The article is written by Gursimran Kaur Bakshi a student at the National University of Study and Research in Law, Ranchi. In this article, the author has explained how potential Indian investors can invest in US startups.
Table of Contents
Introduction
An idea can truly change the world. But change happens eventually and often takes a longer time than necessary. So, use your idea for doing something better. Perhaps, turn your ideas into a startup and take command of the change you bring to the global market.
A startup is a company or a project that is launched by the entrepreneur in the market by himself or with a group of people for delivering a particular service or a product to the market. A startup may always involve risks because you can never be sure how the market will respond to it.
Another better way is to invest in startups that are already a runaway market hit. Both decisions would be accompanied by certain market risks. But there is a saying ‘when you think it’s not the right time to jump, that is when you should jump.’
Entrepreneurs and investors have something in common. They both have to face financial risks. An entrepreneur by setting up a new startup decides to take potential risks such as how the market will react to it. An investor while investing in a startup too considers a risk that the investment might not have favourable returns. That is why investing in startups is neither for the faint of hearts nor for the slim of pockets. However, investing is fun when you have enough knowledge of how the market works.
Investing in foreign startups may look like a daunting task prima facie. This is especially true during the COVID-19 pandemic that has changed the outlook of the market and there is also a paradigm shift in the needs of the people. Hence, Indian investors must be aware of these changes before investing in foreign startups.
The United States is one of the most preferable places for doing business in the world. It is ranked 6th out of 190 countries in the 2020 Report of the Ease of Doing Business published by the World Bank. The startup market is great for Indian investors if they are willing to invest in foreign startups.
Let’s understand how investments can be made to US startups.
How has COVID-19 reshaped the US startup market
Contrary to what one may have expected, the economic slowdown has not impacted the drastic growth of US startup markets. There has been an increase of 24 percent in the US startup market from 3.5 million in 2019 to 4.4 million in 2020. This has been because the US government and the administration have been accommodating in recognising the importance of small startups and businesses.
During the pandemic, the US Small Business Administration provided 3.3. Million Paycheck Protection Program loans to small businesses and startups who were eligible for the same. The scheme ended on 31st May 2021. Such uptick in business during pandemic has been associated with change in customer preferences, expeditious process to start a new business, and growth of entrepreneur by necessity.
How can Indians invest in US startups: step-by-step procedure
Before learning to invest in startups, ask yourself, what kind of an investor are you? Are you someone who is just interested in returns? Or are you someone who wants to invest in a startup because you are passionate about it and genuinely want that business to grow?
Your objective to invest in a startup is directly proportional to your method of investment. To invest in US startups, two important legislations and some regulations are necessary to be taken care of. The two laws are the US Securities Act, 1993 along with the Spotlight on Jumpstart Our Business Startups (JOBS) Act, 2012, and the 2016 Crowdfunding Regulations for individual investors established by the Security and Exchange Commission (SEC) under the Securities Act.
Let’s understand what are the different stages of a startup because investment in a startup may take place based on different stages.
Stages of startups that the investors should know before investing in US startups
This is said that for estimating the success of a startup, it is important that it provides a solution to at least one pain point to the industry in which it is based. For instance, if the demand for filter coffee in a market is high and no cafes or restaurants sell filter coffee because it requires certain techniques, then a startup for the same may work. Without knowing when to invest in a startup, the investors will not be able to invest at the right place and at the right time and thus, this is for them.
There are six stages of a startup in usual cases:
Pre-seed
The importance of the pre-stage is not just to notice a pain point of the market and find the solution to it to venture into the market. You are also required to assess the cost of the opportunity, potential competitors, whether the pain point is based on long-term demand and other alternatives. For instance, in the above-mentioned example, a startup based on filter coffee may not work in the long run. Whereas, a startup similar to Zomato but which focuses only on the coffee market may turn out to be a good startup in the longer run. It is because the demand for filter coffee may vary but the demand for coffee, in general, is here to stay.
This stage is also known as the idea stage where you may also be able to find a co-founder for yourself, who is willing to share financial resources for setting up the startup. It is a stage where investors can offer venture debt funding which is a loan given to the startups to raise working capital.
Seed
This stage is where the materialisation for the startup begins. You are required to decide on a business model and financing. To validate the business models, you are required to do experiments in developing various prototypes of the business model to validate your idea of the startup. Validation requires funding.
