Sideways Startups: An Investor’s Dilemma
One-half of angel-funded companies fail, which is why a winning Investment Strategy for Angels includes diversification. That is, to invest in several companies (rather than a few) each with the potential for home-run returns. Amidst all the talk of failures and exits, we forget there are actually three possible outcomes for angel-backed startups. 1) Many flop (companies that do not return capital to investors) 2) some companies provide angels with an upside on their investment and 3) some companies go sideways. The latter category of investments appeared, at the time of investment, to be high-growth companies and for a variety of reasons survived, but proved to be no-growth companies –hence, sideways. Typically, angel-funded companies that are going sideways have 1-10 employees and sufficient revenues and earnings to be sustainable, but are not attractive acquisition candidates to larger companies. Furthermore, while the company has sufficient cash flow to survive, it cannot generate enough cash to buy-out investors, even at initial investment pricing. Most angel investors hold an ownership position in a few companies that have no exit opportunity. Current US tax regulations stipulate capital gains tax rates for most angel investment with positive returns. For many of those companies that fail, investors can write-off their investment against other income (ordinary income or capital gains, depending on the situation). For those angel-funded companies that go sideways, investors are stuck – no exit, no write-off – trapped with ownership in companies going nowhere.
Some enlightened angels have adopted the following strategy for these companies: They sell their shares (acquired for $25,000, $50,000 or more) to an acquaintance for $100 (or $10, or $1000), with full verbal disclosure that their ownership position is unlikely to have substantial value. The purchase price is considered incidental to both buyer and seller. The buyer has very little invested but maintains potential for an eventual exit or buy-back from the company or other investors. The seller (the angel investor) is then free to write off their investment (net of the selling price), according to the appropriate tax regulations.
This must be an arm’s length bone fide transaction with a short written agreement – and evidence of payment (a check). There should be no agreement (implied or written) for sharing any return above the buyer’s purchase price. Also, “you buy mine and I will buy yours” transactions are discouraged. It is suggested that angels not sell these shares to a family member or to their lawyer or accountant.
CAUTION: I am not a lawyer or accountant. I am not recommending this exit strategy, only describing for readers a process used by others in the angel community. Consult with your attorney or accountant before concluding any such transaction.
Written by Bill Payne
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