Investing in early stage startups might seem a rosy proposition for many retail investors with its lure of multibagger returns.
There are however, significant risks factors associated with investing in startups which you as a small investor should be aware of.
In this post, we will decode some of the risks and rewards associated with investing in early-stage start-ups and help you decide whether this is a game which you would want to play.
The lure!
A lot of portals have come up recently on the web, where individuals like you and me can invest into early stage startups with an extremely low ticket (i.e minimum investment) size.
I will not name any of these portals (which are startups in their own rights) but you can easily find them with a search.
These portals typically lure investors by building a narrative around an existing already successful startup.
The narrative typically goes like this: X amount invested into Startup Y, 5 years ago would have grown by 1000X or more.
They lure you into investing in the startups listed on the portal, by making you believe that you too could identify potential market disruptors; the ones’ that would go on to create immense wealth for their shareholders.
However, before you are drawn into such a narrative, here are certain important factors that you must consider before jumping into the startup investing bandwagon.
The Startup investing game!
Investors who invest into early-stage startups are either high net-worth individuals or investment firms that are specifically constituted for this purpose.
These individuals (a.k.a angles) or firms either possess in-depth knowledge/expertise in the industries in which the potential startups operate or have a team of trusted individuals (read experts) to advise them on these matters.
The investors, always, as a rule meet the founders to understand their vision and clarity of purpose; and gain first-hand information about the operations of the company as well as the industry in which it operates in.
Often, the investment decisions are built around the skill-sets of the founders, their vision or the drive to succeed.
As a small investor, looking to invest into a startup, you often do not have access to such intricate information about the operations of the business to help you form an informed opinion about the growth prospects and future of the company.
While selective information might be available on the portal, founders are wary about putting too much information about the operations of a young company on the web as this might lead to some of the competitors copying their strategies.
Contrast this with more mature companies which are listed on the stock exchanges.
Such companies are mandated by regulations to share operational and financial information with the general public on a continuous basis.
With such information, an investor is able to make more informed judgements about the growth prospects of the company in the future.
The game of chance!
Investors who regularly invest into early stage start-ups know that not all of the companies they invest in would succeed.
In fact the rate of failure is expected to be quite high.
Most investors therefore follow a strategy wherein they invest into a large number of startups across different industries with the hope that eventually a few of them would succeed and grow so big as to give them a more than decent return on their overall portfolio investment.
As a small investor who is looking to invest into startups, the question you must ask yourself here is whether you are willing to take the risk of losing your entire capital invested?
This is because these young startups have all the hardwork to do before they can build a competitive advantage for themselves.
Again, contrast this with investing in listed companies with proven track records and a clear growth trajectory going forward, where the risk of failure is significantly low.
Take the Indian consumer market for example. Companies like HUL or Nestle, have been operational for decades, are market leaders in their own rights and can be expected to remain so in the near future because of the competitive advantages they have built over the years. (Note that is not an investment advice into the stocks mentioned above)
Risk minimisation is indeed the most important ingredient for success in the financial markets.
Game for it!
So if you still believe you want to play the startup investment game, here are a few things that you should know:
Vesting Rights:
When you invest into young startups, you would like to have an ownership interest in the company in the form of equity shares.
However, often, the startups listed on the portal would offer you rights in the form of options plans (CSOPs) which will vest into equity shares at some point in the future upon the happening of some event ( for example an Initial public offer (IPO) by the company).
Note that these options typically do not come with any voting rights.
So before investing into any startup, remember to read the offer documents very carefully to understand not just the vesting terms and conditions but also your rights as an investor.
Exit Plan:
Unlike the stock markets, where one can easily liquidate his/her investments, getting an exit from your unlisted startup investment may not be very easy.
In the absence of a secondary market, the only time you might get an exit from your investment is when a large investor buys you out or the company successfully launches an IPO.
It might take years for any of these events to occur. Moreover, there may be the vesting conditions to consider.
So before investing, make sure you do the homework and understand clearly what your eventual exit path is going to be.
Only risk so much of the capital that you can afford to lose.
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If you are interested in investing in the stock markets you can read my article on Investing in your first stock.