Funding at this stage is mostly based on ‘3F’ namely Friends, Family, and Fools. The first two investors are investing at this stage because they know you and your capabilities. That is why their focus of investment is you and not your idea. Thus, the funding from their side will be limited to validate the business model.
Whereas, fools are those who are investing without knowing the risks involved in it and that is why they are not known as sophisticated investors. But you never know. That foolishness may turn profitable.
Also, many startups are self-funded. When a startup is established on personal funding or operating revenues, it is known as bootstrapping. Bootstrapping is done at the stage when the business does not have any assets.
As against bootstrapping, another way of raising capital for the startup is through getting financial support from angel investors and the participation of incubators. Angel investors are semi-professionals/private investors who use their own money to invest. They may be acquainted with your capabilities but their investment is based largely on the market validation that you have claimed for your startup. They invest in the company in return for an equity share in the company.
Further, it is preferably important that you have a team. The team may consist of early employees who are willing to work with you on the basis of the market claims you have made on the product or the service the startup wishes to launch. A team at this stage is also important since the next stage requires the testing of the product.
Thus, the first two stages focus on idea validation.
Early-stage
This is an important stage where the idea is finally left to evolve as a product or a service. Usually, a product at this stage is tested to be a minimum viable product (MVP) which is not a final product but has minimum features to satisfy the needs of the customers.
MVP is used to see the response of the potential customers, to find out the areas of improvement, and whether the new version of the product with the suggested changes will satisfy or fulfill the needs of the customers. Crowdfunding and public demos are ways of MVP that can help in raising funds for the product.
Venture capitalists and accelerators may play an important role in financing the company at this stage. A venture capitalist is a private equity investor that provides funding to startups exhibiting high growth potential in exchange for an equity stake. It does so not with its own private money but pooled from investment companies and corporations.
A venture capitalist does not fund startups at the initial stage but at the stage where the startup looks forward to expanding itself. Since it is not possible for a venture capitalist to get returns on their investment at the very early stage of the startup when the same is focusing on validating its ideas.
Growth stage
A startup only reaches this stage when it becomes successful in testing the minimum viability of the product. This is the stage that focuses on the profitability of the product and meeting the strong demands of the market. At this stage, the company has to focus on growth which means they would be required to employ more people, venture into the new sector of your targeted audience, and adjust to the new demands of the market. Since this stage requires a new approach altogether, it has the highest failure rate.
Funding at this stage is done through venture capital and corporate venture capital in addition to the above-mentioned ways. The above two stages focus on product/market fit and that is why investment at this stage becomes important for the growth of the startup.
Expansion phase
At this stage, the company which has now proved its demand in the market wishes to expand further can do so by bridging funding through raising IPO and acquisitions. IPO helps the company to expand from being a private company to be called a public company. Expansion can help in upgrading the infrastructure, recruiting more employees, and generating more profits.
When a company wishes to expand its growth, the process is called a scaleup. According to the Scaleup Institute of the United Kingdom and OCDE, for a company to reach a stage of scaleup, the company must grow at an annual rate of more than 20% during the last three years. The growth can be in terms of the number of employees or turnover to be considered a company as scaleup. This last stage focuses on scalable distribution and acquisitions.
The last stage of a startup is the exit stage which is however not necessary. The exit phase is meant for those startups that are established with a specific goal and once that goal is fulfilled, it becomes redundant.
What to know before investing in US startups
Identify a disruptor
A disrupter is that product or service which is here to solve the pain point of the market. If a startup targets a disrupter, the startup has the potential to work. For instance, as mentioned above, if a market has a demand for coffee delivery but there are no cafes or restaurants offering the same, launching a startup of coffee delivery is a disrupter.
Investors do not invest in a startup randomly. They try to identify a disruptor that has the potential for growth in the future.
Understand this with another example. Imagine that there was no Netflix. But during the COVID-19 pandemic when most of the countries were in lockdown, Netflix as a concept was introduced for the first time. Now, this startup has the potential to create strong waves in the market. Because first, it took advantage of the fact that entertainment is an indispensable part of people’s lives, and especially during the pandemic, people need this to distract their minds and enjoy themselves amidst all uncertainty.
So, Netflix is that startup that will attract investors because it has the potential to bring a paradigm shift in the market.
Team sheet agreement
A team sheet is a non-binding agreement between an investor and the startup company which mentions things related to due diligence apart from every basic information about the startup. Even though it is not binding, it can be considered as one of the most important agreements for an investor because this prima facie gives an idea to him whether his investment will work out or not.
