How to know which door to knock for investment

The folk story of Ali Babaand forty thieves is well known. “ Abdulla had marked a cross on the door to identify Ali Baba’s house to his captain of forty thieves. Fatima , Ali Baba’s servant saw this, and drew a white cross on the door of many other houses. That night the forty thieves rode into the town and began looking for a house with a white cross on the door. They were confused upon seeing that several doors had crosses on it. They had to leave the town without finding Ali Baba’s house. They were angry with themselves.”

This little anecdote is symbolic of the venture investment scenario today. Early-stage entrepreneurs looking for investment find that the number of investors has grown exponentially in the last few years. But they are confused on which door to knock, for one cannot keep on knocking doors endlessly as the night is slowly slipping away. The numbers indicate the imposing situation. There are at least 4,000 angel investors today. The probability of finding the right investor is, therefore, one out of four thousand. Insight into the investment morphology of different categories of investors can help exclude many from the consideration set, thus reducing the time taken for fund raising.

Investor categories

Broadly, venture investors can be classified as: Angel investors, who invest their personal capital in seed and early-stage start-ups; boutique venture firms, that make venture investments in early and growth stage start-ups; large financial institutions such as banks or NBFCs that have venture investment arms; and, large corporations that make investments out of their balance sheet in select promising ventures that could lead to some synergies with their existing businesses.

Investment patterns of the four investor categories reveal several insights. First, among the different start-up categories, angel investment is concentrated in software and internet services, internet marketplace and e-commerce, and consumer products and services. There are not many angels investing in other sectors such as fintech and payments or hyperlocal and logistics categories. Second, most of the angel investment deals happen within the first three years of incorporation of the start-up. Angel investors have limitations in making large ticket investments that the older start-ups require.

Third, the investment landscape is dominated by boutique venture firms. It is, therefore, critical for entrepreneurs to be aware of the investment style of seed and early stage-venture funds and be prepared accordingly. Fourth, while the corporates and institutions may invest more per deal, the low frequency of their investments makes it difficult to reliably run after them.

Valuation

An important component in the start-up investment is the process of arriving at a valuation. Apart from promise and hope, the only thing an entrepreneur can offer in return to the investor is shareholding in the venture.

Naturally, entrepreneurs would protect the shareholding fiercely and would prefer to dilute as less as possible. The investors, obviously, would aim for as large a pie as possible. Understanding the patterns in investor ask can potentially reduce the expectation match.

Angel investors, in general, seek a higher shareholding per million invested in start-ups. This is followed by boutique venture firms. The reasons behind the discount demanded by angel investors could be attributed to: their willingness to invest in very early-stage of the venture when the risk is highest; quicker process; fit with the start-up lifecycle; and, their ability to add value. While corporates and institutional investors seek a lower shareholding per million invested, the number of investments that they make are fewer.

Summary

Knock and the door shall be opened is a biblical saying. However, it is important for the entrepreneur to know which door to knock for investment and when. Analysis by investor categories indicate that angel investments are predominant in the software and internet services category as compared to any other sector. Further, angel investors tend to invest more frequently in start-ups that are within three years of their incorporation. In addition, the price that they pay for a pound of flesh might be lower than that of other investors because of the higher risk they take.

Bottom-line for entrepreneurs: understand the trade-off in investor choices, though it could nevertheless be a Hobson’s choice.

The writer is a Professor at IIT Madras, an Associate at Harvard Kennedy School, Harvard University and co-founder of YNOS.in