Capital Markets Theory You Can Use

I’ll be the first to admit that financial capital markets theory can be dry as dust and that mostly you should just live your best life in blissful disregard for almost all of it. Today, however, indulge me in discussing a capital markets rule that can help you avoid fraud, seek better investments, and make you a more successful entrepreneur.

Powerpoint slides like this one are so stupid

A recurring and guiding principle of my financial writing is that most people could benefit a bit from “thinking like a banker,” and this is one of those ways to do that.

Here’s the finance theory: The yield, or financial return, available to you as an investor is equivalent to the cost of capital of the company offering that investment opportunity.

Huh? I know, I know. What does that even mean?

It means that if you earn 0.5 interest on your savings account at the bank, or if you get a municipal bond paying a 2 percent yield, that’s how much the bank and the municipality have to pay to use your money. That’s their cost of capital. Banks and muni bonds are pretty straightforward examples of the theory.

The theory also means that if you end up earning 8 percent per year by owning a public stock for thirty years – from a combination of dividends and price appreciation – that public company has effectively endured an 8 percent cost of capital per year throughout that time. This point is a bit more abstract, since the company might have only paid out, let’s say, 2 percent in cash dividends on the shares. But in aggregate the idea is still true, and here’s why. If the original owners of the shares, or the company itself, had never sold stock in the first place, all of that 8 percent annual investment return would be captured by the company or its original owners, not the outside stock holders. Since it wasn’t retained, that’s their cost for having sold shares thirty years ago. If you make a lot of money owning stocks, it was pretty costly for the founders who originally sold

Can I interest you in an above-market rate CD?

Of the many applications for this important theory, avoiding fraud is the first to come to mind. Let’s say you’re a Texan of some means in June 2005, looking for a nice high-yielding, but safe, place to park your cash, during that low-interest rate environment. A friendly salesperson offers you a bank CD with Allen Stanford’s Stanford International Bank, with a 7.45 percent 12-month certificate, compared to the average US bank CD at the time of 2.8 percent. Great deal, no?


Stanford’s company claimed access to unusually attractive investment opportunities. But a key thought for Stanford CD investors should have been this: Why would Stanford’s company incur such a high cost of capital? As an investment rule, if the investment opportunity seems to offer far more than would be available elsewhere, your fraud-detection spidey-sense should make you ask: Why does that company need to pay so much to use my money?

On the more legitimate side of investing, the theory can be quite useful for skeptically evaluating risky things like high yield bonds or initial public offerings (IPOs). Let’s say back in 2011-2012 you were tempted to buy Greek bonds at a highly distressed 15 percent (or more) yield. That’s an amazing-seeming yield for government bonds, and such a nice place, too. They have beautiful islands! The yogurt’s incredible. What could go wrong?

A skeptical thing to remember is that the Greek government itself, if it had the cash, could purchase those bonds themselves in the open market and lock in a 15 percent return on capital through retiring their own debt. Obviously, for that whole time period, it didn’t have the cash, at all. Which is a worrisome thing if you’re contemplating owning their debt. Private bank lenders to Greece ended up taking a greater than 50 percent “haircut” on the value of their loans in 2012.

This cost of capital theory also generally makes me skeptical of IPOs, even of excellent or “hot” seeming companies. Here’s the thought process. If the current private holders of companies believe that the company they own offers a good return on capital in the future, they generally don’t look to sell shares.

snapchat_ghostDid you figure in March 2017 that you’d make a 15 percent annual return buying the IPO for Snapchat (SNAP Inc)? Well, the skeptical thought is that the pre-IPO owners – who know infinitely more about the company than you do – wouldn’t typically give up a 15 percent annual return if that seemed likely. When founders sign up to sell their company through an IPO, I generally interpret them as saying the following: “The best days of growth for this company are probably behind us. I’d prefer to get my money out while the getting is still good. I can make more money elsewhere.”

