This article has been written by Angshuman Pal pursuing a Remote freelancing and profile building program course from Skill Arbitrage.

This article has been edited and published by Shashwat Kaushik.

Introduction

The global economy is ever changing as we evolve with time. The magnitude of change is increasing more than before. We have seen a lot of happenings in recent days. Priorities like the environment, sustainability, terrorism and pandemics are changing the market dynamics of every economy. Government mandates are changing depending on priorities. Large enterprises are no longer the sole controllers of economies. Rather, medium and small enterprises are increasing in number. Startup companies are contributing a lot to this ecosystem, especially during the post-pandemic era, in recent days.  The development of startup ecosystems across various economies gave birth to a new era and became the next big thing in the industrial revolution.

Background of investment strategy for startups

Large scale enterprises, state sponsored and private, as well as enterprises with a multinational presence, have revolutionised various economies during World War I & II; they have contributed substantially to building economies in previous decades but failed miserably during recent days.

It is observed that large scale enterprises are no longer self-sustainable when ecosystems and supply chains are broken due to war embargoes, or emergency situations like pandemics, etc. We are seeing how large enterprises are lobbying for frequent bail outs, contributing to debt traps in giant economies like the United States. Policymakers are looking for stable solutions. Hence, prioritising sustainability became a key mantra in this era. This, in turn, has given birth to microenterprises and startup ecosystems. 

Policymakers across all the leading economies are showing adequate passion for startups and are very positive about them. They are helping to build special economic zones for startups, contributing further nourishment to startup ecosystems.

Individual investors, families, communities and enterprises—everyone is very much betting on startups today, expecting multifold growth in their investment kitty. Positivity about startups is floating everywhere, across the globe.

Understanding why

Let’s explore why startup investment is so lucrative.

Passionate innovators and technocrats are grouping themselves and founding startups every day. Startup enthusiasts and new age entrepreneurs are taking maximum risks and determination to achieve their dreams and entrepreneurial goals. Taking advantage of their small size, startup companies are adapting themselves quickly to market dynamics, irrespective of the situation that arises. This agility advantage brings a high possibility of growth as well as probability of a high return on investment within a very short span of time, irrespective of market conditions. 

Hence, no one can ignore startups as the most lucrative investment avenue; and it is estimated that this trend may continue for the next two decades.

Do startup investors make money

Startups are the most prioritised and lucrative investment avenue for almost every investor in today’s context. But, honestly, it can be a journey full of fun, if and only if they take the necessary precautions and can adapt themselves to a higher risk appetite. 

Ways to invest in startups

The process of investment in startup companies varies from country to country during the previous decade(s). However, in recent times, most of the startup enthusiast countries have made startup investments under a strict regulatory framework and transparent SOPs are in place. Hence, systems across all investment routes are more or less similar in most countries. In India, all startup investments are governed by the SEBI regulatory framework. 

Let’s discuss a few well-established startup investment routes investors have opted for as per their comfort, depending on size and type of investment:

Angel investing

Independent investors can invest directly in startup companies as individuals or as families and manage the investment privately, naming it Angel Investing. When availing of this type of investment route, startups are immensely benefited not only by the investment corpus but also by business expertise, expert advisory, experienced mentorship and a trustworthy network of individuals and business houses all together.  But, they have to abide by the likes-and-dislikes of individual angel investors.

Investors can gain the maximum return on investment through this channel. However, irrespective of all regulatory protections, angel investments are not at all secure in nature.

Investment through VC (venture capital) funding

A VC fund is a systematically created pool of investment corpus collected from different private investors, categorising their priorities and investment interests. Professional investors across the world, technically called venture capitalists, are generally found in this type of funding activity as they favour a streamlined process of identifying beneficiary startups,  strict governance and a private institutional framework for securing investment and maximising return on investment.

Investors can gain the maximum return on investment through this channel. However, irrespective of all regulatory protections, investments in startups through VC channels are not 100% secure by nature.

Investment through crowdfunding

Independent investors can also invest in small chunks, becoming part of a large group of investors through a crowdfunding channel. Here, they collect and compile together a large corpus and invest it into a startup company or into a specific project of a startup company. When availing of this type of investment route, startups need to abide by the terms and conditions of the crowdfunding platform or channel. Still, they are immensely benefited not only by the investment corpus but also by business expertise, expert advisory, experienced mentorship and a trustworthy network of individuals and business houses all together.

