Angel Investment- Adrenaline and endorphins

Last week I received exit cheque from one of my early angel investments in 2019. A chemical free cosmetics start-up and not my finest pick. Yet, a modest reward of 3x in 3 years. Not bad for COVID times at all! Building a brand in a crowded cosmetics space is very tough and exit options are also limited and moreover I knew nothing about the business. Last month, https://www.1stopbarber.com/plans-pricing another start-up sent an exit cheque equal to my invested amount. No multiplier, but at least I didn’t lose my principal. That’s some solace in the angel investment world.

 

I started my Angel Investment journey recently in 2019 after 30+ years in Corporates and about 12 years of investing in equity markets. Today, post 17 investments, 2 exits, 0 dead and “on paper” XIRR of 40% and reviewing almost 200+ start-ups, I must say – Angel investment is a completely different ballgame. I wanted to sum up my learnings over these 36 months:

 

1. Why Angel investments?

 

• Though this investment category comes with very high risk, it most definitely has the potential of giving very high returns. My broad learning from the experts, if one invests in say 30-35 start-ups over a specific period (2 – 5 years) and decides a fixed & same amount (either ₹2 or 5L or 10 L) for every start-up and is a consistent investor, it is probable that one would make a return IRR of around 35% which is perhaps the highest amongst all the investment categories. Having said this, that is not the sole reason one should jump into Angel investment bandwagon.

 

• Sense of Achievement or ‘Kick’ if you may – Start-ups are very different from “new” business which could be anything from a retail franchisee to a trading house to a manufacturing unit. A Start-up identifies a specific problem and tries to solve it with innovation by either a product, a technology, or a commercial model in a highly scalable model. In most cases, these start-ups will fail and shutdown eventually for lack of scale, funds, and many other reasons. Some will succeed and deliver fantastic results and thus the valuations.

 

The whole process of identifying, investing, observing them innovate, fall/get up multiple times, scale 10/20/30x and conquer the world or die eventually is a thrill of different kinds and satisfaction.

 

2. How to start? Two broad options for angels to invest –

 

• Find a start-up on your own, do your due diligence, convince the founder to accept your funds, negotiate the SHA and then monitor periodically for performance.

 

• Alternatively, join a platform like DFAN where all you do is pick one based on your intellect, write a cheque and then – sit back and enjoy the show. These platforms receive 000’s of applications each year and they do multiple screenings to select maybe 1% which are presented to you to pick a few each year. These platforms also negotiate SHA on behalf of all the angels to ensure protection for minority shareholders.

 

I am on 2-3 such platforms to ensure good deal flow and choices.

 

 

 

 

 

3. How to pick the right start-ups? What should you look for while identifying the start-up for investment? My experience is to look for the following five bullets in the order of priority- Founder, Problem, Market Size, Competition & Valuation Potential.

 

• Founders’ pedigree, confidence, strategic mindset, ultimate vision for the start-up and execution experience,
• Problem definition and the solution and/or the market getting disrupted and the proof of solution acceptance by market or customers. I typically look for revenues of approx. few crores spread over multiple customers.
• Total addressable market size (is it 100’s of millions or billions of $’s). I prefer a billion $ plus.
• Competitive moat, entry barrier for competition, number, and strength of competitors. I like to see no more than 2-3 competitors if the TAM is large enough.
• Valuation potential (Is it 5x or 100x) & potential exit options e.eg., Series A/B/C. IPO or acquisition or merger with others.
• An oft overlooked side of angel investment is SHA Terms. Like any other commercial transaction, SHA terms govern the rights of a shareholder and many time, an Angel which happens to be a minority shareholder does get a disadvantage.

 

4. What will happen to my money? The following multiple scenarios happened with my investments so far –

 

• Three of my 2019 investments are into tech start-ups solving various travel industry problems. Covid hit all of them the hardest however all three effectively used the Covid period to enhance their products, trim the cost and innovated both technically/commercially & came out stronger than before. Valuations of two are 5x & 8x in three years with great expansion plans and the third is planning another fund raise shortly. Extremely satisfying.

 

• One start-up founder lost all his co-founders in tough times though retaining their stake. The founder is highly competent but lost interest as all the absconding co-founders would also share in profits without investing time and energy. This one will probably become zero eventually.

 

• I met with Mr. Anand Mahindra early 2020 and shared how we both chose to invest in an Indian start-up which is solving brail literacy for blind globally using tech. He was quick to reply – Feels good, isn’t it? This start-up while slow to expand in terms of valuations (2x in 3 years) is most satisfying.

 

• Another founder ran into debts and decided to sell the start-up to cover the same. The only saving grace was – he negotiated with the buyer to return the principal to the angels. Better than becoming zero. 😊

 

• One of the start-ups with a promise to solve fruits and veggies waste from farm to kitchen from 50% to 3% using a very innovative model is already 12x in 3 years.

 

• One of my investments is into a content start-up. The founder ran a traditional business and decided to launch a digital + transformed version of the same business for which they raised funds. The start-up isn’t scaling fast enough, and they recently offered to buyback angels shares at an IRR of 15%. Not exciting at all. Learning – The founder should be 100% focused on the business you are investing in.

 

• Some of my other 2021 investments are into Metaverse, Fintech blockchain, SaaS solutions to optimise renewable energy plants worldwide, healthcare clinic aggregator, AI & computer vision-based cancer diagnostics. All extremely promising and highly competent founders that I am very proud and thankful to be associated with as an investor.

 

5. Major terms and conditions – Few terms that can impact an Angel’s return on investment.

 

• Dilution – A promoter can issue additional shares and proportionately reduce the value of an investor’s shares. Example – Let’s say a promotor raises funds at a valuation of Rs. 10 Cr and issues 100,000 shares. So, each share is valued at Rs.1000. At any point of time, the promotor can issue fresh 100,000 shares reducing the value of each share to Rs. 500. To protect from such dilution, angel should seek a term called anti-dilution which limits the promotor’s ability to do this.

