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There is no set definition of what a startup is. It generally is a company that looks to make an innovative product or extend a service in order to make a dent on the status quo and thus solve a major problem in the process. For example – Uber made an app to connect the riders and the cab drivers, a concept that disrupted the everyday way of hailing a cab. This efficiently solved the problem of both the stakeholders in an innovative manner.
What differentiates a normal or traditional company from a startup is however not the actual product or service (although it may) but the way they both operate. A traditional business scales at a very linear rate through organic growth tactics and is generally profitable from day one. However, a startup grows at a very fast rate through the help of huge amounts of capital and resources and thus may not even be profitable till a couple of years into operation. The focus for both types of business are very divergent and that is basically what differentiates a startup from all the other types of companies that exist out there.
For example – Facebook became one of the largest companies in the world in a matter of a decade, but there are businesses that have existed for two to three decades and haven’t achieved the scale of Facebook till now.
It is obvious not all startups become huge and it primarily depends on the idea that is being implemented but the same idea can be implemented with a traditional business mindset or a startup mindset.
Why Do Startups Need Money?
As explained in the previous section, startups are companies that operate with a hyper-growth mindset. They obviously need huge amounts of capital and resources to achieve the same which in most cases has to come from external sources. External sources means the capital which is used in running a business is not just the personal capital of the founders or directors of the business but people and firms external to the business.
These people and firms believe in the business and thus give money and other ancillary resources to help the founders make the startup a success. In return they are given ownership of the company (stocks) and/or interest on the amount extended (in case of loans). These serve as incentives for people to invest in the business.
Funding Life Cycle of a Startup
A startup raises multiple rounds of capital from different sources and for diverse purposes during its lifetime. Broadly the kinds of capital can be divided into equity and debt capital.
| Type of Investment | Angel Investment | Venture Capital | Venture Debt | Private Equity |
|---|---|---|---|---|
| Stage | Idea Stage | Prototype Stage to Growth Stage | Growth Stage | Growth Stage to Pre-IPO Stage |
| Profile of Investors | Friends, family and HNIs | VC firms deploying capital of HNIs, Family offices, Pension funds, etc | Debt funds deploying capital of Insurance companies, pension funds, MNCs, etc | PE firms deploying capital of hedge funds, large MNCs, pension funds, etc |
| Holding Period | 4-5 years | 8-10 years | 1-3 years | 5-8 years |
| Exit Event | Institutional Capital Raised Event | Acquisition or IPO of the startup | No exit event needed | Acquisition or IPO of the startup |
| Risks | Very High Risk – Reward Ratio | High Risk – Reward Ratio | Moderate Risk – Reward Ratio | Moderate Risk – Reward Ratio |
A startup ideally repays all its equity investors when it gets acquired by another company or goes for an Initial Public Offering (IPO) in the stock market. Events like these are called “exits” in the startup ecosystem.
A debt investment on the other hand has its own repayment timeline and is generally not dependent on the happening of an “exit”.
How Can Retail Investors Participate in Startups?
A retail investor can participate in all these different investment options across the life cycle of a startup. The investments can be further be divided into two categories:
- Direct Investment – In this case the investor directly invests in the startup in question without any third-party involvement like a VC/debt/private equity firm. Angel investment is generally a direct form of investment.
- Indirect Investment – In this case the investor invests in a VC/debt/private equity firm and then the PE firms in turn invests in different startups using the money they have raised from investors like yourself.
Steps to follow include:
a. You need to contact your investment/financial advisor in order to invest through the indirect option. He/she will research and give you a list and profiles of all the different funds looking to raise money at the time.
b. Go through the different options available and make a decision on factors like:
- Type of asset class
- Target returns
- Focus of the fund (specific sector, theme, market, etc)
- Holding period
- Credentials of the fund manager
- Historical performance
c. You can now set up a call with the fund representative to clear any queries you may have and also take it forward. Generally there will be some paperwork involved before you can actually give your money to the fund.
Things to Keep in Mind Before Investing in a Startup
There are a hundred things that could be listed down to keep in mind before investing in a startup, however here are the main ones that should be on your checklist no matter what-:
- Idea – Generally a startup investment is just an idea with a small sample testing for validation. Hence it is really important to completely understand the idea and the business before putting your money in.
- Founders – As a startup investor, with very little validation to bank on, the most important people become the founder. Founders are at the helm of affairs and in a way as a startup investor you are investing in the idea and the people who are going to be implementing the idea.
- Market Size – For a startup to give you good return for your investment, it needs to cater to a large enough market so that it has good potential for being big in the future. A business catering only to a particular locality or a small area can ideally never be called a startup since startups operate on a massive scale in their quest to achieve dominant status.
- Competitors – Startups are all about achieving scale at an exponential rate and becoming the dominant player in the market. Hence it becomes very important to know what other players already exist in the market so that the company that you may potentially invest in has good strategies to deal with them.
What Amount Can You Invest in a Startup?
Any individual whether Indian, foreign or NRI is allowed to invest in a VC/debt/private equity fund provided you have the minimum amount of funds available to invest in these instruments.
The minimum amount is INR 1 crore for an individual investing in any of the above instruments.
An angel investment on the other hand does not have any minimum investment and thus purely based on your direct agreement with the startup that you are interested to invest in.
Should You Invest in A Startup?
Advantages
- High Reward Potential – Generally, a startup investment is made when the company is small and has a lot of growth potential to become the next big thing. Hence if you catch the right bird early, your investment could see exponential growth in a matter of a few years.
- Change-maker – As a startup investor, you end up investing in ideas and companies that you might end up changing the world for the good. Hence it serves as a good opportunity for people to make their contribution to making the world a better place.
- Side Hustle – A lot of people making angel investments actually see startup investing as a side hustle from where they can generate an additional income stream. With the excitement and innovation constantly happening in the startup ecosystem, it becomes a great avenue to put your extra hours to analyze and invest in startups.
“You can’t connect the dots looking forward; you can only connect them looking backwards. So you have to trust that the dots will somehow connect in your future.”
Steve Jobs
Disadvantages
- High Risk Investment – As startup investments are made at an extremely early stage, the business model and the team may not always be stable like a mature company. Hence there becomes a high risk of losing your money in case the startup ends up going defunct.
- High Volatility – A startup goes through an extremely rollercoaster first couple of years not only in terms of its money but also its founders, teams, other investors, market conditions, competitors, etc. Hence there is a very high level of uncertainty and risk involved at all times from a financial and emotional perspective when you make your investment.
- Long-holding Periods – A startup investment generally has an average holding period of 7-8 years. Hence it’s an extremely illiquid investment, which may not be a good idea if you are someone who may have use of the funds on a short notice for an emergency.
Bottom Line
The startup ecosystem in India is at an exciting phase right now with deals and activities happening at an unprecedented rate. This provides a great opportunity to a lot of retail investors to invest and reap the returns of the great Indian startup story. However, it is important that you exercise caution like any other investment and understand your investment properly before going ahead with it.