Investors can gain the maximum return on investment through this channel. However, irrespective of all regulatory protections, investments in startups through crowdfunding channels are not 100% secure by nature.

Investment through startup bonds 

Investors can also invest their corpus in startup companies, purchasing bonds from companies governed by regulatory frameworks. Startup companies pay back the borrowed money with fixed interest within a specified date, as mentioned in the bond. The bond certificate should be duly approved and signed by the specific regulator.

Investors with a lower risk appetite who look for a fixed, assured return can avail of bonds.

Investment through private equity trusts

Similar to VC funds, private equity trusts also systematically create a pool of investment corpus collected from different private investors, categorising their priorities and investment interests and managed by empaneled professional investment firms. Professional investors across the world are generally members of this type of investment trust, as they favour the streamlined process of identifying beneficiary companies. For investments, private equity trusts prefer mature businesses over startups; hence, private companies are prioritised. Similar to VC funds, private equity trusts also ensure strict governance and a private institutional framework for securing investment and maximising return on investment.

Investors can gain the maximum return on investment through private equity trusts. However, irrespective of all regulatory protections, investments in startups through VC channels are not 100% secure by nature and hence require an adequate risk appetite from investors.

Investment through pension fund

Recently, one of the largest pension firms in Britain has started putting a large percentage of investor’s corpus into various early stage startups, creating an exemplary trend. Investors, who avail themselves of self-invested personal pensions (SIPP), have better chances of multiplying their investment corpus by investing in private equity trusts. 

Investors can gain a much better return on investment through this pension fund as well. Soon, we may see a similar trend across the world, maybe also through pension regulators in India.

Risks of investing in startups

Now, let’s talk about the risks involved in investing in startups.

Compared to all other institutional investment opportunities, startups are very new avenues and investment in startup ventures is prone to higher risks and has multiple risk factors, as follows:

Insecure market risk

Many startups are working on innovative ideas with a mission to make a difference in the world. However, it is not sure whether the market, i.e., end users, will take the idea positively or not. Only a very few startups make a strong and positive impact with their social enterprises and finally generate a good return on investment. Hence, investment in an innovative startup is not secure by nature.

Credit risk with an unstable business

Many of the startup founding teams are new to business and may not know important business skills. Many startup founders are good at technology but novices in business management and entrepreneurial skills. Hence, the real performance of the business may not be stable enough to repay the principal amount or interest amount on time. Startup companies have higher default rates in general compared to companies that are already established or run by experienced businesspeople. Hence, adding startups to one’s own investment portfolio increases credit risk to a higher degree for investors.

Risk because of liquidity issues

Startup investments are not liquid most of the time, which technically means that it is difficult to sell off investments easily and quickly at any point in time. Buyers or sellers at any point are not easily available because of the limited size of the secondary market. Sometimes, rigid terms & conditions restrict investors from liquidating their investments at their own volition. These all impact investor’s ability to cash returns easily.

Non diversification related risk

When invested solely in a single startup, its performance is totally dependent on its own performance. The total investment will be lost if the specific startup fails to perform or underperforms within a specific timeframe. Planful and equal diversification of the total investment kitty into multiple startups of different emerging domains and types can balance this performance issue and mitigate the risk to a large extent.

Risk caused by reinvestments

If a specific startup generates an outperforming return within a specific timeframe, a few investors become greedy and reinvest the return in the same. This in turn can cause the risk of poor ROI (return on investment) in the long run as market conditions may change, hence the performance. Investments in earned profits with fresh, attractive avenues can be lost because of a lack of exploration. 

Risk because of a sudden inflation outburst

If the investment in startups does not grow in line with market inflation, it will end up being a capital loss for investors. Or a sudden outburst of inflation, occurring due to an unexpected situation (a geopolitical situation like a war, a sudden natural calamity or a pandemic outburst), can impact the native purchase power of the investment amount over a time-period. Startup investors need to create a portfolio taking these points into consideration; otherwise, they can end up with a capital loss on their total investment value.