Now, I know that founders’ decisions are more complex than that – having to do with personal liquidity, pressure from private equity owners, and maybe a strategic need to scale up a business. But still, a factor in their decision is whether they can make a high return in the future, or whether they don’t mind some other damned fool taking that risk from here on out.

Finally, I think understanding the “investor’s return = company’s cost of capital” idea can make you a better startup entrepreneur. If you’re an entrepreneur and you truly believe in your company’s product even though it’s still in an early-stage of development, why (OH WHY?!) would you be in a rush to sell part of your business to angel investors? I know you need the money now. But if you succeed wildly in the future then the cost of that capital will be nearly infinite. If you believe in your company’s prospects, selling a piece of it is an outrageously expensive way to raise money. More founders should fight with tooth and claw to never sell equity in their company, and certainly not at an early stage.

Please see related posts:


Twitter IPO

Facebook IPO



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Angel Investing – Some Data

angel_investingLet’s say you read my earlier post on angel investing and decided – despite my helpful warnings – that you would still like to pursue angel investing in your area. You don’t listen, do you?

Well anyway, your next step as a smart money person would involve collecting data about angel investing to, you know, educate yourself before throwing your money at a few startups.

Aha! Now that’s a real problem. You will find angel investing a frustrating place to gather anything more than anecdotal data.

But then again you have me. I’m here to sift through available studies on angel investing to let you know what is knowable, before you jump in.

In contrast to angel investing, we typically know extraordinarily detailed things about publicly traded companies we might invest in. You could find with a quick online search which CEOs of public companies like to dress up like the Pope or which ones resort to spreadsheets to make perfect cupcakes. But finding angel investing facts and data can prove elusive. Because angel investing is done at a small scale – tens of thousand of dollars to a few million – when compared to its big brother venture capital – at a few million to tens of millions – we sometimes have to turn to venture capital data for information.

Key pieces of data you might want to know before investing include:

  1. How scarce is money for entrepreneurs who need angel investments?
  2. What percent of funded companies succeed in making money for angels?
  3. How long will your capital be tied up?
  4. What kind of returns can you expect from angel investing?

After presenting each piece of data I’ll do a little interpretation of the numbers. Let’s take these one at a time.

About scarcity, according to a report on venture and angel investments by the Ewing Marion Kauffman Foundation 30 percent of venture capital and angel investments occur in just four metropolitan areas: Boston, San Francisco, Los Angeles, and New York. Even in those areas, only an average of 1 percent of startup firms receive the full amount of money the entrepreneur seeks, while the national average is 0.6 percent. Firms in Austin, according to the Kauffman report, successfully raise venture and angel investments at twice that rate, while entrepreneurs in other Texas cities like San Antonio, Dallas, and Houston firms report success rates of 0.9, 0.9, and 0.6 percent respectively.

I interpret this data to mean that providers of angel and venture capital in areas of capital scarcity – meaning outside of the big four metropolitan areas – could, conceivably, be an advantage. When you provide a thing that other people can’t otherwise find, that might tilt odds and negotiating terms in your favor.

To answer the second big question – what percentage of firms actually make money for investors – we turn to the Angel Resource Institute an industry group which publishes semi-regular data. Their 2016 report shows that 70 percent of angel-backed firms lose money for investors, meaning 7 out of 10 angel-backed startups return less than 1X of an investor’s original investment. That’s a lot of failure.

On the other hand, we could interpret this data in baseball terms, and say that regularly batting .300 could conceivably still win the game. The Angel Resource Institute further reports that 10 percent of angel-backed firms tend to make up 85 percent of the cash generated and returned for investors. To continue the baseball analogy, we see that investors depend on a homerun from one in every ten at-bats in order to make money.

The Angel Resource Institute also helps set our expectations for the third question, which is about how long an angel investment will tie up our capital. They report an average holding period – the time between investment and “liquidity event” – of 4.5 years. The first thing I think is that that’s a long time to have money tied up in a speculative, illiquid investment. The next thing I think it that 4.5 years represents the average, so many commitments will stretch far longer than that. My friend Tom Dickerson, a venture capital firm founder, laments that many venture capital investments seem to stretch on and on, seemingly without end. Patience is both a virtue and a necessity here.

