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Investing in start-ups: The search for the next big hit

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Jayant Pai
Last Updated : Aug 10 2015 | 12:28 AM IST
The past few years have accorded cult status to investors such as Peter Thiel, Ram Shriram, Accel India & Tiger Global. This is because the companies they backed - Facebook, Google and Flipkart, respectively - have become household names and metonyms for the new economy. Tales abound of how they had the prescience to spot these fledgling outfits, how they monetised that insight and had the patience to ride the wave, culminating in them becoming billionaires. The upwardly spiralling valuations of the next round of start-up companies such as Airbnb, Snapchat and Uber have added fuel to the fire.

Such talismans have whetted the appetite of institutional investors worldwide, all of them eager to grab the next big thing. This has resulted in the tables being turned, with the moneybags courting start-ups in their 'garages', rather than the other way round. The search for the next 'unicorn' (a start-up with a valuation of $1 billion) has often led to a 'spray-and-pray' approach, with institutions backing a slew of newbies - all professing to change the world - in the hope that a couple would lead them to the pot of gold at the end of the rainbow.

As always, investors who have become rich serve as brand-ambassadors for that particular asset class, extolling its virtues. Hence, as with stocks, real estate and art, investing in start-ups has emerged as an asset class in itself. It has also begun hogging the headlines of pink papers.

Financial product providers, being what they are, have latched on, offering funds devoted exclusively to start-ups. Funds which once targeted only ultra high net worth individuals (UHNIs) are now moving down the curve and catering to the upper middle class, as evidenced by falling ticket sizes. In other words, a larger number of uninformed (albeit well-off) investors are being drawn in. Often, these are structured as private placements, thereby escaping rigorous regulatory scrutiny.

Are these funds investment-worthy? As is usually the case, the answer to this will vary, based on the investor and his / her situation.

Here are a few points to be cognizant of, prior to taking the plunge:

Survivorship bias: Many start-ups have done well for themselves as well as their investors. However, as with anything else, the media ignores myriad start-ups that have failed. Let alone being the next Google, many start-ups are unable to even secure a second round of funding, as they fail to attain pre-set milestones. In a winner-takes-all scenario, backing a loser is injurious to financial health.

Representative bias: Seasoned investors lament that newbies are only employing the 'squint test' before investing. This involves squinting at a start-up and convincing oneself that it has the same attributes as a unicorn. For instance, a search-engine company which 'seems' like the next Google at first squint.

Pedigree of the fund: While past performance is no guarantee, avoid investing in a start-up fund launched by a promoter with no experience of nurturing start-ups. Prowess in late-stage / pre-initial public offering investing might not be relevant, while investing at the 'ground floor' stage. The kind of hand-holding required at this stage is markedly different.

The fund's mandate: Choose a scheme, which does not invest in a cluttered sector. For instance, a scheme which has the freedom to invest in start-ups providing logistics solutions to farmers and fishermen might be more promising than those which say they will restrict themselves to investing in more mainstream start-ups such as chat app developers and fashion portals. While both categories are risky, the former might have to contend with less competition.

Liquidity: These schemes invest in illiquid companies. Consequently, they are unable to offer investors unfettered liquidity. Investors who invested in real estate funds in 2007-08 will testify to this. Start-up funds are a few degrees riskier than real estate funds, as 'trade-sales' are not very common. Hence, do not invest more than a small portion of your liquid net worth into such schemes.

Skin in the game: Check the fund's promoters and fund managers' investment in the scheme's corpus. As a thumb rule, the higher the amount, the greater the commitment to the scheme.

Manage your expectations: Funds might state that despite valuations rising sharply over the past few years, "we have barely scratched the surface in terms of the addressable universe". Discount all such talk by 50 per cent and assess whether you still would like to go ahead and invest.

Investing in start-ups can be highly rewarding. However, as seasoned investors say, "Assess the downside first and do not bet the house on any one single bet". Let the quest to become rich through 'sunrise' companies not destroy your night's sleep.
The author is head - marketing, PPFAS Mutual Fund

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First Published: Aug 09 2015 | 11:46 PM IST

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