Unlocking The Potential Of Startup Equity: An 8-Pointer Strategy

Introduction To Startup Equity Investments 

If you have an innovative idea that solves a common problem and a solution that can be scaled up, then India is a reliable ecosystem to fulfill your entrepreneurial dream. India ranks third in housing startups, with over 1,17,254 DPIIT-recognized startups as of December 2023. Although the startup culture is young in India, its fast-paced nature and support from our government have led to a 15x rise in the total funding of startups in the last ten years.  

A few years ago, startup equity investment was considered a game only for large investors like venture capitalists, private equity firms, and the like, with the required initial investments amounting to crores.  Elevation Capital, Sequoia, Matrix, Kalaari, Blume, Venture Highway, and Anicut Capital are well-known start-up investors. 

Indian startups are now witnessing a significant shift in sources of funding. Alternate startup investment routes like crowdfunding, venture debt, and revenue-based financing are increasingly becoming more popular with both founders and inviting a different persona of investors. With this paradigm shift, new investors, including individuals, can invest in start-ups at small ticket sizes. Let us dive into a 6-point strategy to keep in mind before investing in startup equity.

8 Things To Keep In Mind While Investing In Startups

1. Understanding The Risks And Rewards

Any startup investment opportunity comes with a disclaimer of the risks involved. While the potential rewards from any investment may be huge, so can the losses. Despite the promises of alluring returns, an investor should weigh the possible risks, too. They should vet the financial stability, quality of the leadership and management, product-market fit, and startup scalability before committing the money.

2. Expected Rate Of Return

Expected returns on investment in startup equity can vary widely depending on various factors, including the startup’s valuation, growth trajectory, market conditions, competition, management team, and the overall viability of the business model. 

During the initial phases of a startup's journey, investors typically anticipate a return of 3 to 5 times their initial investment within 5 to 7 years. While some investors may experience significant gains if the startup succeeds and achieves a liquidity event such as an acquisition or IPO, others may face losses if the startup fails to generate sustainable revenue or attract additional funding.

3. Conducting Due Diligence On Startup Opportunities

Due diligence is crucial for any investor looking for startup funding. It helps an investor evaluate the startup’s market size, viability, vulnerabilities, and probable profitability. An investor should study the financial backing and health, previous success stories, management and leadership philosophies, transparency and other core values, and legal and regulatory compliance before investing in startup equities. 

4. Evaluating The Startup's Business Model And Market Potential 

The success of any startup eventually depends on the revenue it earns from its products or services. Therefore, for a startup to succeed, it should have broad market potential, i.e., it should have a high number of potential customers and a robust business model to meet the requirements of these customers. 

5. Assessing The Team And Leadership Of The Startup 

According to a study, 60% of startups fail due to subpar teams and inefficient management. While selecting a startup to invest in, you should assess the leadership and team for their prior experience in similar setups, market and product knowledge, flexibility and adaptability to change according to customer feedback, and necessary industry skills.

6. Negotiating Equity Terms and Understanding Investment Structures

Most profitable investments come when they are made at the right price. The same philosophy goes with startup equities. As an investor, it is important that you understand the investment structure and its term sheet clearly and that they are not biased in favor of the founders only. 

A term sheet refers to a bullet-point document containing the terms and conditions of a potential business/ investment agreement. It establishes a sound basis for future negotiations between its founders and investors. 

7. Investment Timeframe

For each story of instant success, there exist countless startups that require years to turn a profit. Investing in startups demands a long-term perspective, yet it is crucial to gauge the expected timeline to align with personal goals. While some investors are content with waiting a decade for returns, others prefer recouping their investment within 4-5 years.

Assessing the startup's performance history aids in estimating the investment horizon. One metric to consider is the burn rate, which denotes the monthly expenditure. Investors may need to wait longer for dividends if a startup is in its early stages but has a notably high burn rate.

8. Exit Strategies 

Correct timing is of the utmost essence in any investment. It applies to both investing and exiting at the proper stage of a startup. As the saying goes, “Investors are in the business of exits”.

As an investor in startup equity, you must understand the exit potential of the startup. You should know the advantages and disadvantages of various exit routes like IPO, a strategic sale, or a financial exit, along with the right time to exit from your investment. 

Conclusion

Startups and every vocabulary associated with them bring excitement to potential investors. With the multifold rise in numbers and valuations of Indian startups, the interest of Indian investors in holding these startup equities is exemplary. The advent of alternative investment platforms that allow retail investors to own startup equity enables investments and wealth creation. However, choosing the proper startup and investment platform is crucial to cover an investor’s risks. 

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