In my fourth decade of angel investing, I’m happy with my investments but regret having put them in my IRAs. Here are pros and cons of having illiquid, operationally complex and hard-to-value assets in IRAs.
Highlights:
Investing in Startups via an IRA Can Be Burdensome, Here’s Why
How I came to Have so Much of my Net Worth in my IRAs
Thank You Citibank for Encouraging a Young Banker to Save
Thank You Bob Smith for Allowing Me to Fish When the Fish Were Running
Why The Fish Are Not Running Any More
“Some weeks I spend half my time dealing with IRA-related paperwork. I have many better things to do with my life.”
The Initial Investment Is a Lot of Work for Everyone Involved
Corporate Actions Guarantee Constant Attention to the IRA Is Required
Then There Are the Required Annual Valuations
It Gets Worse!
The Upside of Investing in Startups from the IRAs
Conclusion
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Transcript of “Startups in the IRA? Pros & Cons from Decades of Investing”
Guest: Sal Daher
Sal Daher: Hey, this is Sal Daher. I'm delighted you found the Angel Invest Boston podcast in which I interview people who know a lot about building technology startups. I now have a Substack about losing and keeping off 100 pounds of body weight in my 60s. It's called Aging Fit and my goal is to build a community of people interested in keeping fit as they age. Look for Sal Daher on substack.com. Daher, by the way, is spelled Delta, Alpha, Hotel, Echo, Romeo. Enjoy the podcast.
Investing in Startups via an IRA Can Be Burdensome, Here’s Why
I’m starting my fourth decade as an angel investor and have enjoyed the adventure. One thing I would have done differently is avoid investing in startups through my IRAs. Putting startup investments in my IRAs imposed a serious burden on me and on the founders I backed. I am happy with the return I have realized from the startup investments. My only regret was using the IRA for these illiquid, operationally complex and hard to value assets.
Eventually this burden became so great I concluded I had made a grave mistake. That’s why I’m recording this short episode. In it I discuss the pros and the cons of investing in private assets (as opposed to publicly-traded securities) through an IRA. I’m not saying don’t do it, rather if you choose to do it here are some of the advantages and the pitfalls.
How I came to Have so Much of my Net Worth in my IRAs
I made my first angel investment in the early 1990s. After about three years I had a nice exit and was hooked on the idea of being an early investor in technology companies. If you’re curious, the company was Exos and it got acquired by Microsoft. If you search for Beth Marcus together with Angel Invest Boston you’ll be able to read or listen to the whole story (https://www.angelinvestboston.com/beth-marcus-startup-doc).
In those days I worked fulltime as a trader and investor in the debt of Emerging Market countries at a private company in Boston called Turan Corporation. I started out as an employee but eventually became a partner and a friend to the founder, the late Robert P. Smith.
Bob Smith was a pioneer in Emerging Markets (https://www.wsj.com/articles/robert-p-smith-searched-for-overseas-adventureand-distressed-bonds-11548430201) If you subscribe to the Wall Street Journal you’ll be able to read his obituary under a title that starts with Robert P. Smith Searched for Overseas Adventures-and Distressed Bonds. If you don’t subscribe to the WSJ look for Robert P. Smith (Philanthropist) on Wikipedia.
Anyway, while working with Bob Smith at Turan I had many opportunities to invest in the distressed bonds of Emerging Market countries but I was short on investable funds. By that point Bob was a wealthy man but I was just a working stiff whose only investable was funds were in an IRA account with about fifty thousand dollars in it.
Thank You Citibank for Encouraging a Young Banker to Save
I had accumulated those savings while working for Citibank overseas and at their headquarters in New York City a decade earlier. Citibank’s plan had allowed me to put some of my salary into an investment account, pre-tax. I believe there was also a matching component to it. There must have been because my salary back in the late seventies and early eighties was modest and fifty thousand dollars back then was a lot of money.
Thank You Bob Smith for Allowing Me to Fish When the Fish Were Running
Bob Smith generously allowed me to invest at cost in any bond position we were trading so I set up my IRA for self-directed investments and went full tilt at obligations of countries such as Russia, Argentina, Angola and others that had stopped paying their foreign debt. Every single position paid off handsomely so that within a few years that 50K had grown into a modest fortune.
Why The Fish Are Not Running Any More
By the way, don’t get the idea that investing in the bad debt of countries will make you rich today. Far from it. Conditions have changed since Bob and I were like kids at the distressed debt candy store. In those days it was possible to buy defaulted sovereign debt very cheaply because there were simply not a lot of buyers of that class of debt. Today, distressed debt funds abound so defaulted bonds rarely become great buys.
Countries then were also under a lot more pressure to make good on their debt than they are today. Paul Singer’s hedge fund Elliott Capital Management seized the Argentine navy’s training ship, the tall ship ARA Libertad, when it docked in Ghana for lack of payment on $1.6 billion in debt. After a change of government, Argentina would eventually settle with Elliott Capital, and with us, at favorable terms. That’s inconceivable today and it limits the potential upside of investing in distressed country debt.
