An Investor’s Guide To Evaluating And Investing In Early-Stage Startups

June 17, 2023
Fintech
Press

Once inaccessible, investing in private companies via debt or equity, popularly coined as ‘startup investing’ has become an important asset class for investors in India. Rising income levels, availability of historical data, active participation of institutional investors, the end-game in sight with the recent tech-IPOs, more startups entering the unicorn club, portfolio diversification, millennial mindset towards wealth creation, and a generation of leaders across the top tech firms who turned to angel investing or a VC play have collectively contributed to a rise in investments across private companies.

Regulatory bodies like the SEBI have also stepped in at the right time and created a regulatory framework that prioritizes investor interest. As investors plan their strategy around investing in private companies, here is a primer on how private companies complement your traditional investment portfolio. The age-old wisdom of financial planners definitely stands strong and every investor needs to stick to the basics before venturing into startup investments. Emergency funds, life insurance, health insurance, goal-based fixed income instruments like FD, RD, Bonds, Gold, ELSS, etc along with estate and tax planning are areas to prioritize. One needs to consult a financial planner before investing in early-stage startups too. However, India is a severely underpenetrated market when it comes to investments by individuals in private companies. The exposure in traditional asset classes viz, listed equity, mutual funds, bonds, and gold has peaked, and investors are looking at alternative investments to add to their portfolios.

State of Early-Stage Investing in India

Investing in private companies gives the option to invest in startups. The vibrancy of the Indian startup ecosystem has attracted the attention of global investors for growth stage and late-stage funding rounds. The growth story has given confidence to Indian investors who have ventured out to explore startup investing. Initially, HNI and family offices were the early movers to start investing via the Alternate Investment Fund (AIF) route. Once these investors saw some success, a few among them started exploring direct investments in startups.

Some of them have found much success and have created wealth through the direct route, while some have continued using the VC fund route via AIFs, and the emaining few invest via a combination of funds. These developments have given them more confidence in this growing asset class. Eventually, this has led to an increase in their YOY allocation as part of their portfolio. Although certain startup investments have given them very high returns, many of them either gave them average returns or shut down. This experience has given them an understanding of the risk-return ratio, i.e., this is a high-risk and high-return investment class where not all investments give them disproportionate returns. But they are slowly getting more confidence in today’s investing scenario and have come to the hypothesis that private companies cannot be ignored.

Governing Body and Minimum Investment Required

SEBI too has been constantly evaluating the minimum thresholds for investments in this asset class and several committees have presented their suggestions. They have been proactively working on a structure that is investor friendly. Today, an investor can invest from INR 25 lakh onwards in a Category 1 Angel Fund and INR 1 Cr onwards for CAT 1 VC Fund, and other Cat II and III AIFs. A 2022 EY and LetsVenture - Trica report that surveyed 100+ family offices stated that family offices allocated close to 18% of their investible income into startups and VC funds. The growth of investments in this asset class has peaked from $3 bn in 2012 to $25 bn in 2022 (IVCA report).

Why Private Companies and Why Now?

As the Indian ecosystem evolves and matures, young entrepreneurs are seen to emerge and work on solving business and consumer problems. These entrepreneurs will work on disrupting existing business models using technology which in turn will change the way traditional businesses function across sectors. An increase in the number of such business models and new-age founders has resulted in the need for funding their companies across stages.

An investor betting on these new-age founders often aims to get higher returns in early-stage companies than any of their investments. This in turn will also help them to increase the average return on their entire portfolio. If one investment call of the investor works, it has the ability to give the investors upwards of 10X-100x returns on the invested capital over a period of 8 to 10 years.

How to Evaluate Startups Across Early-Stages vs Growth Stages

Evaluating a startup is both an art and a science. At the pre-seed stage when the founder just has an idea, some of the key factors to consider before investing in a startup are the founder’s background, educational qualifications, experience in the domain, previous ventures, size of the market, and the complementary skills brought by the co-founders. The criteria at the growth stage vary as companies are believed to have achieved a product market fit. This means, the startup ideally has a list of paying customers, predictable sales cycles, a clear value proposition, and an expanding revenue pipeline. At this stage, one has to evaluate their go-to-market strategy, distribution channels, scalability, execution team, etc. By the time a company reaches a Unicorn stage, it is late for an individual investor to invest because the valuation is very high, and the upside potential relatively low. In addition to that, the minimum investment in these companies is also very high. It is not advised for individual investors to participate at this stage since a lot of their capital will get blocked in a company that has limited potential in terms of valuation and linear growth.

