Startup funding as an investment option for retail investors: Factors to consider?

You would have heard about startups raising funds to run their business, but what if you can also take a part in their growth story? That’s possible with startup funding investments. This is an alternative investment option that allows retail investors to fund startups for the capital requirement and earn competitive returns on the same. 

In recent years, India has become a hub for start-ups with more than 1,12,718 startups recognised under DPIIT as of October 2023. The number of Unicorns has reached 113 with a total funding of $100 billion. Additionally, from 2018 to 2023, Indian startups have raised a total of $110.08 billion. This shows the increased interest of investors in this alternative asset class. 

However, because start-up funding is a comparatively new investment option and lacks awareness compared to other investment instruments like equity, it becomes crucial for you to understand each and every nuance before making an investment decision. 

Also, investments need to be done as per your overall financial goals, risk appetite, existing investment portfolio, asset allocation, and the requirement of funds.  This makes due diligence a crucial part of investing in startups. 

To help you with the same, in this third article of the series  “Alternative Investment Options in India”, we will talk about startup funding as an investment option for retail investors. We will discuss what it means for retail investors, factors to consider, and everything else you need to know. 

What does start-up funding mean for retail investors? 

Earlier, investments in startups were limited to venture capitalists, High Net-worth Individuals (HNIs), and institutional investors due to the requirement of large funds. However, with new-age platforms, this line has blurred with startup investing becoming accessible to retail investors, too. 

Start-ups usually have a high demand for funding from starting their business to manage day-to-day operations and to take their business to a new height. For this, there are three ways that startups usually raise funds:

1. Angel investing:

This method involves taking financial support from friends, family, or potential investors who provide funds in exchange for equity in the startup. This is a useful funding method for early-stage startups. 

2. Private equity (PE):

In this method, start-ups reach out to investment banks or large institutions for funding. PE looks for a profitable exit via IPOs or buyouts.

3. Venture capitalists (VC):

This is useful for startups requiring large funding amounts for quick growth. VCs look for a high return in exchange for funding.  

Apart from angel investing, the other two funding methods are for growth stage or mature stage startups and often need large funding which bars the entry for retail investors automatically. However, with new alternative investment platforms, this barrier has been lifted. 

These startup funding platforms pool funds from different investors and invest in a portfolio of startups looking to raise funds. This allows startups to gain funding and for investors to get a new investment avenue. Some platforms work as an aggregator and also give you details of different startups raising money and help you directly invest in that specific one.

These startup funding platforms also offer different alternate investment funds (AIFs) investment options such as angel investing funds, venture capitalists funds, etc. managed by their in-house team.  The success of these funds  depends on how well the companies in the portfolio perform, and how wisely the portfolio has been made doing the due diligence. Also, the return and risk involved depend on the startups and their existing stage, i.e. early stage startups, growth or mature start-ups, etc. AIF investing may demand a high ticket size.

The minimum investment amount can be anywhere from Rs. 5000 to Rs 10000 depending on the platform. For angel investing it can be around Rs. 50000. The same goes for the return on investment. It depends on the platform chosen and the startups that the platform invests in. Note that often these are early-stage startups and thus the risk level is quite high. 

Lastly, you can also invest in startups by acquiring their unlisted shares. This can be comparatively riskier than investing in AIFs as you have to conduct your own research and due diligence for the viability of the investment and future potential. There is also a lack of regulations for unlisted shares which can be a concern for investors with low-risk appetite. The vesting schedule, if any, also needs to be considered. 

Now that we know the startup funding meaning for retail investors, let’s get into the pros and cons of this investment option.  

Benefits of startup funding for retail investors 

Here are the top benefits that you can expect by investing in a startup.

(A) Opportunity to invest in an early-stage startup growth

This is a primary benefit that you can get from startup investing. The new-age investing platforms have made it accessible for investors to take part in the growth story of early-age startups. It is similar to investing in Flipkart or OYO a few years back. You can invest in startups that have the potential to grow similarly. 

With low entry barriers in terms of minimum investment required, retail investors can expect good returns in the long run. 

(B) Earn higher returns

Being an alternative investment option, startup funding offers  higher potential returns compared to equity stocks, mutual funds, and fixed-income instruments. 

While the exact return percentage can differ based on the platform selection and their choice of startup investments. The claim is on the high return side. it is often in the range of more than 20% if invested for a few years. However, you must remember that higher returns always come with higher risks. 