Risk caused by forced selling

Forced selling of startup investments is also a primary risk factor that can be caused by multiple reasons, like:

Willful selling due to emergency

Emergency situations or unforeseen circumstances may cause investors to square off all startup investments all of a sudden, much earlier than planned. Most of the time, this type of sell out happens during unfavourable market conditions, resulting in enormous losses. This is also a huge investment risk and an experienced advisor ensures that their clients keep aside emergency funds for unforeseen situations.

Evil eye of bigger shirks

Every startup investment term & condition comes with exit clauses that investors often ignore. Because of this exit clause(s), promoters of a startup or founders of a startup can force an investor to sell their stake with specific conditions, such as an investment round or a lucrative proposal from another funding party. This is the ground reality and has been observed in many cases. Whether this is legal or ethical, it is subject to court proceedings or proceedings under specific regulators.

All exits, forced or voluntary, surely happen at a higher value than the current market price, but obviously at a much lesser price tag if compared to the actual price value that a specific investment can return in the long run.

Risk related to offshore investments

Investors can expose themselves to huge unwanted risks if they invest in offshore startups. Geo-political situation is in an unstable phase nowadays and we are hearing bad news almost every day. Country specific market economics, including inflation matrices, political instability, currency fluctuations and sudden changes in country-specific regulations, can have a negative impact on startup investment, bringing unwanted exposure to potential risk.

How to mitigate the risk factor

Like every business avenue, the success of any startup is prone to failure and perhaps most uncertain among all businesses. Directly investing in a startup without knowing the domain or analysing the experience and capabilities of the founders can be disastrous. Hence, it is advised to do adequate homework well in advance before venturing into startup investment. Greed and rumours can result in wiping out the total investment corpus rapidly; and there is a possibility of scams and bubbles. 

Hence, it is always advised to go with an experienced professional startup investment advisor with proven track record(s) during the early stage of investment. However, there are plenty of popular investment platforms available that claim a lot, but scams are happening often.

Regulators across the world are trying their best to streamline processes and help protect every investment. But, it’s always better to be cautious than to make a blunder and be sorry.

Role of a financial advisor in startup investing

Investment or management of a startup investment portfolio is a challenging job when the only key measurement parameter is performance over a longer period of time. Self investment has various advantages over other methods, but it is only fruitful when an investor is self-disciplined and devotes adequate time every day to managing the portfolio. It is prone to multiple risks if the investor is not prompt in his actions and is not thoroughly updated about every change in market conditions.

Hence, like any other investment avenues, to get maximum return on startup investment, it is always advised to go with a professional investment advisor or consultant. It is known that an adequately experienced, trustworthy, self disciplined and transparent investment advisor can make a significant impact on a startup investment portfolio.

How to find the right startups for investment

It’s a mammoth task to find the right startup to invest in. Investors need to do lots of homework and attend various workshops, awareness campaigns, help files, and everything else possible. Adequate homework, along with background verification of every founding team through professional agencies, is a must. 

However, few investment platforms and startup hubs are doing wonderful work, bringing everyone on the same platform. Hence, investors must take advantage of all these avenues.

1. Identify your investment goals:
   • Determine your financial objectives, risk tolerance, and investment horizon.
   • Consider your long-term vision and how startups align with your investment goals. Create a clear investment strategy that outlines your objectives and guidelines for making investment decisions.
2. Research different industries and sectors:
   • Explore emerging industries and sectors with high-growth potential.
   • Gather information on industry trends, market dynamics, and competitive landscapes. Identify specific sectors that align with your interests, expertise, and understanding to increase your chances of success.
3. Monitor startup news and publications:
   • Stay informed about the latest startup news, funding rounds, and industry trends.
   • Subscribe to tech blogs, newsletters, and publications to stay up-to-date on the latest developments in the startup ecosystem.
4. Attend startup events and networking opportunities:
   • Participate in startup pitch competitions, conferences, and networking events.
   • Actively network with founders, investors, and entrepreneurs to gain insights into the startup landscape. Attend events that focus on the specific industries or sectors you’re interested in to meet relevant professionals.
5. Utilise online startup platforms and databases:
   • Explore online platforms and databases that showcase startups seeking investment.
   • Use filters and search criteria to identify startups that match your investment criteria. Leverage these platforms to research startups, compare their offerings, and connect with founders.
6. Join startup communities and forums:
   • Engage with startup communities, forums, and online groups.
   • Connect with other investors, founders, and professionals to share ideas, experiences, and opportunities. Participate in discussions, ask questions, and seek advice from experienced investors.
7. Conduct due diligence:
   • Thoroughly research the startups you’re interested in.
   • Evaluate their team, product, market, financials, and potential for growth. Analyse the startup’s traction, growth metrics, and competitive advantages to assess its investment potential.
8. Seek professional advice:
   • Consult with financial advisors, investment professionals, and legal experts.
   • Obtain expert guidance on making informed investment decisions. Seek advice on tax implications, legal considerations, and other aspects related to startup investing.
9. Diversify your portfolio:
   • Spread your investments across multiple startups to minimise risk.
   • Consider investing in both early-stage and growth-stage startups. Create a diversified portfolio that balances risk and reward potential.
10. Monitor your investments and stay informed: Startups are inherently risky, and it’s crucial to monitor your investments regularly to make informed decisions. Here’s how you can stay informed about your startup investments:

• Regularly review financial statements:
  • Request and review the startup’s financial statements, including the balance sheet, income statement, and cash flow statement. These statements provide insights into the company’s financial health, profitability, and cash flow situation.
• Track key metrics:
  • Identify and track key metrics that are relevant to the startup’s industry and business model. This could include metrics like monthly recurring revenue (MRR), customer acquisition cost (CAC), and lifetime value (LTV).
• Monitor competition:
  • Keep an eye on the startup’s competitors and their activities. Monitor their product launches, marketing campaigns, and funding rounds to assess the competitive landscape and identify potential threats or opportunities.
• Attend investor updates:
  • Attend investor updates or calls hosted by the startup’s management team. These updates provide an opportunity to hear about the company’s progress, challenges, and future plans.
• Seek professional advice:
  • Consider seeking advice from financial advisors, accountants, or legal professionals who have experience in startups. They can provide valuable insights and recommendations based on their expertise.

Laws governing startups in India

The legal and regulatory framework governing startups in India has undergone significant evolution in recent years, with the government recognising the importance of fostering a conducive environment for the growth of these innovative ventures. Here are key aspects of the laws governing startups in India:

Definition of a startup:

The Department for Promotion of Industry and Internal Trade (DPIIT) defines a startup as an entity that is incorporated in India, has obtained a certificate of incorporation not more than 10 years ago, has an annual turnover not exceeding ₹100 crores, and is working towards innovation, development, or commercialization of new products or services.

Startup India Initiative:

Launched in 2016, the Startup India initiative is a flagship programme of the Government of India aimed at promoting entrepreneurship and innovation in the country. It encompasses a range of measures, including:

• Self-certification for startups: Eliminating the need for multiple registrations and approvals, startups can self-certify their compliance with various laws and regulations. This streamlined process reduces the administrative burden on startups and allows them to focus on their businesses.
• Tax exemptions and other financial incentives: Eligible startups are entitled to a range of tax exemptions and other financial incentives, such as:
  • Tax holiday for three consecutive years
  • Reduced capital gains tax for investments in startups
  • Access to concessional loans and other financing options
  • Seed funding and venture capital support
• Access to funding: Startups can access funding through dedicated schemes and venture capital funds, such as:
  • Startup India Seed Fund Scheme
  • Fund of Funds for Startups
  • Invest India Fund
• Simplified compliance procedures and regulatory relaxations: Startups benefit from simplified compliance procedures and regulatory relaxations, such as:
  • Fast-track clearances for various approvals
  • Relaxation of labour laws for startups
  • Single-window clearance for environmental clearances
  • Simplified intellectual property registration process
• A dedicated Startup India portal and mobile app: Startups have easy access to information and services through the dedicated Startup India portal and mobile app, which provide:
  • Information on government schemes, policies, and regulations
  • Access to online services, such as registration, compliance, and funding
  • Networking opportunities with other startups, investors, and mentors
  • Support and guidance from government agencies and industry experts

