Angel investing, ESOP and the art of building a startup investment portfolio

India’s startup ecosystem is rapidly multiplying with digitalization and adoption of technology. According to a report by Nasscom and Zinnov, India added over 2,250 startups in 2021, more than 600 more than added the previous year. Startups raised $24.1 billion in 2021, a doubling of pre-COVID levels, the same report pointed out.

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With startups showing significant growth over the past two years, the most important thing a startup needs before it can go big is funding. Amit Pamnani, Chief Investment Officer and CGM, Swastika Investmart Ltd, talks about startups, explores the four stages of funding, talks about angel investing, the importance of building a startup portfolio and how startups strategically use employee stock options (ESOPs) in their initial stage to retain employees and alleviate funding issues at the same time.

What is a startup and how to start?

Startup basically means a business that disrupts industry standards or solves the burning problem of innovation, technology, and scalability. One or more founders start the startup to go independent, solve industry challenges or gaps, and fulfill their dreams of going big. The word startup was coined in 1976 by Forbes magazine in the United States when referring to a “budding business”. It became popular after 2000 with the adoption of the technology by businesses and consumers.

What is the biggest challenge before a startup?

Any startup needs capital to grow rapidly and scale nationally and internationally, for which funds must be raised from investors. There are broadly 4 stages of financing –

● Seed Stage – Investment comes from personal savings, friends, family at the idea stage.

● Angel funding – The participation of high net worth individuals, professionals and angel networks occurs after the development of the MVP (minimum viable product) or revenue stage.

● Venture Capital – Venture capital funds are invested in the growth stage. These are alternative investment funds (AIF) registered with SEBI or large companies, foreign VCs

● Private equity – Private equity investors invest at a later stage when the size of the business becomes large and grows very rapidly.

Is there a slice of funding that falls under angel investing?

Angel investing is an art in which individual investors with experience in the industry show interest in investing and contribute strategically to help a startup take it to the next level. The amount of investment in the angel tower can vary from Rs 25 lakh to Rs 7.5 crore and even more in the highly lucrative and scalable idea. Those who invested from 2012 to 2015 began reaping multiple returns from 2018 to 2020.

Angel investors and their success stories

An angel investor in Zomato got 2240x returns by investing Rs 10 lakh in 2010. Sanjay Mehta, a serial angel investor made 280x return from OYO investment exit. BharatPE, a fintech start-up, gave more than 80 times more returns to its angel investors in two years i.e. new investors bought their share giving Rs 102 crore in cash compared to the initial round of Rs 1.9 crore.

In 2021, investments in around 400 Indian startups took place at the seed and angel stage with a total amount of Rs 5,300 crore.

How to find an investment opportunity for angel investing?

One can invest directly or with registered angel networks like IAN, Mumbai Angels, Lets Venture, Venture Catalysts, Agility Ventures, to protect the risk. Angel networks professionally manage portfolio companies, mentor them and plan the exit within 3-5 years of tenure.

Investing in startups as a new asset class

Investors see seed investing as a new asset class along with stock market, mutual funds, FDs, real estate, etc. The profile of angel investors includes industrials, CXOs, high-paying employees. I also made a few investments last year, one of which has been multiplied by 2.5 so far. After digitalization and demonetization, the traction and valuation of startups increased and as a result, the wealth of investors was suddenly boosted, which sparked the fascination of angel investors to invest more in startups.

Enough money is chasing Indian startups, hence rising valuations for high-potential startups with go-getter teams, with a sense of FOMO (fear of missing out) among investors. Moreover, the restrictions imposed by China on foreign FDI, FII and VC, India is the outstanding investment destination for investors from all over the world.

Seasoned angel investors advise building an investment portfolio of 10 or more startups over a 2-3 year time frame to balance return on investment (ROI) and hedge the risk of failure. As a rule of thumb, according to portfolio studies, 5 out of 10 startups may not go bad, 3 may give average returns, and 2 may yield returns greater than 10x. Thus, in 5 years, an investor can expect more than 30% IRR on his investments.

Employee retention, a major challenge for startups

Most startups fail due to product market mismatch, failure to raise the next round, inability to retain or obtain new talent, etc. To solve the challenge of employee retention, startups issue ESOPs (Employee Stock Options). ESOPs are company shares with a vesting and lock-up period of 1 to 3 years. After this period, ESOPs can be tradable and employees can sell a portion of the shares to a third party or the company can buy back at the current market price.

These shares are issued at a discount to top performers to give them a sense of ownership and motivate them to stay with the company for a long time. At Swastika, we had created an ESOP program for a few startups where we kept 10% of paid-up capital as an ESOP pool that companies use to reward top performers. When these companies go for the next round of funding at a higher valuation or can opt for an IPO, employees can sell their shares and generate handsome wealth. In the case of Zomato, more than 18 senior executives became millionaires after its IPO because they owned shares that were received as ESOPs.

Angel funding a high risk, high reward proposal

Angel investing in the startup space is exciting with high risk and high reward ratio. However, investments made with thorough research, due diligence, assessment of team capabilities, market potential, product needs, etc. can increase the chances of success. Startups have huge potential for performance and growth in India as many industries are unorganized and many business models are yet to be digitized as consumer behavior patterns are also changing.

(Disclaimer: Opinions/suggestions/advice expressed here in this article are investment experts only. Zee Business suggests its readers consult their investment advisors before making any financial decisions)