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Are you down with start-up fever? Read this!

September 08, 2015 08:42 IST

Start ups

 

It is risky for individual investors to invest directly in start-ups. Check the promoter team, understand the business and look for an exit route, before deciding on a plunge

Chennai-based Divakar Vijayasarathy, chief executive, MeetUrPro, which provides online legal and financial services, says seven to eight of his high net worth investor clients have invested directly in start-ups.

They have an individual net worth of about Rs 25 crore (Rs 250 million) and their investments are in the range of Rs 15-20 lakh (Rs 1.5-2 million).

“There is huge interest among HNI investors because they see that valuations of start-ups double every three to six months,” says Vijayasarathy. None of these clients has made money so far from their investments.

Even retail investors are talking about investing in start-ups.

Suresh Sadagopan, head of Mumbai-based Ladder7 Financial Advisories, says investors with Rs 500,000 are showing interest in such investments.

“They’re enthused after reading in newspapers about the kind of money start-ups manage to raise.

"While they understand that there is some risk, they are not aware of the extent.

"I would not advise it (direct investment) for individual investors at all,” he says.

The risks of investing in start-ups directly are similar to investing directly in stocks vis-a-vis investing in a fund.

But in the case of a start-up, risks are greater because the exit route is not as clear, unlike stock market investments, points out Arvind Bansal, head, product and advisory, Avendus Wealth Management.

For many HNIs it is a psychological feeling that they may otherwise miss out on the seemingly easy returns from start-up investments.

But, remember that unlike the stock market, in this case either you succeed and multiply your investment or you lose the entire money.

Broadly, some of the factors investors must check for include promoters’ background, valuation, clarity on the business model and an exit route.

Proper scrutiny

Investors must adequately do the due diligence about the promoter team and understand the market segment the company is operating in.

It is advisable to meet the promoters in person and verify if the company has full-time employees for key functions like the core product, marketing and sales, and finance.

Vijayasarathy cites the example of a client who was approached by a start-up importing chips used in solar energy panels.

“The concept was good but the estimate of cash required to go ahead was low, compared to the requirement.

While the promoters had some experience, it was in a different sector.

Besides, they did not have a good marketing person,” he says.

In this case, the client did not go ahead with the investment, as he was not convinced about the promoters’ ability to scale up the business.

The founder or promoter team is important.

“Check if the team has the technical skills and the drive or passion to carry the business through.

"It should not be the case that after one year, the promoters decide to give up the business and go back to their old jobs,” says Bansal.

Clear profit plan

The promoter should have a plan for making profits within two to three years. For instance, the e-commerce space has seen a lot of interest from venture capital funds.

Now, however, investors have starting asking what the exit route is. People are beginning to understand that the road to profitability is not only about user acquisition.

“Remember that your ability to control the business is very less. Be prepared to lose your entire money,” says Vijayasarathy.

Most start-ups have assets that are intangible. Even if they are tangible, it is difficult to put a figure to it, notes Sadagopan.

Potential problems

Even if the business model looks good today, one must look at the potential of the business or likely problems that could arise. For instance, a company manufacturing robots or drones or space-related technology might seem an attractive bet. But, if the government bans the use of drones, the business will wind up.

Back-up

Start-ups operating in the online space are the most visible today. However, an established offline business that is using the online route to expand the existing business might be a better bet than a start-up that is only online.

One of Vijayasarathy’s clients invested in a start-up that was importing European wallpaper and had a turnover of Rs 40-50 lakh (Rs 4-5 million).

As the business already had an established offline presence, the online route was only for expansion. Here, it was possible to check the inventory and so on.

“This is the only HNI client of ours who made money from his start-up investment,” says Vijayasarathy.

Go via angel networks

For individual investors, it is advisable to tag along with someone who has the experience, such as venture capitalists or angel investors who have a strong network. “VC funds have experienced people who can anchor the investment.

For individuals, it is not easy to understand the start-up environment. One can also invest through mutual funds, as many of them invest in emerging businesses or unlisted but promising companies,” says Sadagopan.

It is easier for HNIs who invest in the sectors they operate in, since most of their investments are with friends or people they know.

But, for those who want to invest in fields they don’t know about, the advice is to go through the fund route, says Rajesh Saluja, chief executive at ASK Wealth Advisors.

It also helps in risk diversification, since the investment is spread over 15-20 companies.

“We advise HNIs against passive investment in sectors where they don’t have control.

"That is why it is better to go through funds which will have members on the boards of the companies,” he says.

Avoid crowd-sourcing

There are websites which offer crowd-sourcing.

This means individual investors can invest as little as Rs 50,000-100,000 in start-ups.

However, this is also dangerous, as there is no chance of interacting with the promoters at all, notes Vijayasarathy.

“The entire discussion is online. And, five to seven per cent of the investment goes to the website, the intermediary. One should stay away from such investments completely,” he says.

Be disciplined, don’t place blind bets: Bharat Banka

Bharat Banka, founder and former chief executive of Aditya Birla Private Equity, is now an active mentor to start-ups and an advisor to multiple business houses.

In the past three-four years, there has been a lot of support from high net worth individuals and angel investors for start-ups.

This has helped new ideas and younger founders, and will drive innovation in this space.

But the advice for investors remains the same -- be disciplined and don’t place blind bets, Banka says.

What is your advice to HNIs who want to invest directly in start-ups?

The important thing to remember is that this is the most risky form of investment. Such investments are unlisted and illiquid.

These businesses are still in a formative stage and there is no proven business record. Most founders are first-time entrepreneurs and inexperienced.

These businesses also require long gestation to grow.

This kind of investing is very unconventional for HNIs who are used to seeing profitability, balance sheet and cash flows.

So, HNIs must invest in start-ups only if they understand the business. They should allocate only a small portion of their surplus, say two to five per cent. The investment should be based on their risk appetite.

What are the reasons that prompt HNIs to consider investing in start-ups?

Often, it is more about associating with a start-up which is the driver.

This is not the typical direct equity investment. Investors get to meet the founders and understand the business.

While investing directly, investors can take a disproportionate share in one company if they are confident about the particular business.

But while investing in a pool through a venture fund, even if they like one company more than the others, they have to allocate their money to all the companies.

What would you say to individual investors who want to invest in start-ups through crowd sourcing?

Crowd sourcing and online platforms are usually used to raise money for non-financial objectives.

So, investors should understand that they might not get any returns at all.

They must not get confused between fund-raising through crowd-sourcing and fund-raising by angel investors.

Angel investors who raise money are looking to make profit and might even look to take stake in the business.

Should HNIs buy stakes in start-ups?

Not necessary. Everyone can't play an active role.

It will depend on whether the investor has the ability to perform the role of a mentor.

While they could be successful businessmen, it is not necessary that they will be good as mentors.

But there might be some angel investors without a lot of funds, but with the experience to guide the start-up and can play the role of a good mentor.

Illustration: Uttam Ghosh/Rediff.com

Priya Nair in Mumbai
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