Fourth and finally, what kind of returns can you expect from angel investing? Given the difficulty of tracking angel investments, I apply the largest grains of salt to this answer. The Angel Resource Institute reports an internal rate of return from their latest survey-driven report of 22 percent. That sounds great, but please remain skeptical.

rat_holeMy friend Tom reminds me “the majority of positive returns are concentrated in a handful of venture capital firms. The majority of venture capital funds actually lose money.“ And yet the phenomenon known as “survivorship bias” keeps the successful venture capital firms in front of investors, while the losers disappear quietly.

In addition, the Angel Resource Institute study – while one of the better sources of data we have – has a bias toward angel-backed firms which later receive venture capital. That in turn will skew outcomes toward larger and more successful firms than normal. In addition, if only 1 in 10 angel-backed firms provide nearly all of the positive returns to investors, it’s easy to see how angel investing could provide a below-average result for many.

So, that’s the aggregate data you should have in advance of angel investing. I don’t know, maybe you like opaque, illiquid, speculative areas of investing? It raises the possibility of market inefficiency, which many believe works to their advantage. Still, you will want to get comfortable investing with scant data if you plunge into angel investing.


A version of this post ran in the San Antonio Express News and Houston Chronicle.

Please see related posts:

Angel Investing – An introduction

Seeking Mr. Rathole

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Angel Investing Thoughts

angel_investorThe first thing to know about angel investing is that you probably can’t do it.

I say “can’t do it” not to create some aura of fancy exclusivity for the activity, but rather to point out that entrepreneurs who offer ownership stakes to angel investors may only formally sell pieces of their businesses to ‘accredited investors’ who have a $1 million net worth, or consecutive years of $200,000 in income.

The second thing to know about angel investing is that you probably shouldn’t do it.

I say “shouldn’t do it” because angel investing will likely lose you money.

Don’t get me wrong, I think angel investing is great, both as a benefit to the places where it happens, and to keep the creative juices of a capitalist economy humming along. Even if many investors and many entrepreneurs lose their shirts as individuals, a positive case can still be made that the aggregate economy benefits from the few winners that may emerge from the wreckage. Still, you probably shouldn’t think of it as a way for you to make money personally, but instead as a way for you to generously spread your personal capital, like mulch over a field, to make the entire local economy grow faster.

By the way, there’s no agreed-upon definition of angel investing, but it generally means investing at the scale of between a few tens of thousand of dollars to a few million dollars in early-stage startup businesses. Angel investing is the baby brother to venture capital (a few million to tens of millions invested into a growing business) as well as the child to larger private equity investing (tens of millions to billions invested in a more mature business).

Because of the high risk of individual failure, angel investors and venture capitalists often seek to manage their risk by building a portfolio made up of multiple bets on different companies.

My friend Tom Dickerson, founding partner of New York-based venture capital fund Tulles-Dickerson explained to me the portfolio approach of a typical fund.

“If a venture fund invests in ten companies, you would expect 4 or 5 to be complete zeros, two or three to limp along and survive, and you’re hoping for one or two big wins, with those maybe making you four or seven times your money. With an angel fund, the risks of failure are even higher, so you’re also hoping for one or two even bigger wins to compensate for the higher risk.”

You can see how investors who pick only a small number of companies to fund may in retrospect find out they dug a bunch of dry wells, to use a South Texas analogy.

Chris Burney, Executive Director of the San Antonio Angel Network (SAAN) basically agrees with Dickerson’s portfolio numbers.

One of the SAAN’s ways to increase the probability of a “win” in an angel’s portfolio, according to Burney, is by lowering the available size of investment, to as small as $5,000 per individual. That allows folks with limited capital the opportunity to invest in more startups. His group has grown to 73 members since launching in December 2016, with about a third of the members participating in one of their three group investments so far.

