Investing in start-ups can be rewarding: Here's how you can place a bet

Invest directly if you want to get involved. Opt for a fund if the investment is only for financial gains

Wealthy Indian investors are increasingly looking at opportunities to get involved in start-up companies. And they have started investing directly in companies that have established their businesses or could go for an initial public offer (IPO) over the next few years. “Typically, they are looking at companies that have secured at least Series B funding,” says Srikanth Subramanian, senior executive director, Kotak Wealth Management. The Series B round generally takes place when the company has accomplished certain milestones and is past the initial start-up stage.

Investing in start-ups can be highly rewarding, but direct investing is not meant for everyone. For the majority of wealthy investors, taking the private-equity route could still be the better option.

Change in investing style: In the past, high networh individuals (HNIs) were investing in start-ups, but they were mostly focusing on early-stage companies, where the investment amount is low (Rs 5-10 lakh), and the failure rate is high. But even if one start-up is successful, the returns can be far higher than what an investor can make in listed companies. Now, they are wiser and are only looking at slightly-mature companies. “HNIs now want to be part of start-ups looking for growth capital. They co-invest with other institutional investors who have done the due diligence, thereby reducing the risks involved,” says Gaurav Awasthi, senior partner, IIFL Wealth.

Wealth managers say that this renewed interest started last year. But deals were not closing, as stock markets weren’t doing so well, crimping the risk-taking ability of investors.  “When stock markets do well, investors are willing to take higher risk. 2018 was a bad year for the stock market. But the present year has been positive,” says Nishant Agarwal, managing partner and head - family office, ASK Wealth Advisors.

Another reason why investors are flocking to start-ups is that returns from private-equity (PE) investments are not meeting their expectations. Wealth managers say that the net returns from many PE funds have been close to listed-equity investments after accounting for tax and profit sharing.

Direct is not for everyone: Investing directly in a start-up is similar to putting money directly in a listed company. Despite all the recommendations from experts and analysts, the investor has to do his own due diligence. HNIs who were investing directly have different reasons for doing so, but one thing is common among them – they track the company and its performance regularly.

Some of the direct investors have expertise in the area where the start-up operates, say, a promoter of a pharmaceutical company looking at start-ups in the healthcare space. Then, there are professionals like Sachin Bansal and Binny Bansal, founders of Flipkart, who want to help and mentor companies. Wealth managers say that when a client wants to invest in start-ups, they ask a few questions before offering recommendations. They try to understand whether he is looking at financial gains or wants to get involved. Then they ask for the holding period, return expectations, sector and city preferences, and other factors.

On the other hand, if a client is coming only for financial gains, wealth managers advise him to opt for the fund route instead of going direct. “There are some private equity and Alternative Investment Funds (AIFs) that have established track records that passive investors can look at. By investing via funds, they can also get to diversify across multiple companies,” says Prateek Pant, head – products and 

solutions, Sanctum Wealth Management. Another benefit of going for the fund route is that an investor can get marquee companies at a lower investment amount. Say, a well-known start-up is raising money where the minimum ticket size is Rs 25 crore. Going through the fund route can help you take exposure to such companies.

Exit matters the most: While there have been over 20 unicorns in India, none of them has gone for an initial public offer yet. For start-ups, IPO may not be a feasible option unless they are profitable. But there are other options for exit. An investor can offer his holdings when there is a strategic buyout. An example: Flipkart’s buyout by Walmart where existing shareholders like Softbank got exit. Another option is selling when the company goes for the next round of funding. Say, after Series B, the start-up goes for Series C fundraising. This happens when a business is thriving and needs fund to develop new products or expand into new markets or acquire other companies.

In developed markets, there is a secondary market for unlisted companies where investors trade among themselves. “In India, since such transactions have started happening, there is a secondary market that is becoming vibrant though it's nowhere near to the size and scale that we see in developed countries,” says Subramanian.