How can an Investor Invest in Startups?

An investor can invest in startup companies in two ways - directly and indirectly. In the case of direct investment, individuals source investment opportunities and invest in them directly. They identify startups and founders who have a unique business model, strong past track record and deep domain knowledge. In direct investments, the individual has a limited bandwidth to perform due diligence, and most decisions are made based on gut feeling. This is also because there is nothing much available other than a pitch deck and the founding team.

Having said that, there are three main ways of indirect investment in a startup,

1) Angel Networks, 2) Syndicates, and 3) Angel Funds

Angel Network

An Angel Network is a group of individuals coming together where they source investment opportunities and invest in startups collectively as a group. Each individual invests a small amount and the total contribution is pooled from multiple investors. The amount becomes substantial collectively and can be invested in the startup. These networks are open to investment across sectors but they also limit the investment in one company since the risk is the highest at this stage. They prefer to invest in multiple companies and diversify their portfolio

Syndicates

Syndicates are run by individuals who are called syndicate leads. They have strong domain expertise and a large network within the founder community. They source deals from their network of founders, evaluate them, and are typically the first to commit to an investment. Then they share the opportunity with other individual investors who follow them because of their investment thesis, sectors, past success, and track record. Even in syndicates, like angel networks, individuals invest small amounts in multiple companies. Syndicates are the first group of investors in companies. Due to the fact that their turnaround time is fast, founders like to go to syndicates even before an angel network.

Angel Fund

The third route of investing in startups is via the Angel Fund route which falls under an Alternative Investment Fund. These AIFs raise investment from HNIs and invest in startups. Angel funds are licensed by SEBI and have to meet all regulatory guidelines, both pre-and post-investment. These funds have a clear investment thesis, criteria of investment, and the stage at which they invest. They are headed by General Partners who are responsible for managing the investment and day-to-day operations of the fund. In an AIF, an investor should commit a minimum of INR 25 Lakhs to be deployed over the investment period which typically will be between 4 and 5 years. Angel Funds have a life cycle of 8 to 10 years from investment to exit. This structure is very investor friendly since investors have the choice of selecting the companies from the deal flow and can choose to invest in companies where they feel confident. In addition to that, the other benefit of this structure compared to other categories of AIF is that the drawdown of the committed amount is only when an investor confirms to invest in a company. This helps the investors to manage their cash flow and deploy over a period of 4 years only in the companies of their choice. The fund manager also takes responsibility for tracking the progress of the investment and has to share a quarterly update on the investee company with the investors as per SEBI regulations.

The best way to invest in startups is via the indirect investment route for new investors. Each of these investment styles has a different approach in terms of the number of transactions, level of evaluation, and post-investment tracking. Indirect investment through the fund route follows a standard process for investment in startups which includes, evaluation of the business model, size of the potential market, reference check, and due diligence on the company, including legal and regulatory checks. For investors looking to invest via the direct route, unless one has in-depth knowledge about a domain and knows the founders in person, it is a risky channel for individuals to invest in startups directly. There are other challenges like difficulty in getting regular updates on the progress of the company and lack of negotiating power since the investment amounts are typically very small. Hence, using the right channel is very important to mitigate the risk of investing in startups. Good Management, a proven track record of work, ethics, governance, SEBI Registration, the theme of investments, the stage at which the investment is being made, etc are some factors to be assessed before investing via these routes.

How can Investors Build a Deal flow Through Direct or Indirect Routes?

As per some past data, only 10% of the companies that started were successful. 50% of companies failed after a Series A round. Hence, capital raised isn’t the only metric for a successful startup. In an early-stage investment, the most important element is to have access to as many companies as possible. A good deal flow can come from anywhere. Hence, it is very important to be very active in deal sourcing. One needs to build a good funnel in case of a direct investment strategy. Some of the common sources of building a good deal flow are incubators, accelerators, and alumni networks.

