was choosing its customers and was already at cash flow break-even, but the investors might get stuck as minority shareholders if it became difficult to sell.

In this case, a deal structure with a note convertible to common would allow the investors to convert if the company sold or went public, thus getting their upside, or call the note after two years if the company was not able to exit but was generating positive cash flow. The deal structure can impact the attractiveness of an investment opportunity by addressing contextual or other factors.

Challenges with the business opportunity, or the time frame, can sometimes be addressed by finding a key member of management or an active angel who can help the company to move much faster through active use of their network.

Between people, opportunity, deal and context, there are a variety of multirelational issues and opportunities. Invest in companies that have outstanding elements or at least good combinations and you will hit some winners.

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Case Study: An Angel Investor with an Agenda

• Regina Herzlinger and Beatriz Muñoz-Seca

Editors’ Note: This fictionalized case study will appear in a forthcoming issue of Harvard Business Review, along with commentary from experts and readers. If you’d like your comment to be considered for publication, please be sure to include your email address. Gloria Londoño scanned the tables at the Opera restaurant. Victor Serna was sitting at […]

Editors’ Note: This fictionalized case study will appear in a forthcoming issue of Harvard Business Review, along with commentary from experts and readers. If you’d like your comment to be considered for publication, please be sure to include your email address.

• RH Regina E. Herzlinger is the Nancy R. McPherson Professor of Business Administration at Harvard Business School. Beatriz Muñoz-Seca is a professor of production, technology, and operations management at IESE Business School, University of Navarra.

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