An Investor’s Dilemma

The buzzword these days is startups. There are companies out there that are making revolutionary breakthroughs in a gamut of sectors that are laying the foundation for the way we live in the future – be it driving, cooking, monitoring and treating mental health…the list goes on. Some of these are on their way to becoming the next unicorns, whereas most of them are will go belly up. The question that comes to mind then is, should you invest in these companies? Well, I’m not an advisor; so I can’t answer that question for you, but if you’re interested in investing in early stage startups, also known as angel investing, there are a couple of things to bear in mind. I’m going to try to elucidate some of them here.

According to the tenets of portfolio management, you should build your portfolio depending on your risk appetite (which in turn will influence your returns), your investment horizon, your tax position, any legal/regulatory restrictions you may face, your liquidity constraints, and any unique circumstances or preferences you might have. Once you’ve figured out where you stand based on these points, you can start building your portfolio. One of the best ways to diversify your portfolio is to invest in different asset classes, such as equities, debt, commodities, alternative investments, etc. Technically speaking, the sweet spot you should try to achieve is for the correlations between these asset classes to be low. Angel investing, and investing in startups in general, along with venture capital funds, private equity funds, hedge funds, etc. fall under the alternative investments asset class, which does have low correlations with more traditional asset classes, such as equities and bonds.

The obvious problems with this asset class are that it is risky, illiquid, and that the time horizon  within which you can start seeing some returns is quite long (between 3-5 years, if you’re lucky). Keeping in mind these problems, it would be advisable to invest a small percentage of your net worth (about 5%) into this class.

Alright, so now you’ve got an idea as to how much money you want to invest. How do you go about deploying these funds? The thing you need to remember is that startup investing (like most other kinds) is a portfolio game in which you have to build a healthy portfolio of companies that you’ve invested in. Hence, you should spread out the money earmarked for this asset class among 10-20 companies. The reason I say this is that the harsh reality is that not all the investments you make are going to pan out. I’m sure you can now appreciate why building a good portfolio is vital.

When should you invest in a startup? It doesn’t take an expert to figure out that if you invest in a company during the early years of its existence, you’ll get a larger stake of the business for a relatively small amount of money. This is a grey area, but angel investing can be considered as a pre-Series A round. This means that the startup you’re evaluating has already raised money from family and friends, has a team in place, has started gaining some traction, has some sales, and has started generating some revenue. The founders are now looking for more funds from you to sustain themselves for the next 12-18 months, hopefully by which time it will be an attractive opportunity for institutional investors, such as venture capitalists, to pump some funds in. This is generally called a Series A round of funding. Angel investors are usually bought out during a Series B or Series C round.

As mentioned earlier, this entire process will take roughly 5 years. During this period, it is imperative that your portfolio companies get guidance from domain experts, and that they are being monitored, to ensure that they’re on the right track and that they’re meeting targets.

The last point I’m going to mention is perhaps the most crucial one to consider: the founder(s) of the company. These are the people who are going to be involved with the business most intimately; the ones who will fight to keep their idea alive and who want it to grow from a tiny spark to a brilliant flame. At least, this is what you should hope the founder(s) feel. Along with that enthusiasm should come a lot of experience, and maybe even a few past failures. These will hold any competent founder in good stead for any upcoming venture.

Before I end this, I want to give you some food for thought. In India today, there are roughly 1,000 angel investors, and this number is slowly growing. This number is very small, indeed, when you compare it with the nearly 500,000 angel investors that are present in the United States. This is because currently, it is predominantly the UHNIs (Ultra High Net worth Individuals) who are acting as angel investors in India. It can be concluded that we need to increase the number of angel investors in the country so that the companies in the budding startup ecosystem have access to funds required to scale up their operations.

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