Due-diligence requirement
For investors, it is always advisable to carry out due diligence research that helps you form a decent opinion on the potential investment you would be making. Due diligence concerns itself with almost everything relating to the startup- employer’s liability agreement, employees’ contracts, company, and its stakeholders, potential competitors, management, Intellectual property rights concerns, and the overall growth of the company.
Simple agreement for future equity
If you are planning to invest through various crowdfunding platforms, you should be acquainted with the concept of the Simple Agreement for Future Equity (SAME). There are startups that do not directly prefer determining the valuation of the company since it takes a lot of time. Hence, they prefer what is termed convertible instruments.
A convertible instrument is of two types, SAME, and notes. This instrument helps the investor to invest on the basis that they can use it to convert it to equity at a later stage. A convertible note can be converted into future equity based on a future transaction. It is sought of like a loan that the investor gives at an early stage. But it comes with a maturity date.
SAME refers to the future equity stakes based on your investment in a company in the event of the sale of the company or in a case where an additional round of financing is required. It is not dependent on the maturity date but has a valuation cap.
Many crowdfunding platforms such as WeFunder are based on SAFE which is not considered safe by the SEC because there is no guarantee that the event will arise in the future. Your stakes depend on probability unlike in cases where you have the ownership of a stock of the company based on a priced equity round.
Priced equity round is based on a negotiated valuation of a company wherein you get the fixed ownership of preferred stock in consideration of the monetary investment. It’s much safer especially if you are a first-time investor.
Things that first-time investors must remember
Apart from knowing all the things mentioned above, it is suggested that a first-time investor may follow in the footsteps of a lead investor. While thinking about investing in a startup, look for the lead investor– how he has invested, at what stage of the startup did he invest, is his investment giving him favourable returns, etc.
Which kind of Indian investor can invest in US startups
There are two categories of investors, namely, accredited and non-accredited. An accredited investor in simple terms is an institutional investor or an individual who is able to invest in a security that is not generally available to the public. These are known as sophisticated investors.
An accredited investor is defined in Section 2(15) of the US Securities Act, 1933 (as amended in 2018). An individual person shall qualify under the rules and regulations of the US SEC as an accredited investor on the basis of various factors such as:
- Financial sophistication
- Net worth
- Knowledge
- Experience in financial matters
- Amount of assets under the management.
Further, the definition of a person under Section 2(2) means:
- Individual or trust
- Corporation
- Partnership
- Association
- Joint-stock company
- Any unincorporated organization
- Government or political subdivision
An accredited investor is defined by Rule 501 of Regulation D of the Act as a person whose income exceeds:
- $200,000 for the last two years and is expected to remain the same in the current year
- $300,000 for the last two years and is expected to remain the same in the current year if the income is jointly earned.
- The net worth must exceed $1 million either individually or with the spouse.
Further, Rule 506 which is also known as the safe-harbour rule allows private companies to raise public offerings by accredited investors. A Foreign investor is not debarred under Rule 506 as per Section 5 of the Securities Act.
However, there is no requirement that the person needs to be an accredited investor because the EB-5 offering( allowing foreign investors to be eligible for permanent residency in the US provided they invest in US business that helps in creating employment in the US) is not sold to non-US accredited investors. It only needs to be in compliance with Regulation S.
A non-US person has to fulfill conditions under Regulation S which are:
- The investor is not a US person which means he is not a permanent resident of the US.
- He is not acquiring the securities for the benefit of any US person.
- The investor must be physically located outside the US both at the time of purchasing the securities and at the time of execution when the investor delivers the subscription agreement.
- He must not engage in hedging transactions with the securities purchased.
An unaccredited investor, on the other hand, would be an individual investor who would want to invest in a company in exchange for returns and is also defined under Rule 501. Until 2016, non-accredited individual investors were not allowed to invest in private companies. Now, however, the Crowdfunding Regulations, 2016 allows everyone to invest in startups.
A non-accredited investor must be someone having an annual income or net worth below $100,000. They are limited to invest no more than $2,000 or up to 5 percent of the lesser of their net worth or annual income.
Can Indian investors make investments through equity crowdfunding platforms
Investment in startups can be done through equity crowdfunding platforms. These crowdfunding platforms allow individual investors to invest in the early stages of startups. Crowdfunding, unlike any other way of investment, is an easier way of attracting funding at the validation stage of a startup. Crowdfunding is nothing but pooling money from different resources.
At this stage, since the startup needs funding to grow, the amount of investment does not necessarily have to be large. That is why, even individual investors including family, relatives, and friends can invest. This is apart from the angel investors.
