Why do Investors Invest in Startups
Aug 4, 2023
When it comes to investing, it is not ideal to put all your eggs in one basket together. To avoid losing big in their investments, investors take steps such as portfolio diversification.
Portfolio diversification means spreading your investments into different asset categories. Thus, it will significantly reduce financial risks. This is where startups come in. Startup investment is substantially different from traditional assets, bonds, and stocks. Unlike stocks and bonds, startups have the potential to provide exceptional returns.
India's startup economy has been flourishing since 2016, witnessing a rapid and positive expansion of businesses throughout the country. There were about 652 startups launched in the south Asian country of India in 2022. Furthermore, an overall total of 58,000 startups have been launched so far in the country.
To add more fact, as per a recent Mar '23 IVCA report, Start-up’s have attracted the highest investment both in terms of value and volume.
In January 2023, super angels and angel networks made 30 investments. The largest funding deal involving angel investors was the $12.5 million investment in content creators’ platform Rigi, which saw participation of Kunal Shah, MS Dhoni, Amit Kumar Agarwal, Chakradhar Gade and others.
As per the above chart, Financial services has attracted the highest number of deals, few notable transactions are PhonePe raising $445 mn, NoBroker raising $218 mn, KreditBee raising $200 mn, and Insurance Dekho raising $150 mn. There was also increasing interest in agtech and gaming startups during this period. On the other hand, the excitement around edtech startups decreased in Q1'23 compared to previous times.
Overall, investors believe to outsize their return while investing in start-up’s. Let’s consider the hypothetical example where an investor has 10 companies in portfolio. Among them, 2 companies turned out to be superstars, making more than 50 times the money you initially invested. 3 companies did really well too, giving returns of at least 20 times the investment. 5 companies did okay, providing returns of about 10 times the investment. Unfortunately, 15 companies failed completely, resulting in zero returns. The rest of the companies either gave very little returns or just barely made any profit.
On average, your portfolio grew by about 21% over 7 years, which is decent. However, this average could be much higher if some companies grow really fast. When companies experience rapid growth, like increasing their value by more than 50% each year for several years, it can lead to incredibly high profits. Companies that show this kind of exceptional growth are the ones that can have a massive impact on your overall investment success. These high-growth companies are called Category A companies in this example.
Portfolio Returns
Category | Category Return | Return Assumption | Invested Capital | Total Return | Time Frame(Yrs) |
|---|---|---|---|---|---|
A | >50X | 70X | 2 | 140 | 7 |
B | 10X-50X | 30X | 3 | 90 | |
C | 5X-10X | 7X | 5 | 35 | |
D | 1X-5X | 3X | 30 | 90 | |
E | <1X | 0.7X | 45 | 31.5 | |
F | 0X | 0X | 15 | 0 | |
100 | 386.5 | 21.30% |
Investors, especially angel investors, invest in startups because they see the potential for extraordinary growth. Startups are young, innovative companies with exciting ideas and business models. They might have unique products or services that solve a problem in a new way. When investors find startups that have the potential for rapid growth, they get really excited because these companies could become the superstars of their investment portfolio.
The power of compounding also comes into play with startups. When a startup experiences rapid growth, its value increases at an accelerating rate. This can lead to a snowball effect, where the company's increasing value attracts more investment and resources, allowing it to grow even faster. Investors who get in early and support these high-growth startups can benefit immensely from this compounding effect.
Investing in startups carries risks. Not all startups will succeed, and some may fail completely, resulting in losses for investors. However, the potential for finding those few superstars that deliver massive returns is what drives investors to take the risk. These high-growth companies, like the Category A companies in the example, can redefine the success of an investor's portfolio and make their investment journey incredibly rewarding.
Let’s explore the key reasons of Investing in startups:-
One of the primary attractions of startups for investors is the potential for remarkable returns on investment. Startups operate in an environment conducive to rapid growth, often armed with disruptive technologies, unique business models, or untapped markets.
Potential for exponential growth: One of the main reasons why investors are attracted to investing in startups is their potential for high growth. By investing in startups, investors can help fund the growth of the company, and in turn they can potentially see a significant return on their investment.
Innovation and Disruption: Startups are often founded by entrepreneurs who have innovative ideas that challenge the status quo. Investors are drawn to startups because they offer an opportunity to invest in disruptive technologies and new business models that could change the game in their respective industries.
Diversification and Portfolio enhancement: Investing in startups provides an opportunity for portfolio diversification. Investors understand the importance of diversification in their portfolios. By investing in startups, investors can diversify their portfolio and reduce their overall risk. Also they can potentially offset losses in other sectors and maximize overall returns.This diversification strategy allows investors to hedge their bets while exploring new frontiers of potential growth.
Early stage Valuations: one of the key attractions of startups lies in their early-stage valuations. Compared to established companies, startups are typically undervalued in their infancy stage, giving investors an opportunity to enter at a lower cost. This early-stage investment can result in significant gains if the startup achieves success and experiences substantial growth over time.
- In the first half of 2023, the financial services sector had the highest-ever value of exits at US$2.7 billion across 31 deals. Healthcare also saw impressive growth with 11 exits worth US$1.5 billion, more than double compared to the previous year, driven by the US$1 billion exit from Manipal Hospitals by TPG and NIIF, the largest exit in that period.
- While secondary exits continued to constitute approximately 60% of the total exit value. However, the year also witnessed a notable surge in startup initial public offerings (IPOs). Companies like Zomato, Nykaa, and Freshworks enjoyed remarkable public market debuts, showcasing the potential for exceptional returns. Overall, 2021 marked a defining change in the VC exit space, leaving an indelible impact on the investment landscape.
Conclusion
Investors choose to invest in startups for various reasons.While the journey is filled with risks, the potential rewards are undeniable. By investing in startups, investors become an integral part of shaping the future, while simultaneously positioning themselves for substantial financial gains.