16 Dec 2020, 13:05 — 10 min read
Startups are young, emerging companies working on breakthrough innovations that fill need gaps or eradicate existing complexities in the ecosystem. These companies are in a constant endeavour for new development and markets. They have agility embedded in their inventive thinking.
Funding start-ups is glamorous; but the big question is - how much return can it generate as an investment asset class? Angel investors fund start-ups for several reasons but the first and foremost reason is that they believe in the idea, project, or passion. They want to make the entrepreneur’s start-up successful with the help of disposable capital available at their end. Investing in start-ups is more an art, less of science - it isn’t meant for everyone, and is subjective. There is no method to this madness nor a defined college degree to help you learn venture investing. Every deal, experience and strategy shared in the public domain is anecdotal. But, if there is one critical skill an angel investor needs, that is how to recognise what makes a great start-up founder.
Angels are individuals who come from successful backgrounds; their names evoke trust in the minds of customers or future investors. They back startups by associating their name with them, which provides entrepreneurs the required creditworthiness in the market.
Angel investors provide capital for small entrepreneurs but are not in the money lending or financing business. The finance they provide is for that first round of seed capital, to build the idea and vision into a reality. Entrepreneurs can also find angel investors in their family and friends who are likely to support with the capital on terms favouring the entrepreneur. Angels risk their money on people, teams and ideas that are fragile in nature. Hence it is called risk capital investment.
Angels are individuals who come from successful backgrounds; their names evoke trust in the minds of customers or future investors. They back start-ups by associating their name with them, which provides entrepreneurs the required creditworthiness in the market.
“Why I love start-ups as an asset class for investment is because I can offer my time besides capital. In other investments, like public equities or real estate, I can’t influence an outcome. Venture investing is a people business, so if you like meeting, working with, and helping people, then your chance of success is very high. With early stage start-ups, as their lead investor, I work closely with founders to create a positive outcome".
Also read: Funding options for Indian SMEs
Before beginning a discourse on the merits and demerits of investing in start-ups, let’s first understand investing in start-ups from the bottom up. What is investing? It is the process of putting money into various physical or abstracted assets with the expectation of making a profit. One can expect to make a profit on the money invested by seeing an increase in the value of the asset - whether real or perceived - and selling off the asset at the increased value. When you invest in a company - public or private - you invest in the asset that is the company itself; you get a part of the ownership of the company. As the value of the company increases, so does the profit you can make by selling off your stake.
One basic learning that every early stage investor should know is that startups follow the Power Law - a small % of the startups you invest in will give you the majority of your profits.
A key difference between investing in public companies and private ones, like start-ups, is that in public companies, selling off your stake is much easier and near instantaneous. The same cannot be said about private investments such as in start-ups, it is one of the most illiquid asset classes. It can give you huge profits, but those profits will be only on paper for the most part as realising an exit takes a lot of time.
One basic learning that every early stage investor should know is that start-ups follow the Power Law - a small percentage of the start-ups you invest in will give you the majority of your profits. Take for example Andreessen Horowitz’s portfolio. They are one of the top VC firms and about 60% of their returns come from about 6% of their deals. What does this tell us? It means that to truly make a profit from start-up investments, one should be able to access that 6% of deals. The rest of your investments may or may not materialise significant returns for you, but that 6% of your portfolio is where the return is.
If you invest in a few start-ups, it’s like buying lottery tickets; it’s the portfolio approach that helps the early stage investor create mega returns. Having given this background, let us come to the question at hand – Are start-ups a good investment? Start-ups are high-risk, high-return investments that follow the Power Law. It is not about the number of hits you have, but the magnitude of those hits. That is where we find the answer to our question. The wealth creation opportunity that start-up investments provide is nearly unparalleled. But it is also extremely risky and conditional.
So, when are start-ups good investments? It is a good idea to invest in start-ups when one has the appetite and the capacity for the high risk involved. An investor with a mission to give first, help founders and build a business, will win this game. Becoming an angel investor doesn’t require heaps of money. In fact, many of the angel investors we spoke to started off by writing relatively small cheques. One must be capable of creating a significantly sized portfolio of investments in the hope that some of the investments are part of the 6% and gives one huge return. One can create a start-up portfolio by investing about 5 - 10% of their total investment capacity in such an illiquid asset class. It is worth noting that the money invested here must be thought of as a sunk cost - until and unless an exit is realised. The investors must be able to stay patient with their capital - the best companies can give returns after 10 years.
The toughest part of investing in start-ups is gaining access to the top tier of deals that can give you huge hits. When one has access to that 6% of deals, it is a great idea to invest in start-ups. One cannot ascertain, at the get-go, if a particular investment will provide the returns you hope, but one can invest in start-ups that can give unparalleled returns you hope for, if they work out. To gain access to the top start-ups, one has to put in time and effort to become a part of the start-up ecosystem, become a part of various investor networks and collaborate with other lead investors and VC firms.
Start-up investments can provide disproportionate wealth creation opportunities. Before investing in start-ups, every investor should ask themselves - Am I ready to take on the capital risk? Do I have the required time and effort to build a portfolio? And last but not the least - Do I have the patience to wait for the disproportionate return? Investing in early stage companies is about capturing the value between the start-up phase and the public company phase. Most people assume that successful angel investors are a lot like professional gamblers who take huge risks with their capital. They may have few things in common, but it’s not what you’d expect in the process nor outcomes. Angel investors have learned how to minimise risk and generate luck. They do this by making a series of small, calculated investment bets after evaluating the start-up, to test their assumptions and find new opportunities. Each small bet is something they can afford to lose because it’s a small investment of time or money. To the outside world, it looks like they just get lucky a lot, but to the trained observer, they only invest when they know they have the best chance of getting 100X.
Sanjay Mehta is a technology evangelist and an entrepreneur turned VC. As a private investor, Sanjay has invested in over 130 global start-ups. He achieved notoriety in the media for his first cheque investments in Oyo Rooms and Block. One - Two Unicorns in his portfolio. He has been a TiE Board Member for over three years before founding 100X.VC, a 2019 SEBI registered fund sponsored by Mehta Ventures Family Office. 100X's goal is to invest first cheques in 100 seed stage India domiciled start-ups every year. Sanjay was honoured with TiE Hall of Fame in Jan 2020 for his outstanding contribution in angel investing. He has been awarded Angel Investor of the year by LetsVenture, has made the Forbes List of Investors, and has been named as a SuperAngel and one of the Top Twitter Voices by Entrepreneur magazine.
If you are a startup founder ready for the next level of growth, it is important that you know how to pitch to an investor. In a webinar organised by GlobalLinker, I shared key tips for startups to pitch to a VC and answered some queries too. Watch the webinar recording below.
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