 

• Right’s issue – Promoter can at any time come up with rights issue. A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. This type of issue gives existing shareholders securities called rights. With the rights, the shareholder can purchase new shares at a discount to the market price on a stated future date. The company is giving shareholders a chance to increase their exposure to the stock at a discount price. Example – Say the share price is Rs. 1000 and promotors comes up with rights for shareholders to buy new shares at say Rs.300 to raise additional funds. It is important that the SHA should allow angel investor to participate in such rights issue and prudent for the angels to participate in such rights and reduce the average share price.

 

• Issue of compulsory convertible debenture (CCD’s) – A compulsory convertible debenture (CCD) is a type of bond which must be converted into stock by a specified date. Convertible debentures may be converted into the company’s equity after a set period. That convertibility is a perceived advantage, so investors are willing to accept a lower interest rate for purchasing convertible debentures. Example – The CCD terms for conversion to preferential shares could be – CCD will convert to share at a valuation discount of 20% within 18 months if any investor invests minimum Rs. 5 Cr at a valuation of Rs.100 Crores. If this does not happen within 18 months then the CCD will convert to a preferential share at valuation of Rs. 25 Cr. Angels must get a right in the SHA to participate in such offers and must look out for such offers from the company as they can substantially benefit from such offers.

 

• Promotor’s salary – An angel must know and capture in the agreement what kind of salary can be drawn by the promoter/s.

 

• Liquidation and/or winding down – Startups by nature carry a risk of failure and angel should know or negotiate what happens in such an event. All startups will have funds in the bank, receivables, payables, debt & assets. Whatever funds are remaining who has the first right for the same.

 

• Runway left – It is important to keep a tab of what is the runway left before & after the fund raise. If the runway after the fund raise is less than 18 months, it is prudent to avoid the investment.

 

• Fund raise/Round status – Another point to check if the round is getting fully or partially subscribed. If it is partially subscribed, then do not invest.

 

• Add on Round information – In the fund raise round is add on to the main round, very important to get full details/status of the main round. If the main round is more than 2 months old and the funds have been transferred already and company has started using the same, do check the runway and the commitments made by founder in terms of scale up etc and only if convinced then make the commitments.

 

• Team size – Another point to explore is the team size of the company and it’s breakup. If you are convinced regarding the adequacy of the team for various function then only make the investment.

 

• Government regulation – Government can create regulations which impact businesses. It is important to understand possibility and impact of the same on the startup.

 

 

6. Do’s & Don’ts and some learnings –

 

• Please do not offer advice and guidance to founder unless he/she specifically asks. Your tiny investment does not make you the owner. Founders do not need your advice, nor do they want to befriend you. All they want is your cheque and then for you to disappear. Do cheer their efforts and forget you invested your hard-earned tax paid money, which if goes down will devastate you 😊.

 

• It pays off to have your own philosophy of angel investing. After investing in all kinds of start-ups have decided to only invest in B2B technology-based SaaS start-ups with global ambitions with current valuations of less than ₹50 Cr. This is a domain I understand the best having spent 30+ years in B2B technology space. Do not go by “tips”.

 

• Be very aware of FOMO, i.e., deciding to invest out of the fear of missing out. There will always be another opportunity & one which will be better than this. You should take your time to decide and do it only when you are convinced. Make phone calls to friends who may give you insights into founders, domain, tech or maybe even the start-ups. FOMO led me to invest in a few start-ups which I now regret. Do take time to read the due diligence reports.

 

• Writing cheques is in your control but entry and exit into start-up is not. This is not a mutual fund or FD with superlative returns, and you can’t buy/sell when you want. This is an experiment to solve a problem. The founders decide when you get to exit and at what valuations. Invest an amount which you can forget for say 5–7 years.

 

• I have been approached by a few founders with a decent exit option when their start-up was doing very well. My choice of rejecting the sell offer paid off as these start-ups posted significantly higher valuations right after a few months.

 

• If you know nothing about the domain and/or industry, please stay away as chances of making mistakes are the highest. Also – any opportunity which seems to be too good to be true is just that i.e., “not true”. Stay away!

 

• I do try and understand my rights as a tiny minority investor in the SHA in the event start-ups shutdowns or at the time of exit.

 

• I stay away from start-ups a) who are at the idea stage. I look for revenue generating ones which proves many aspects of a new business b) I also stay away from ones where the problem definition is not clear c) My gut feel is not positive.

 

• I have put a limit of 5% of my total investments (Mutual funds, PMS etc) into angel investments to ensure losses do not put a big hole into my wallet.

 

• Be also aware of how the platform is making money. Some take annual fee, some take % of profits. I like the model of annual fee.

 

• Do let your CA know about your Angel investment and understand the tax aspects. Government has laid down guidelines for Angel investor in terms of net worth etc. The angel investments are treated as unlisted equity and thus will be taxed accordingly. Offshore Angel Investments are complicated. Do talk to the platform and/or your CA and learn about the compliance requirements for sending fund abroad and when bringing back the funds with returns.

 

• Going forward, I have decided to be laser focussed in qualifying the opportunity as per my own vision and philosophy. My return expectations are now to set to 50-100x out of these investments.

 

To summarize, Angel Investment is not for the faint hearted and nor is it the same as stocks or mutual funds. However, besides the possibility of superlative returns, the thrill of picking a few start-ups amongst hundreds and watching them grow is unmatched. It also is a serious source of adrenaline and endorphins throughout the lifecycle which is the reason for angel investing.