An angel network like SAAN does not serve as an investment advisor – because as always, buyer beware! – but does seek to share best practices on early stage investing. Members of the SAAN pay annual dues in order to network, self-educate, and take advantage of the screening and due diligence that Burney and the rest of the network provide.

An additional advantage, besides the coffee and companionship, is access to deal-flow that you wouldn’t otherwise see. The SAAN for example seeks to coordinate with more long-established groups like the Houston Angel Network (HAN) and the Austin-based Central Texas Angel Network (CTAN).

The ultimate attraction for angel investors is that theoretically a small amount of capital can buy enough of a stake in a startup that success in the business reaps outsized rewards. Sun Microsystems co-founder Andy Bechtolschein wrote a $100,000 check to Google founders Sergey Brin and Larry Page in 1998, even before they had opened a bank account for their fledgling business – perhaps the most famous angel investment of all time. Thought to have given Bechtolschein 1 percent of the new company, that stake would have been worth around $250 million at the time of the company’s 2004 IPO. Held until today, that 1 percent in Alphabet Inc (now the official name for Google) would be worth around $6.5 billion.


Needless to say, that experience is not the rule of angel investing. As Boromir might have said about your angel investing attempts, one does not simply purchase 1 percent of the next Google, any more than two halflings have a chance of sneaking into Mordor to destroy the one ring. Most of us Boromirs make poor angel investors. In fact, the best attitude for an angel investor to adopt is to assume most investments will go to zero, because they usually do.

But hope springs eternal. Our system requires that those with more capital than ideas take a flyer on those who have ideas and energy, but not enough capital.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

See related post:

Searching for Mr. Rat-Hole

Angel Investing – Some Data



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City Direct Equity Investments – UGH


A version of this post appeared in the San Antonio Express News.

I read with much interest the story last week of the San Antonio City Council approving a direct investment of $1.75 million in city funds to move three startup medical device manufacturing companies to San Antonio.

And by “much interest” I mean the story made me want to stab my own hand with a sharp pencil.

I hate this sort of thing.

Not because of straight up corruption

Let’s leave aside the obvious problem of ‘economic development’ schemes like this, in which public entities give targeted incentives to a specific, private company: You know, because private individuals who benefit may feel quite ‘grateful’ to their public sponsors. Public sponsors in turn – elected and appointed officials – may then have an incentive to direct public funds to private beneficiaries to keep the ‘gratefulness’ cycle going.

That’s all obviously just straight up corruption and not really what I’m aiming for here in my critique of city-directed ‘economic incentives’ for private companies. [1]

What I really hate about this is something quite different, having to do with three business concepts: selection bias, market efficiency, and the structural short-run conflict between entrepreneurial goals and public policy goals.

Taken together, they greatly reduce the odds that this type of economic development works out for the public good in the long run.


I’ll address these in order.

  1. Selection bias

Would you like your city (or state, or county) to grow companies focused on wooing public investment and public ‘economic development’ incentives? Or would you like your city to grow companies that focus on profitability without a public subsidy or public investment? Because the way you attract companies to your city (or state, or county) introduces a real selection bias to the pool of companies you end up with.

In my experience, the kind of startup company that takes public money – with all the attendant scrutiny, ‘job creation’ requirements and ‘salary’ minimums – is a different sort of company than one that achieves sustainability without that public money.

  1. Market Efficiency

Private investors constantly scour the market for small but growing companies that provide a reasonable chance at future profits.

Small but growing companies in turn often seek direct investments from private investors known as ‘angel’ or ‘venture’ capitalists.

It’s not a perfect system, and market inefficiencies occasionally arise.

But when a company turns to public funds like this, what that signals to me is that private capital sources – the professional angel and venture capitalists – have already declined to invest in the growth of this company. That’s typically because professional angel and venture capitalists do not find the risk/reward profile of that investment sufficiently compelling.

risk reward

Now, professional investors may be wrong to have overlooked the growth and profitability potential of these medical device companies.

The angel investing market may be inefficient.

