Let’s presume that your stock market return on average is 10% per annum under steady market conditions, while that from a startup is around 7%, assuming the investee startup has started showing positive cash flow. The average return from this portfolio (stock + startup) after a period of say, two years will be around 17.6%.
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| Investing in the stock market is all about financial returns. When you are an angel investor while you are looking for a return, you have an emotional attachment to the business and the team. When you invest in the market, you are not emotionally behind any of the companies. If they don’t return suitably, you mercilessly switch to another asset. -- Sanjay Bhasin |
Your actual returns may, however, be far from this number, either on the higher or lower side, depending on the state of the market and the general state of the economy. These two factors will affect your stock market returns, which might even plunge below zero and be negative during market troughs. In such a case, the other 40% of your investment will still earn you positive returns, provided you have been judicious enough in choosing the startup. In this way, a startup investment acts as a cushion and provides you some immunity against market inclemency.
This, of course, does not mean that startup investment provides you sure returns. Murphy and his law can strike any time. However judicious you have been about choosing the right startup to invest in, things can still go wrong. The worst case scenario would be investing in a bad startup during a market downturn. The hole in your portfolio will be black and suck in all your dough!
Ratio play
Like Bhasin, there are others who see stocks and startups as two independent asset classes, with there being no trade-off between the two. These investors might decide to devote only a certain amount of their assets into startup investing, irrespective of the size of their corpus or the returns. There are others who believe in adjusting their portfolio over a period of time depending on the corresponding returns. In both the cases, the risk-return appetite of the investor has to be charted out first.
On the face of it, rather than going for random asset-allocation, it might seem wiser to go for the latter option. There is, however, no reason why one approach should be better than the other.
Chaos Theory still applies and an equation derived after several complex iterations might just be equal to a random selection in this case as well!
Identifying a ‘good’ startup
Parenting a new entity does excite you, but only when the expected returns are good. If the success rate of startups in India were to be 10% (that is, only one out of ten startups would succeed), you should be able to identify that one startup while it’s still a toddler! Here, we’ll borrow a few lessons from angel investors.
There are certain common indicators that help you gauge that, such as the nature of the idea, scalability of the business model, available or potential markets, projected earnings (cash flow), related risk, etc. Adequate analysis of the idea and the revenue model of the startup will take care of the first three. The last two are the much-favored variables in the risk-return analysis. Although the actual analysis is more complex, you can do a few basic calculations that will give you a fair idea of the actual figures.
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| Always be prepared to lose some amount of money in the beginning. But when you’ve got a winner in your hands, the amount of returns and the degree of satisfaction that you get out of that one success makes it all worthwhile. -- Saurav Srivastava |
Let’s assume you are eyeing a startup XYZ in the education sector. The value of current assets is Rs 5 crore and long-term liabilities are worth Rs 2 crore. Hence, net working capital is Rs 3 crore. They are looking for an investment of, say, Rs 20 crore, out of which Rs 10 crore will be used in the very outset for product manufacturing. The projected cash flows for five years are, say, Rs 3 crore in the first two years and five, seven and eight in the last three years. The Internal Rate of Return (IRR) in this case would be 34%. The net present value of the startup is over Rs 15 crores. After cash infusion, the valuation will rise to Rs 35 crore. Let’s assume you invest Rs 5 crore into XYZ, thereby owning equity over 14%. If the projected valuation in five years’ time is, say, Rs 50 crore, the cumulative return over five years on your invested capital would be over 40%.
Your expected return from XYZ will depend on several other quantitative and qualitative factors, one of the most important being the degree of risk. Your expected rate of return is affected by two significant risk variables—industry beta and risk premium. Industry Beta, in this case, will be the beta generally associated with the education sector in the country. Both the quantities are dependent on industry-performance and, to some extent, on the performance of the market.
Pincushioning the portfolio
Activist investors like Warren Buffet see market troughs as huge investment opportunities. That’s because Buffet has enough capital cushion for a possibles higher failure rate and enough skill to rear that one investee company out of ten that is slated to make it big.
Angels in India follow a somewhat similar approach while investing. Almost all angel investors we spoke to confessed that they have allocated some percentage of their portfolio to investing in startups, out of which another percentage is for cushioning. Imagine a pincushion that has enough fluff and spunk to withstand the pin-pricks of failed startups. The pin-cushion, in this case, is the corpus of the investor.
Srivastava, a veteran angel minces no words when he says, “Always be prepared to lose some amount of money in the beginning. But when you’ve got a winner in your hands, the amount of returns and the degree of satisfaction that you get out of that one success makes it all worthwhile.” Hence, investing in a startup might not be all that different from stock investment. Just like in the stock market, you should invest in a startup only if you have enough capital to lose, without it affecting your portfolio much; that is, you’ve got to take risks. Caution and precaution are necessary. Don’t sow the oats generously. Sow them intelligently!
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