An Easier Way to Bet on the Next Facebook

Good news for wealthy investors looking to get in on the ground floor of the next Facebook or Twitter: The risky but potentially lucrative world of "angel" investing is getting easier to navigate, and tax breaks are making it more attractive.

Angel investors put money in privately held, high-growth start-up companies.

In the past year, the number of investing groups catering to angel investors has jumped by 13%, to 340, according to the Angel Capital Education Foundation, an education and research group. Many of the groups make the process easier by allowing investors to share the work of researching particular investments.

Just be warned: Angel investing can be devilishly dicey. While the basic requirement is that investors be "accredited," having a $1 million net worth excluding the value of their primary residence, they also should have the stomach for blowups.

In a recent study done with a researcher at the Federal Reserve Bank of Atlanta, , a banking and finance professor at the University of Tennessee-Knoxville, examined roughly 400 completed angel investments that lasted at least a year and found that more than 100 ended with the company going out of business, handing those investors an average annual return of minus-93%.

But the returns can be extraordinary if the ventures succeed. Another 180 investments in Mr. DeGennaro's study were ultimately bought by other companies, giving their investors average annual returns of 84%.

A rule of thumb: Angel investors should be prepared to have their money tied up for seven to 10 years. And angel investments should make up no more than 5% of a wealthy person's overall portfolio, says , a financial adviser in Exton, Penn., who last year began putting some clients into the investments.

Angel investing is rebounding from its financial-crisis doldrums, researchers say. In the first half of 2010, investors committed fewer dollars in this niche than the same period a year earlier but spread them across a larger number of deals. Angel investments totaled $8.5 billion across 25,200 ventures in the first half of last year, a 6.5% decline in dollars but a 3% increase in deals from the same period a year earlier, according to the Center for Venture Research at the University of New Hampshire. While final 2010 data aren't yet available, it appears that total angel investment has ticked up from 2009, says , the center's director.

With the federal and state governments looking to spark job growth, angel investors can take advantage of an expanding set of tax breaks on small-business investments. Under a law enacted late last year, investors won't have to pay any capital-gains tax on certain small-business stock they acquire before the start of next year. The stock must be held for more than five years, among other requirements.

A number of states also have enacted tax breaks for angel investors recently—and in some cases, you don't need to live in the state to benefit. Minnesota, for example, last year began offering a 25% tax credit for certain investments in small businesses headquartered in the state. Out-of-state investors who don't have any Minnesota tax liability can get a refund from the state. The state tax credit helped build momentum for the Minnesota Angel Network to launch earlier this year, says , the group's executive director.

Angel groups can be anything from casual get-togethers to more formal organizations that charge dues and have paid directors. While each member tends to stay actively involved in investing his own cash, rather than delegating the work to a fund manager, group membership can in many ways smooth the process for angel investors.

The Minnesota Angel Network, for example, will put entrepreneurs through preparation "similar to martial-arts school" before they have any interaction with potential investors, Mr. Leonard says. That preliminary work includes having mentors review the business plan and financials, he says, and it should help reduce risk and save time for investors shopping for deals through the network.

Another benefit of such networks is visibility. While entrepreneurs may have a tough time finding individual angel investors, they will have no problem finding the larger groups, says Mr. DeGennaro, who is also a member of an angel group based in Nashville, Tenn. A small team within the group rigorously screens potential investments, he says, presenting fewer than 10% of them to the broader group of angels. That way, the larger group can spend more time reviewing high-quality deals rather than sifting through piles of mediocre ideas.

The local groups are key because more than 90% of angel investing is done within half a day's travel time of the investor's home, Mr. Sohl says. A list of angel groups by region is available on the Angel Capital Education Foundation's website,

While most angel investing remains local, broader networks also are popping up. AngelList, launched last year, is a free online community that connects qualified angel investors around the world with entrepreneurs. The site allows investors to collect data on a broad swath of start-ups seeking investment and anonymously ask questions of the entrepreneurs, says , AngelList's co-founder.

Other strategies to tone down risk in angel investing include being very selective but also diversified, experts say. Only one or two of every 10 investments will generate any significant return, Mr. Sohl says. Given the risk, "don't do it unless you'll make 10 or 20 investments over time," Mr. Ravikant says. Since $25,000 is generally a starting point for angel investments, that requires plenty of cash to spread around.


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