Who knows? Maybe the City of San Antonio Economic Development team may have a market-beating strategy for identifying a positive risk/reward formula that private investors have declined to take. I mean, it could happen, right?

But I doubt it. And I would never bet on it.

  1. The short-run conflict between entrepreneurship and public policy goals.

Look, here’s the biggest problem.

Public officials want to be seen to create “jobs.” At “good salaries.” That’s fine.

But entrepreneurs don’t seek to create jobs. At any salary.

Entrepreneurs, at least the good ones, want to create the least number of jobs possible. I’m not saying this because entrepreneurs are inherently mean-spirited, but rather, because hiring people is expensive.

Successful small companies – and big ones too – have to constantly try to eliminate jobs to make a company financially sustainable. The market is too darned competitive to survive when you’re burdened with too many people on the payroll. If public officials get the chance to dictate the number of jobs, and the salary minimums of jobs, I guess I have my doubts about how that business is being run.

You show me an entrepreneur willing to be told by a city entity how many people to hire, when to hire them, and what to pay them, then I will show you an entrepreneur who isn’t going to make it in the long run.

A tangential, but I think illustrative, note: The biggest joke of Mitt Romney’s 2012 presidential candidacy was his claim to be a ‘job creator.’ Romney was no ‘job creator.’ On the contrary, he was one of the most successful job destroyers of all time.

Because that’s what Romney’s firm Bain Capital is good at. They buy a company, wring out expensive costs (all those “good salary” jobs!) and then resell. In the short run, the more jobs you eliminate, the better. I’m not saying this to besmirch Romney’s record. I’m sure he was a fantastic capitalist. Cutting costs is what capitalists, and entrepreneurs do, and often that means eliminating jobs. But Romney as “job creator?” Give me a break.

I mention this to illustrate the short-run differences in goals between entrepreneurs and public policy officials

Ok, now back to San Antonio.


I hope I’m wrong

I hope to be completely wrong about this $1.75 million direct investment. Despite my misgivings, I will be thrilled when these three startup medical device companies spur innovation, trigger job growth, add to the ‘entrepreneurial ecosystem’ and even generate a positive return on public capital.

It could happen! I hope it happens!

But I would never, ever, choose to bet on it with my own money. And I’m sorry when the city chooses this for me.


Please see related posts on:

The “Economic Development” Catastrophe of Curt Schilling

The “Economic Development” deal with Nexelon Solar manufacturing


[1] That kind of obvious corruption is what the New York Times had in mind in pointing out in 2012 that Dallas-based tax consultant G. Brint Ryan worked to secure tax breaks for private corporations in Texas while personally donating $250,000 and $150,000 for the Governor and Lieutenant Governor respectively. I don’t mean all that, since it’s all too obvious how each group benefits there at the expense of the public good. I mean, who could deny it with a straight face?



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A Source of Angel Funds: Your IRA

entrepreneur-insideKaren Blumenthal’s column in The Wall Street Journal over the weekend featured two of my favorite topics, self-directed IRAs and entrepreneurship, in a combined article.  The details in the article, as well as the details of using a self-directed IRA to fund a small company, are complex.

  • ·         You can’t lend money personally to the firm
  • ·         You can’t guarantee a loan to the firm
  • ·         You can’t ‘self-deal,’ which might prohibit taking a salary from the company

But, the article goes on to describe, you may be able to fund, or buy early shares in, a start-up company.  While of course by definition this involves extraordinary risk, it’s also the kind of thing which could in rare cases lead to a Mitt Romney-sized IRA. 

Only a few investments in IRAs are outright banned by the IRS, such as life insurance and certain collectibles, as well as one’s own home. 

For mid-career entrepreneurs or angel investors with some built-up retirement savings, it’s an intriguing thought that many do not know about.

Please see related posts on the IRA:

The Humble IRA

IRAs don’t matter to high income people

A rebuttal: The curious case of Mitt Romney

The magical Roth IRA and inter-generational wealth transfer

The 2012 IRA Contribution Infographic

The DIY Movement and the IRA


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