A friend of mine has a risky new startup. He was able to secure angel funding recently and I asked him on what terms. “It is a convertible note that will turn into shares at the same price as the Series A investors, plus a 20% share bonus.” In other words, if the company navigates its way through all of the risk that afflicts a startup’s first few years the investor will buy in at almost the same price as the professional venture capitalists who waited for the concept to be proven with customers and proven to be executable. Given that venture capital in general returns about the same as the S&P 500, such an investment should only be sensible if there is at least an 80 percent chance of the startup making it all the way through to Series A ($2-10 million in VC money).
The other seed funding rounds that I’ve heard about are happening at valuations of around $3 million pre-money. That’s a lot more value put on a team of three 25-year-olds than in most years.
Aside from sky-high valuations, another obstacle to earning a good return from a venture capital investment is the recent increase in tax rates. Tax law changes, including the Obamacare surtax, mean that capital gains that formerly faced a federal tax of 15 percent are now taxed at 23.8 percent, a 1.6X increase in the amount of investment profits that will feed the federal government instead of the investor and his or her family. And unlike with an investment in the S&P 500, the angel investor does not get to choose when to take a capital gain or loss. The company will either fail or be acquired on a schedule that cannot be controlled. (There are possible exemptions from capital gains tax for qualified small business stock investing, but it seems hard to predict whether or not one will in fact qualify (see this article).)
I wrote about what a bad deal angel investing was back in June 2010 (posting) but the terms seem worse today.
What do readers think? Is the world of tech startups in a bubble? At the valuations and on the terms angel investors are offered, why isn’t it better to invest in big companies that can profit from the growth of robust economies around the world?