Many seed-stage investors are very active on social media platforms like Twitter and LinkedIn. Founders follow them and reach out to them at the right time. In case an investor does not have the bandwidth to do this, joining an angel network/syndicate/fund gives you access to a curated set of companies. However, investors need to do in-depth research and due diligence before shortlisting any of these indirect routes.

Ticket Size

Depending on your investment appetite, the amount being allocated stems from your net worth and portfolio strategy. However, if an investor can allocate INR 25 Lakhs to INR 1 Crore over a period of 3 to 5 years, it is better to be a part of an Angel Fund. However, in case the investment appetite is more, options like direct investment, investing via a VC fund, or a combination of these two can be considered.

Know What You Are Investing in - Important Instruments

There are primarily two broad instruments for raising capital (equity and debt). These are equity shares and convertible notes. Under both of these instruments, there are several sub-instruments like Common Shares, Compulsory Convertible Preference Shares, Optionally Convertible Preference Shares, Compulsory Convertible Debenture, SAFE notes, etc. In the case of an equity instrument which is the most familiar option, the investor will know the valuation of the company, the price of the share at which they are investing in the company, and the percentage of equity the investor gets in the company in return. Since equity shares are issued in a priced round, investors need to note that their equity percentage will reduce each time there is a fresh round of capital raise. However, in the case of a convertible note, the price of the shares will be known only when the convertible note is converted into equity on a future date. The conversion terms are derived on a future date subject to the startup meeting certain predetermined conditions set by the investors namely the size of the raise, valuation, and time period within which they are able to raise. So, there is an element of uncertainty involved in the case of convertible notes.

Equity instruments were traditionally common in India whereas convertibles are something new and have become mainstream over the past 5-6 years. Companies use different kinds of instruments depending on the kind of business model and the stage at which the company is operating. There is no single instrument that fits all sectors. It remains completely between the investors and founders and the terms they negotiate.

How to Mitigate Risk and What is the Average Waiting Time

The average investment period in a startup from investment to exit is 7-8 years. An investor has to plan and be prepared to wait for that period to start getting an exit. It is important for investors to use only the capital which they don’t need for this time frame to invest in private companies. There are always some lucky bets which give you a return in 3 to 4 years but at a portfolio level, 7 to 8 years is an average waiting period. The exit period would also sometime change according to the sentiments of the investors which may depend on macroeconomic indicators like interest rate, investment cycle, etc. One of the ways to mitigate risk is to invest based on collective intelligence which comes from investing in groups. In case you are investing with your gut feeling, the risk is very high and there are 90% chances that you will end up making a lot of bad investments.

There are two strategies; spray and pray, where one invests a very small amount in multiple companies and waits for a few of them to hit a jackpot, or alternatively invests a slightly larger amount in a lesser number of companies where one understands the sector well. Investment diversification is also a strategy where you spread out your risk by way of investing in different sectors, ex. B2B Vs B2C.

Angel or early-stage investment sounds glamorous. However, it is also the riskiest category of asset classes due to the inbuilt nature of the risk involved in investing in startups. The risk of one losing their invested capital is very high and not all companies give you great returns. Therefore, one should use only the excess money post savings and goals to invest in this asset class. The other most important thing is to invest via the indirect method of investment. It is advisable to consult a SEBI-registered financial planner before investing.

Conclusion

With AIFs, corporates, and family offices growing in participation across private companies, the Indian startup ecosystem has been able to win the confidence of local investors. This has unlocked a large pool of domestic capital to support startups. With the increase in the quality of entrepreneurs and acceptance of entrepreneurship as a career culturally in India, we as a nation are poised to help solve global problems and work towards making India a $5 Trillion economy in the next 5 years. This asset class or ‘startups’ are expected to play a huge role in this milestone.

(Shreyas Chandra works as the Head of Investor Relations at Merisis Opportunities Fund, a Cat-1 Angel Fund that invests in growth-stage startups. He is an angel investor in 20+ startups. This article appeared in Inc42)

AUTHORS

Shreyas Chandra

Head - Investor Relations

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