(C) Portfolio diversification 

Startup funding also offers diversification. There are four types of diversification that retail investors can expect: 

i) overall portfolio diversification by investing in alternative asset classes 

ii) investing in rising businesses from different industries and segments 

iii) investing in startups at different stages of their growth 

iv) investing in multiple startups for different tenures via angel or VC funds to diversify the startup funding portfolio. 

This ensures that the overall risk can be spread across a long horizon. 

Risk Factors of startup Funding for retail Investors 

Startup investing comes with its own set of risks that retail investors must understand before making a decision. 

(A) Loss of capital

Startups are businesses in the making. Also, most startup funding platforms offer opportunities for early stage startups. As per reports, 70% of startups fail in the first two years, which creates not only the risk of bidding goodbye to returns but also to the initially invested capital. 

Such a high-risk investment is not suitable for average retail investors in India who value stability and gradual growth of their portfolios. 

(B) Lack of liquidity for exit 

This is another risk that needs to be accounted for. Just like any business, there is no overnight success in startups. This can result in capital staying invested for the long term, especially with angel investing or unlisted shares, and can be hard to liquidate. However, the exact liquidation terms depend on the platform offering startup investing. 

If you are looking for liquidity like stocks or mutual funds, startup funding would not fit your investment shoes. There needs to be a longer investment horizon to earn better returns via this investment option. 

(C) Shareholding dilution

Startups dilute their ownership to raise capital and there is a constant need for funding which means more investors will step in, in the future. The end result is a dilution in your equity holding. This is especially true for angel investing in startups. For example, the startup wants to transform from an early stage to a mature stage and wishes to raise capital via VC or PE, this means dilution on the part of angel investors based on the agreed terms. 

This means, your returns can reduce significantly if the dilution is high. Thus, research well on what are the dilution parameters and their impact on your returns on the platform you are choosing for startup funding investments. 

(D) Lack of transparency on financial forecasts 

Unlike Listed companies, which come out with periodic financial statements, as per SEBI guidelines, and allow investors to have a clear understanding of where the business is heading, this is not the case with startup investing. 

You are investing in startups via an investment platform and it is an alternative asset class. Startups are not required to announce financial results like listed companies. Maybe you can access their future forecasts in terms of financial performance and valuation but those are based on assumption and cannot be taken as literal. 

There is also a lack of scrutiny for startups compared to listed investment options. This makes it suitable only for investors with a high-risk appetite. 

Factors to consider while investing in startups as a retail investors

Here are a few factors that can help you with due diligence while investing in startups.

(A) Platform credibility 

For now it is difficult to assess. There is no regulatory supervision of these platforms. All these platforms are backed by other fintechs and their promoters and this is the only pitch they have. In fact these platforms itself are kind of start ups which many times are dependent on their investors funding. 

So technically, you will invest in a start up through a startup, which could be backed by another startup. You may meet the promoters (if you want to invest a big amount). If you can play with the numbers and you find a company on their platform worth investing in, you may ask for the audited financial statements and get it verified. 

These platforms may also be working on commissions and have conflict of interest in promoting a specific company. Negotiate well.

(B) Startup portfolio and liquidity 

Check the terms and conditions associated with investment tenure. This needs to align with your overall financial goals and risk appetite. If you need funds in a short period, say less than one or two years, startup funding may not suit your profile. 

Also, evaluate the platform on the basis of how many startups and in which sectors are part of their portfolio, and what are the basis of adding them on the site. Investing funds in startups operating in a similar segment can lead to a concentration of funds and increase risk. 

(C) Taxation 

Taxation is an important part to consider. Check the selected investment platform for how the returns are distributed and what tax they will attract. 

You will be required to pay capital gains tax on your investment gains or dividends if received. If needed, consult a tax expert to understand the implications of startup investing. 

Conclusion 

Startup investing sounds like a great way to diversify an investment portfolio and earn higher returns but it is important to remember that higher returns also attract higher risks. In this case risks are huge. Do look at such investments only after providing for other important life and financial goals. Never put your hard earned money in the lure of earning fast returns. You only hear the success stories around but remember there are more failures than successes in startups.  

So in my view, though there are ways to invest, You need not invest in all the available options. Go with tried and tested investment options which also comes with their share of risk and returns, but which can be managed. In the startup kind of investing, I feel it is only the startup founder that makes money.

Unless you understand the business, the numbers, and have confidence on the platform, then only try your hands on it.