This kind of funding is better than other modes of funding, at least at the early stage, because the startup does not have to be vetted necessarily, or own assets, or have valuation. However, in other modes such as if the startup is looking for venture investment, the valuation of the startup is required.
Some of the most known platforms are mentioned below.
Wefunder
Wefunder is a public benefit corporation and one of the most known platforms amongst angel investors in the US. It is registered with the Financial Investment Regulatory Authority (FINRA). However, the investment contracts on WeFunder are based on SAME which is not considered as safe by the SEC.
SeedInvest
SeedInvest was founded by Ryan Feit and James Han in 2012. SeedInvest is registered as SeedInvest Technology, LLC (SeedInvest). It has become the first equity crowdfunding platform to allow 90% of the American to invest in startups in 2015. It allows you to browse and invest in various US-based startups.
StartEngine
StartEngine allows both accredited and non-accredited investors to invest.
Republic
Republic is registered as OpenDeal Portal LLC and allows you to invest in different US startups, real estate, crypto, and video games through its website. It is a funding portal registered with the US SEC and is also a member of the Financial Industry Regulatory Authority.
MicroVentures
It allows both angel investors and venture capitalists to invest often at the same time in pre-vetted startups. It is also a full-time investment bank and registered broker-dealer with FINRA.
Seedrs
It allows all types of investments including co-investment of angel investors and venture capitalists. It also allows secondary trading of shares.
EquityZen
It allows only accredited investors to invest in Pre-IPO startups.
SharesPost
It allows institutional and individual investors to invest at any stage of the startup. An investor can invest in small startups and even bigger IPOs that are unicorns with a valuation exceeding over $1 billion.
How to make venture capital investment
Another way of investment is done by venture capitalists who fund at a later stage of the investment (growth). A venture capitalist, as defined above, mostly invests at the time when the startup wishes to go public through Initial Public Offering. But there is no restriction on them investing in the pre-seed stage. Venture capital investment can either be made by a venture capitalist firm or an individual. One of the most successful startups which raised capital through this is Uber.
Further, venture debt funding can also be made by venture capitalist firms or through individual investors along with venture capital.
Can syndicate investment be made in US startups
Syndicate investment is co-investing and can be helpful for potential Indian investors. This process allows the backer to co-invest with syndicate leaders. A backer is something with minimal experience whereas; a syndicate leader is someone who is professionally experienced. There are three qualities of a syndicate leader as explained by Naval Ravikant, the co-founder of AngelList. According to him, a syndicate leader should have:
- Access to capital- the required capital to invest.
- Proprietary deal-flow- the chances of receiving business proposals or investment offers.
- Good judgment- knowledge and market experience.
Why should Indian investors invest in US unicorns
The US has produced some of the most known unicorns (Airbnb, Facebook, and Google) and is still producing them. Investing in unicorns is a two-way street because if investors are running behind unicorns that will give them profitable returns and unicorns are looking for reputed investors. The gameplay here is for experienced players and not for naive average investors. It is also important to note that not all unicorns have opted for an IPO.
Some of the top known US unicorns are:
In this list, the maximum valuation reached is $95 billion for Stripe and the least is Magic Leap with $ 4.5 billion.
The rewards and risks in investing in US startups
It is not unknown that 90% of the startup will not be able to make it to IPO. There could be different reasons for that. The clearest understanding that any investor should have before investing is that they might lose all their money. You cannot be an investor if you are not ready to lose it all.
While investing at the early stage of the startup, the risk would not be much as compared to investing pre-IPO. It is because the valuation of the company is not much and would not have to lose a large investment. However, the risk gets bigger for venture capitalists and those who invest in unicorns because even though the market can be predicted, it is still based on probability.
While rewards in investment are profits, ownership of equity shares, and satisfaction. The two are materialistic while the third is not as not all investors are investing for money. Some investors truly want the business to grow and believe in their ability. Thus, these are the pros and cons of investing in a startup. Whereas, the US market currently seems to be more lucrative since the growth and acceptance of startups are much more in that country than anywhere else. That is why it attracts global attention.
Conclusion
An attempt has been made in the above article to explain to you the nuances of foreign startups and how Indians can invest in US startups. This will be beneficial for all those Indians who are new to the investment markets but have the flair for investing in foreign startups. However, one should learn the ability to understand how the startup market works, how it is currently working, and what can be the potential future before investing in it.
References
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join:
