Angel investing, ESOPs and art of creating investment portfolio of startups

India's startups ecosystem is mushrooming thick and fast with digitization and tech adoption. As per a report by Nasscom and Zinnov, India added more than 2,250 startups in 2021, over 600 more than what was added in the previous year. The startups raised $24.1 billion in 2021, a two-fold increase over pre-COVID levels, highlighted the same report. 

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With the startups showing significant growth in the past couple of years, the most important thing that a startup needs before it can make big is funding. Amit Pamnani, Chief Investment Officer & DGM, Swastika Investmart Ltd, speaks about startups, explores the four stages of funding, talks about angel investing, the importance of creating a portfolio of startups and how startups are strategically using Employee Stock Options (ESOPs) in their initial stage to retain employees and mitigate funding challenges at the same time. 

What is a startup and how does one get started?  

The startup essentially means a business that is disrupting industry standards or solving the burning problem with innovation, technology, and scalability. One or more founders commence the startup to become self-employed, solve the challenges or gaps in the industry and achieve their dreams of becoming big. The word startup was coined way back in 1976 by Forbes magazine of the USA about ‘budding company’. It became popular post-2000 with the technology adoption by businesses & consumers. 

What is the biggest challenge before a startup? 

Any startup needs capital to grow rapidly and scale at the national and international level, for which funds are required to be raised from Investors. There are broadly 4 stages of funding - 

● Seed Stage – Investment is raised from self-savings, friends, family at the idea stage. 

● Angel funding – Participation from high-net-worth individuals, professionals, angel networks are done post-development of MVP (minimum viable product) or revenue stage. 

● Venture capital – Venture capital funds are invested at the growth stage. They are SEBI registered alternate investment funds (AIF) or large corporates, Foreign VCs 

● Private equity - PE investors invest at a later stage when the company’s scale becomes large and is expanding very fast. 

Is there a funding bracket that falls under angel investing?  

Angel investing is an art wherein individual investors having experience in that sector show interest in investing and contribute strategically to help a startup grow to the next level. Investment amount in angel round may vary from Rs 25 lakh to Rs 7.5 crore and even more in the highly lucrative and scalable idea. Those who invested during 2012 to 2015 started reaping multi-times returns from 2018 to 2020.   

Angel investors and their success stories 

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

In year 2021, investment in around 400 Indian startups took place at seed and angel stage with aggregate amount of Rs 5300 crore. 

How to find an investment opportunity for angel investing? 

One can directly invest or with registered angel networks like IAN, Mumbai Angels, Lets Venture, Venture Catalysts, Agility Ventures, 100x.vc to safe guard risk. Angel networks manage the portfolio companies professionally, mentor them and plan the exit in less than 3 to 5 years tenure. 

Startup investment as a new asset class 

Investors are taking startup investment as a new asset class along with stock market, Mutual funds, FDs, Real estate, etc. The profile of angel investors includes Industrialists, CXOs, high paid employees. I also made a few investments last year, out of which one investment has grown 2.5x till now. Post digitalisation and de-monetisation, the startups’ traction and valuation got increased and hence investors’ wealth got sudden spur which generated fascination amongst angel investors to invest more in startups. 

Good enough money is chasing Indian startups hence valuations are rising for high potential startups with go-getter teams, with a feeling of FOMO (fear of missing out) in Investors. Further, restrictions by China on FDI, FII and foreign VCs, India is the exceptional investment destination for Investors around the globe. 

Seasoned angel investors advise to create an investment portfolio of 10 or more startups in 2-3 years duration to balance the return on Investment (ROI) and hedge the failure risk. Typically, as per the portfolio studies, 5 out of 10 startups may not go bad, 3 may give average returns and 2 may generate over 10x returns. Hence, in 5 years an investor may expect over 30% IRR on investments. 

Employee retention a big challenge among startups 

Most of the startups fail due to product market mis-fit, failure in raising next round, unable to retain or get new talent, etc. To solve the challenge of employee retention, startups are issuing ESOPs (Employee Stock Options). ESOPs are shares of company with a vesting period & lock-in of 1 to 3 years. Post this period, ESOPs can be tradable and employees can sell some of the shares to a third party or company can buyout at current market price. 

These shares are issued at a discount to high performing employees to bring a sense of ownership and motivate them to stay for long in the company. We at Swastika had created ESOPs scheme for few startups wherein we kept 10% of the paid-up capital as ESOP pool which companies are utilising to reward to best performing employees. When these companies go for raising the next round of funding at higher valuation or may go for IPO, employees can sell their shares and generate a handsome wealth. In the case of Zomato, more than 18 top executives became millionaires post it’s IPO as they had shares which were received in the form of ESOPs. 

Angel funding a high risk, high reward proposition 

Angel investment in startup space is exciting with high risk & high returns ratio. However, investments made with thorough research, due diligence, assessing team capabilities, market potential, product need, etc. can increase the chances of success. There is tremendous scope for startups to perform & grow in India as many sectors are unorganized and many business models are yet to be digitalised as consumer behaviour patterns are also changing. 

(Disclaimer: The views/suggestions/advice expressed here in this article are solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision )