In recent years, the startup boom has ushered in a new asset class for investors – Angel Investment. Along with other investments such as equities, real estate and gold, a lot of high net worth individuals (HNI) have taken to angel investing.
In the US, angel investors are families and friends who help a promoter long on passion but short on money. This fund raising is done by the entrepreneur before approaching a venture capitalist (VC). Typically VCs insist on revenue traction with proof of concept of the product offered by the company.
In the last decade, a lot of start-ups have been funded by VCs. Several of them have also achieved the much written about “Unicorn status.” With angel investing preceding VC funding, entrepreneurs have raised money from angel networks.
Successful exits rare...
While angel investing can encourage entrepreneurship, successful exits have been an exception. It would make sense for investors to have realistic expectations before putting money in a start-up. In India, successful angels have been entrepreneurs who have created companies on their own before becoming investors. Their operating experience and ability to hand - hold entrepreneurs have created successful enterprises.
95 per cent start-ups fail...
However with mushrooming of startups, a lot of high networth individuals (HNIs) have taken to angel investing, chasing the next unicorn (a start-up valued more than a billion dollars). Empirical evidence proves that 95 per cent of start-ups fail and most of them do not meet their initial business plan projections.
Public equities can be valued with past financial data and historical returns. Real estate can be valued by rental yield and net asset value. Gold is universally accepted as a medium of exchange. Startup valuation is always abstract. Entrepreneurs give a business plan based on projections. Angels invest on the entrepreneur more than on the scheme.
The euphoria in the start-up world has given rise to unicorns. Several angels are funding to find the next Flipkart and Ola. Many start-ups are copying the American business model. Money is chasing all these start-ups to create the next unicorn. The left out feeling and fear of missing out has created an environment where tonnes of money is chasing these. Some of the companies are valued more than the traditional old economy companies with profits and healthy cash flows. Timeless financial metrics like profit margin, ROE, ROCE... have been replaced by burn rates, GMV in the name of apps and disruption.
When the entrepreneur loses control
Aggressive fund-raising, expensive valuations and stringent legal clauses like liquidation preferences have also made entrepreneurs lose control of their company to venture capitalists. For the entrepreneur, it is a dream. For the investor, it is another investment in his portfolio. It is critical for the entrepreneur to chose like-minded investors whose interests are aligned with those of the entrepreneur. Venture capitalists also have to keep the life cycle of their fund before committing the money to the businessman. A sustainable business is always built with money from customers, not with the money from investors. Value for customers will always precede the valuation in a successful business.
Spray and pray model...
With high failure rate, angels prefer to invest in a basket of start-ups in a typical spray and pray model. While this diversified basket of start ups is a great risk-mitigation strategy, it creates bandwidth problems for HNIs to mentor the startups.
Successful entrepreneurs invest in few startups and mentor them with their entrepreneurial experience. Concentrated portfolio enables them to have sufficient bandwidth to mentor the companies.
While angel investing ecosystem is inevitable to promote entrepreneurship in India, angel investments do not give the liquidity and price discovery offered by other asset classes. With government encouraging startups, angel investing can evolve as a great funding platform over a period.