Why invest in startups?
A startup is a venture started by entrepreneurs and inventors who have a unique product or service offering with the aim to make it highly sought-after and irreplaceable. The core of every startup is innovation and imagination, finding solutions to existing problems and deficiencies, or creating a completely new line of product or service. This thing can be an inherent risk in startups, while usual companies work on an existing template that has proven efficacy. Startups have to create a template from scratch which may or may not work. This brings us to the question…
Investing in a startup is a high-risk, high reward game
Public company shares can be simply purchased in exchange for money. However, in the case of startups, the industry expertise and devout able time you bring to the table is also considered as currency to buy the shares.
Investing in a startup early which later grows up substantially will make you enormous profits even after covering up for your initial losses and failures.
Before 2000, most of the value creation happened in the public market like investing in Apple and Microsoft. This, however, has shifted to the private market as more and more companies, especially tech, prefer to stay private and realize much of the value creation before going public.
A major drawback is a fact that 90% of startups fail and may return only the sum you invested initially or nothing.
Equity in a startup or private company is relatively illiquid. The holding period can be over 7–10 years with some occasional liquidity events occurring during the period.
Deciding the right opportunity and best practices for investing in a startup
Starting with the basics, before going forward with any investment opportunity conducting due diligence, critically evaluating the business plan and model for generating growth and profits. Are the policies sound and economics of the idea has the ability to gain traction in the market.
Not getting bogged down by the financial data and valuation figure given by the company. Many times valuation is just a best guess about the company’s worth. Looking at the financial data of a company in the early stage might not give many actionable insights. Run the numbers and look at the bigger picture of what the company is telling you about itself.
After you have evaluated the company and scrutinized the data pause for time being and do the same to yourself. Investing in a startup is a risky and long-term commitment. You may face the uncertainty of huge losses and it will years before you realize your profits and cash out. As Behavioral Economists have stated people experience greater discomfort from losing money than pleasure from gaining. Do you have the stomach for facing such a situation?
Ways to invest in startups
If you are an avid investor and interested in new innovative ideas you might have watched ‘Shark Tank’ or another similar show, where a panel of renowned investors interview founders and inventors of a creative solution to a common problem that might have been overlooked. The founder looking towards commercializing his/her product, and investors looking for an attractive investment opportunity having the ability to turn into a multi-bagger. They negotiate a deal in which the founder gets money to set up his/her company and investors get their stake, a lot of times majority. Sorry to burst the bubble but that’s not how it’s done.
· Pre-seed Funding
Pre-seed funding is also known as pre-seed capital, is the earliest stage of investing in a new company. This is required to get the business started. The process comes in such an early stage that it’s usually is not included in the funding rounds. Investment usually comes from the founders, family, and friends. It’s also possible that the investment in this stage is not in exchange of equity. Nowadays, there are several pre-seed funding platforms available wherein investors looking to invest can search for opportunities. Another option for pre-seed funding is a crowdfunding platform, we’ll take about them in detail later.
· Seed Funding
Seed funding is an early investment, also the first official equity funding stage. The round aims to help the company to grow and generate its own capital. Seed funding helps get things started before the business earns any revenue. The funding helps the company in its initial steps like infrastructure cost, marketing, development cost, researching the consumer demographics, and setting up the founding team. Investment is the fuel of any business and seed funding is the first drop of this fuel. Potential investors in the round are founders.], family, friends, venture capitals, and angel investors. Angels are the most common investors in this round as they appreciate riskier ventures. Investors get an equity stake in exchange for their investment. While the funding amount does vary between seed funding but it’s not uncommon for the rounds to be anywhere from $10,000 to $2 Mn, a pretty huge sum right?
· PE Funds
PE Funds are a pool of funds to be invested in various types of equity and debt instrument that represent an opportunity for a high rate of return. It is usually set up as a limited liability partnership, so your loss is limited to an extent. The tenure is fixed and can range between 7–10 years after which the fund elapses and the funds are distributed back to the limited partners. The PE firm hopes to successfully exit during the tenure. Typical exit paths for the firm are total exit or partial exit:
PE Funds are not available to everyone, more like an exclusive club membership, Institutional funds and accredited investors usually make up the primary sources of private equity funds as they can afford to invest large sums of money for longer time periods. PE funds represent an excellent opportunity for a high rate of return.
Leaving the traditional ways aside, in the late 2000s another option for fundraising and investing in startups took off the ground ‘Crowdfunding’. Crowdfunding combines crowdsourcing and microfinancing, large groups of people come together to provide capital to these projects and ventures. The platforms allow investing with a minuscule investment in multiple ventures compared to traditional means, so yeah it provides smaller investors with an opportunity to get exposure to the skyrocketing returns that startups give, sounds enticing right? The platforms are primarily online, this leverages their ability to streamline and centralize fundraising.
Delaying the IPO comes with certain advantages for Startups
In an ideal situation, an IPO would be the next natural step in a process that provides liquidity to investors and employees while also generating funds for business. A successful IPO, however, necessitates not only a strong balance sheet and robust growth, but also earnings, or at the very least a credible road to profitability. Given the local market characteristics, this is a difficult order for many businesses.
- Startups can avoid the temptation to generate quarter-to-quarter gains and focus on establishing their company up for long-term success.
- Companies can save $2 Mn — $5 Mn in IPO execution expenses and fees associated with reporting critical information to the public market.
Startups that choose to remain private may frequently raise $50 million or more in late-stage rounds, which act as “quasi-IPOs,” generating significant fortune for early-stage investors.
Source: Pitchbook and Capital IQ
How startup investing really works
• Investing in a priced equity round, in which investors pay a set price for shares in a firm.
• Investing in convertible securities in which the amount invested “converts” into equity over a period of time.
Convertible securities, such as convertible notes and Y Combinator’s SAFE papers, are frequently used by seed and early-stage investors to invest in firms. Priced equity rounds are more popular among investors in later-stage firms (Series B or later).
When can you expect a return or are you locked in forever?
Source: Pitchbook and CBInsights
Exits are what investors care about, but many founders dream of becoming a unicorn and avoid using the word “exit” until it’s too late. Despite this, M&As accounted for 97% of departures in 2020. And the majority of them occurred prior to Series B.
Exit or no exit: A fatal call
For investors, when to get out is equally important as when to get in. Fundraising from investors is about more than just getting the money you need to carry your business forward; it’s about building a relationship with them that goes beyond the cheque. When combing the horizon, an investor sees chances arise and vanish in the blink of an eye, making patience difficult. However, patience is a virtue that can benefit in the process of blockbuster exits. Make-My Trip’s, venture capital investors, were among the first to invest and the last to exit, hung on to their investments for nearly 10 years, which is unusual in the Indian venture capital industry. Their multi-bagger returns demonstrate how perseverance may pay off.
M&As have been used as an exit tool by more companies in India than IPOs. Several fast-growing Indian unicorns are looking for non-organic expansion alternatives. So don’t try to sell or undervalue your investments. Be patient and pragmatic. Exits may be the beginning of the next great thing!
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