1. Legal Framework:
   • The Companies Act, 2013:
     • Provides the legal framework for the incorporation and operation of companies in India, including startups.
     • Introduces the concept of “One Person Company” (OPC), making it easier for individuals to start their own businesses.
   • The Startup India Act, 2020:
     • A comprehensive legislation aimed at further streamlining the startup ecosystem in India.
     • Establishes a National Startup Advisory Council to advise the government on policies and programmes related to startups.
     • Introduces the concept of a “Startup Founders’ Cell” to provide legal, regulatory, and compliance support to startups.
   • The Foreign Exchange Management Act, 1999 (FEMA):
     • Regulates foreign exchange transactions in India, including those related to investment in startups.
     • Provides specific provisions for foreign direct investment (FDI) in startups.
2. Investor Protection:
   • The Securities and Exchange Board of India (SEBI):
     • Regulates the Indian securities market, including the issuance of securities by startups.
     • Has introduced a framework for crowdfunding platforms, enabling startups to raise funds from the public.
   • Alternative Investment Funds (AIFs):
     • AIFs are privately pooled investment funds that are not regulated by SEBI.
     • Startups can raise funding through AIFs, subject to certain conditions and regulations.
3. Intellectual Property Rights (IPR):
   • The Patents Act, 1970:
     • Provides protection for inventions and grants exclusive rights to the patent holder.
     • Facilitates the commercialization and licencing of startup innovations.
   • The Trade Marks Act, 1999:
     • Protects trademarks and service marks, enabling startups to establish and protect their brand identity.
   • The Copyright Act, 1957:
     • Provides protection for literary, artistic, and other creative works, safeguarding the intellectual property of startups in these areas.

Game of investing at early stage

Startups get crucial support from an early stage investor that helps them face tremendous challenges during critical times. But we know that startups, by nature, have very high levels of innovation and creativity, as well as a high level of risk. Hence, investment in a startup at the seed or pre-seed level can bring lots of risk to an investor’s portfolio. However, if invested systematically and professionally, these investments can bring a very high return with a very high risk to reward ratio, as it is an opportunity to invest in avenues before they become a big thing in front of the mainstream public.

This brings a huge uniqueness and advantage that is not possible with any other form of investment instrument available.

Importance of diversification

Startup investments are lucrative if risks can be taken care of from Day 1. But, no one is actually willing to leave it like that because it is a high-risk, high-reward game. Nowadays, everyone is excited about investment opportunities that offer great potential for returns. 

This unique problem can be solved If an investor thoughtfully plans to invest in early stage startups, equally distribute her startup investment kitty into, say, about ten startups. However, these companies should necessarily be diverse in sectors and industries. Diversification in investment kitty of this type will also spread the risks involved. If a specific startup fails to perform during a specific time period or gets evaporated, it will have a distributed impact on the total investment corpus and get adjusted.

Conclusion

The startup ecosystem has been expanding in India since 2000. But it’s happening after a decade since the Securities and Exchange Board of India (SEBI), the market regulator in India,  announced strict regulations (Alternative Investment Funds AIF Regulations) in 2012 to institutionalise investments in startups through alternate funds. It has clearly specified  the Code of Conduct in Regulations and clarified the responsibilities of managers and members of investment committees so that investors’ interests are protected. SEBI has also released the Alternative Investment Funds Regulations in 2021 and updated multiple amendments to meet the long standing demand of the Indian Private Equity and Venture Capital Association (I VCA).

We are seeing a lot of startup centric activities like startup hubs coming up across the world, including in India, even in Tier 2 and Tier 3 cities as well. A new code of conduct for AIFs, fund managers and investment committee members is already in place so that startup centric activities are regulated. A similar code of conduct for other stakeholders, like startup investors, is also in the draft phase and will soon be floated by the specific regulatory body.

Hence, the startup ecosystem in India, in line with other major economies, is growing rapidly beyond expectations. Regulatory frameworks are also being updated rapidly by regulatory bodies, visibly increasing their systematic vigilance. No one likes to miss golden opportunities. Hence, the time has come to join hands and feel free to create separate investment kitty centering startups.

References

1. 10-Step Startup Investment Guide – Board of Innovation : https://www.boardofinnovation.com/blog/startup-investment-guide-10-steps-to-assess-whether-a-venture-is-suitable-for-investment/
2. https://seedlegals.com/resources/how-to-invest-in-startups/
3. https://inc42.com/glossary/startup-investors/
4. https://www.linkedin.com/pulse/mastering-startup-investment-acquisition-starters-guide-exitsmena
5. https://www.sebi.gov.in/sebi_data/meetingfiles/apr-2021/1619067585946_1.pdf
6. https://seedlegals.com/resources/how-to-invest-in-startups/