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.
