July 2019

STARTUPS AS AN INVESTMENT ASSET CLASS

Sanjay Mehta
Startup Investor

Funding startups is glamorous, but the big question is how much returns can they generate as an investment asset class?

 

Start-ups are young, emerging companies working on breakthrough innovations that would fill the need gap or eradicate existing complexities in the ecosystem. These companies are in a constant endeavour for new development and researching new markets. They have agility embedded in their inventive thinking. Angel investors fund a startup for several reasons but the first and foremost reason is that they believe in that idea, project or passion. They want to make the entrepreneur startup successful with the help of the disposable capital available at their end.

 

Investing in startups is more an art and less of a science – it isn’t meant for everyone; it 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. 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 make the idea / vision into a reality. Entrepreneurs can also find angel investors in their family and / or friends who will support them with capital on terms favouring them. Angels risk their money in people, teams and ideas which are fragile in nature. Hence this is termed risk capital investment.

 

Angels are individuals who have a good, successful background; their names evoke trust in the minds of customers or future investors. They back the startup by associating their name with it, which provides the entrepreneurs the required creditworthiness in the market.

 

Why I love startups as an asset class for investment is because I can offer my time besides my 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 and helping people, then your chances of success are very high. With early stage startups as their lead investor, I work closely with the founders to create a positive outcome. Before beginning a discourse on the merits and demerits of investing in startups, let’s first understand investing in startups 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. A key difference between investing in public companies and private ones like startups is that in public companies selling off your stake is far easier and near instantaneous. The same cannot be said about private investments – hence investments in startups 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 because realising an exit takes a lot of time. It is an illiquid investment.

 

A basic, fundamental point that every early-stage investor should know is that startups follow the law of power – a small percentage of the startups you invest in will give you the majority of your profits. Take (for example) Andreseen Horowitz’s portfolio. They’re 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 startup investments, you should be able to access those 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 real return is. If you invest in few startups it’s like buying a lottery; it’s the portfolio approach which helps the early-stage investor create mega returns.

 

Given this background, let us come to the question at hand, “Are startups a good investment?” Startups are high-risk high-return investments which follow the power law. It is not about the number of hits you have, but the magnitude of those hits. That’s where we find the answer to our question. The wealth creation opportunity that startup investments provide is nearly unparalleled. But it is also extremely risky and conditional. So when are startups good investments?

 

It is a good idea to invest in startups when one has the appetite and the capacity for the high risk involved. The investor with the mission to give first, to help founders and build business will win this game. 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 give one huge returns. One can create a startup portfolio by investing about 5-10% of one’s 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 ten years.

 

The toughest part of investing in startups is gaining access to the top tier of deals that can give you the huge hits. When one has access to those 6% of deals, it is a great idea to invest in startups. One cannot ascertain at the beginning whether a particular investment will provide the returns one hopes for – but one can invest in startups that can give the unparalleled returns that one hopes for if they work out. To gain access to the top startups, one has to put in time and effort to become a part of the startup ecosystem, become a part of various investor networks and collaborate with other lead investors and VC firms.

 

Startup investments can provide disproportionate wealth-creation opportunities. Before investing in startups, every investor should ask himself – 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 startup phase and the public company phase.

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