Given the popularity of startups, it is very likely one or more of your friends and family have become the founder of a new venture. And if they have an inkling that you have disposable cash, you may have been approached for funding.
Understandably, playing angel and investing in what may turn out to be a unicorn is very tempting. But you may want to pause to consider some sobering statistics – 1 in 5 startups fail in the first year itself, as per Failory, a startup resource organization; only 30% break even, as per employment data firm Zippia. The analysis is from the US, but the financial viability is not likely any higher in India. So, should you rush in to invest in what is called the ‘friends, family and fools’ round’ or fear to tread as an angel?
The simple principle to use is to only take on the risk that you are comfortable with, after analysing potential issues.
To start off, while the founders may be very optimistic about the business potential, do your due diligence. For instance, you must try to get a basic understanding of the market, competition, skill set of the team members to deliver, potential customers and business plan. If needed, get help from subject matter experts.
Two, you may want to make your payments in more than one installment. While the need for money seems ‘immediate’ for startups, there is less benefit in moving money from your account to theirs if the business plan requires the funds over a few months. Track how they are progressing against milestones and only add more funds if you feel satisfied.
Three, you must estimate the amount that you are comfortable completely writing off and invest only that. You must ensure that the company raises the required money before writing your cheque—investing ₹10 lakh when the venture needs ₹40 lakh to reach a milestone is money thrown away.
Four, in the early stages, founders need support in the form of mentoring, access to other funding sources, and other such. If you are not comfortable with these, you may offer soft support until the startup is able to attract other co-investors.
The next decision to consider is the suitable instrument to invest—equity, debt, or convertible. A loan is often a simple way to provide funds as the terms and expectations are clear.
The reward is limited for the investor and hence may be a preferred choice for founders who may want to retain shareholding. There are two issues to consider here. One, there are restrictions on who is allowed to provide the loan. Check if you fall within the eligible list. Two, loans may be suitable only if the startup can either raise additional funds to repay the loan or generate enough cash flow to refinance the loan with a bank when it is due.
Equity is also simple enough: the amount invested gets you a certain number of shares in the venture. This may be an optimal choice if the startup takes a while to provide return on investment. However, the common stumbling block is the valuation of the business to assign share price, as early-stage venture valuation is not easy.
Convertibles, which are typically debt that will convert to equity after a certain period or on some conditions, are a more common instrument for investment as they provide flexibility in structuring the transaction. For example, valuation need not be fixed and can be deferred to the next funding round, when there is possibly more clarity on revenue and profits. Also, they can be simple to execute quickly. Equity has the highest risk and if the startup does well, it has the potential to offer the highest return. Convertibles are next in both risk and return. That said, even within a sector or stage, there are a lot of company-specific factors to consider. So, ideally, invest in a portfolio to reduce overall risks.
Whatever be the amount and the instrument, be sure to have it recorded in black and white. Informal arrangements may not serve you well. In case of a loan, lay out the interest rate and repayment terms. For equity or convertible, there are somewhat standard legal terms to include. Engage with a lawyer to draft the agreement. Be sure to include information rights so that you get regular reports on how the startup is progressing.
Meera Siva, CFA, works with early stage startups and investors.