“Some weeks I spend half my time dealing with IRA-related paperwork. I have many better things to do with my life.”
By 2013, Bob and I had wound up the business because it was hard to compete with the deep pockets of players like Elliott Capital Management. That’s when I ramped up my angel investing. Since I had invested in distressed bonds via my IRA, it seemed only natural that I should invest in startups through that vehicle as well.
In those days my IRA custodian was Merrill Lynch and the number of transactions were relatively few so the whole thing was manageable. Subsequent custodians (Merrill went out of that business long ago) and the growing number of transactions caused the management of the IRAs to eat up my life. Some weeks I spend half my time dealing with IRA-related paperwork. I have many better things to do with my life.
The Initial Investment Is a Lot of Work for Everyone Involved
You see, custodians have to make sure that the investments in the IRA are done at arm’s length. This is required by the tax code to avoid the possibility of people cheating on their taxes by paying themselves funds from their IRA disguised as losing investments. Thus, there is a close review of the transaction by the custodian at the time of the investment. This review can take days to complete and can require an excruciating amount of paperwork. So, the initial investment is burdensome for the investor, the custodian and the company receiving the investment.
Corporate Actions Guarantee Constant Attention to the IRA Is Required
Anyone familiar with startups knows that investors are frequently required to participate in corporate actions. A waiver is needed for the next round of funding. Holy moly, a convertible note converts into preferred shares. Wait, we need to raise another round. All of these events in the life of a startup investor are magnified in complexity by the presence of an IRA custodian. Merrill Lynch was pretty easy on this score because they had the common sense to allow me to sign the documents on behalf of my IRAs as long as they got copies of the documents I signed. Some IRA custodians, though not all, don’t allow that. They demand that that all the documentation be reviewed and signed by them which is really time-consuming and frustrating. I discovered this belatedly after making dozens of investments through a certain custodian.
Then There Are the Required Annual Valuations
Going in to the investment initially is a hassle, the corporate actions via the custodian are frustrating, but then there are the mandatory annual valuations of the assets in the IRA.
The tax code also requires non-traded assets to be valued annually. This does not sound onerous, but it can be. When Merrill Lynch was my IRA custodian, the investments were valued at year end. I had a checklist of a dozen or so assets to get valued, usually by the startups themselves. It was a bit of work but it was manageable.
However, with one of my current custodians I had eventually more than fifty investments needing valuation. This meant that almost every week of the year I had to be chasing a founder for a valuation. They did not do the year end thing. It was manageable initially because the custodian’s reporting showed when an asset had been valued last, allowing me to plan my work of getting the investments valued. Then my main IRA custodian revamped their system so the process became totally opaque and anxiety-producing.
I am bombarded by letters from the custodian in question threatening to resign custody unless I produce a valuation by deadline X. The threat is real because if the custodian resigns it reports a distribution of the asset to IRS. This can be deemed a taxable event even though it is totally disconnected with any funds flowing to me from the startup. Bottom line, I live under the constant threat of being forced to pay taxes on phantom income if my IRA assets are not valued in time.
To top it all off the worst IRA custodian keeps raising the hurdles I must clear with the valuations.
It Gets Worse!
To paraphrase the late-night TV commercial, it gets worse. At around age 73, IRA holders have to start making Required Minimum Distributions (RMDs) from IRAs. In my late sixties I worry about having to make RMDs from accounts holding illiquid assets which are hard to value. I worry about paying taxes on investments that may yet go to zero.
The Upside of Investing in Startups from the IRAs
But it was not all bad. For starters, it allowed me to invest in many more companies than I could have invested from non-IRA resources. That led to meeting some outstanding angel investors, founders and other players. It was also comforting to have Uncle Sam participating in some of the losses when startup investments went to zero in the pre-tax IRA. Unfortunately, that comfort was tempered by seeing post-tax money from my Roth IRAs evaporate in startups bets I thought were sure winners. It’s a highly unpredictable asset class.
Conclusion
Looking back, it would have been wiser to make fewer and smaller investments from non-IRA funds and to have more time to do fun things with my family and friends instead of chasing overworked founders for valuations.
Angel investing can be rewarding and great fun but look long and hard before investing in private assets such as startups through your IRA. Make sure you are up to the work of making the initial investment, that you are willing to jump through all the hoops new funding rounds and conversions will present, that you have the sainted patience to handle the annual valuations and that RMDs are on the horizon.
If you found this podcast useful, I invite you to learn more about angel investing at AngelInvestBoston.com (Link to the Angel Invest Boston Podcast). There you will find seven seasons of interviews with angels, founders and other players in the Boston’s vibrant startup ecosystem.
Also check out my work at Substack. You can find me under Sal Daher or Aging Fit.
Thanks for listening. This is the Angel Invest Boston Podcast. I’m Sal Daher.
SAL DAHER: I'm glad you were able to join us. Our engineer is Raul Rosa. Our theme was composed by John McKusick. Our graphic design is by Katharine Woodman-Maynard. Our host is coached by Grace Daher.