Given the popularity of startups, it is quite possible that one or more of your friends and family have become founders of a new venture. And if they get the impression that you have disposable cash, you can be approached for funding.
Obviously, it’s very tempting to take on the role of an angel and invest in what can become a unicorn. But you might want to pause to consider some grim statistics — according to the startup resource organization, Fellory, 1 in 5 startups fail within the first year; According to employment data firm Zippia, only 30% break even. The analysis is from the US, but the potential for financial viability in India is not high. So, should you be quick to invest in the ‘Friends, Family and Fools’ round or be afraid to walk in as an angel?
The simple principle to use is to only take the risk with which you are comfortable after analyzing the potential issues.
To start, while founders can be very optimistic about business potential, do your due diligence. For example, you should try to gain a basic understanding of the market, competition, the skill sets of team members to deliver, potential customers, and business planning. Take help of subject experts if needed.
Second, you may want to make your payments in more than one installment. While the need for funds for startups seems ‘urgent’, if the business plan requires funds over a few months, there is little benefit in transferring funds from your account to theirs. Track how they are progressing against milestones and only add more funds if you feel satisfied.
Third, you should estimate the amount that you are comfortable with writing off completely and invest only that. You Should Make Sure the Company Raises the Necessary Funds Before Writing Your Check—Invest 10 million when the enterprise is needed 40 lakhs of money is thrown away to reach a milestone.
Fourth, in the early stages, founders need support in the form of mentoring, access to other funding sources, and the like. If you are not comfortable with these, you can offer soft support until the startup is able to attract other co-investors.
The next decision to consider is the appropriate instrument for investment – Equity, Debt or Convertible. Loans are often an easy way to provide funds because the terms and expectations are clear.
The reward is limited to the investor and hence may be the preferred option for founders who wish to retain shareholding. There are two issues to consider here. One, there are restrictions on who is allowed to provide loans. Check if you fall in the eligible list. Second, the loan may be suitable only if the startup can either raise additional funds to repay the loan or generate sufficient cash flow to refinance the loan with a bank, when it becomes due.
Equity is also quite simple: the amount invested gives you a certain number of shares in the venture. This can be an optimal option if the startup takes some time to provide return on investment. However, valuation of the business is a common barrier to determining the share price, as valuing an early-stage enterprise is not easy.
Convertibles, which are typically loans that convert to equity after a certain period of time or on certain terms, are a more common instrument for investment because they offer flexibility in the structure of transactions. For example, valuations need not be fixed and may be deferred to the next funding round, when there is probably more clarity on revenue and profits. In addition, they can be simple to execute quickly. Equity carries the highest risk and if the startup performs well, it has the potential to deliver the highest returns. Variables are forward in both risk and return. That said, even within a sector or stage, there are plenty of company-specific factors to consider. Therefore, ideally, invest in one portfolio to reduce the overall risk.
Whatever the amount and means, be sure to enter it in black and white. Informal arrangements may not serve you well. In the case of a loan, set the interest rate and repayment terms. For equity or convertible, there are some standard legal conditions to incorporate. Connect with an attorney to draft the agreement. Be sure to include rights to information so that you get regular reports on how the startup is progressing.
Meera Siva, CFA, is the director of Shelter Venture Fund, a global early-stage impact fund that invests in innovative low-income housing startups.