If you look at it from an overall basis, there are two types of persons in the economy. First are those who have set up and run a business on their own. We call them entrepreneurs. The second category is of people who work for a remuneration from either the Government, a public sector enterprise or a private company. We call them the salaried class.
The salaried class progresses as they go through their career and keep saving for their various requirements, including a rainy day. They are therefore net savers and investors into the financial markets.
Typically, as entrepreneurs grow their business, the funds that they have at their disposal start to limit their ambitions. They then, if they are convinced of the long-term prospects of their business, look out for external sources of funds. This category, therefore, usually borrows from the financial markets.
As you are aware, there are several means in which these firms can raise funds. It starts with friends and family who support for some time. Then it is the formal markets. If the business has enough assets and a concrete plan, it may be able to raise debt from the various institutions and banks that lend to companies.
However, very soon there comes a need to raise equity. Equity by nature is participative. While debt will provide fixed returns and no more, equity investments may go up or down without any limits. If business fails, you may lose all money and if it does well, sky is the limit to the returns that can be generated on your investment.
So equity investment should be looked at as if someone is allowing you to participate in their business by providing capital to them. You can have your own business, run it, control it and invest into it, or the next best thing is to invest into someone else’s business where you are comfortable with the person(s) and the business model. Simply put, finding the right business models and honest people who run it is the essence of all research that is done to invest into equities.
The ways you can participate in someone else’s business are many. The most basic form is if you know the person from before and want to do something together, you set up a partnership firm. The person brings his knowledge and hard work, you bring in the capital. This is an extension of friends and family, where money is given only on trust and faith. If you do not know the person from before and it is unlikely that you will be the only person investing, the earliest stage of a company where external investors are invited is called Angel Investing.
As a metaphor, it denotes the investor as an angel who comes in to help at the time of need. However, this is as commercial a transaction as any. The investors analyse the business thread bare, put in several clauses in the final contribution agreement to protect their interest and try their best to get a good bargain on the pricing/valuation of the business.
This is really early-stage investing where the corporate structure has not evolved. It is being run by two-three persons on an ad-hoc basis; the underlying business model or technology has not been fully proven. Therefore, the risks of the firm failing are the highest, but if it succeeds, the returns can be in hundreds of percentages (multibaggers).
Angel investing has over the last few years become much more organised. There are platforms that have been developed where both investors and fundraising companies are associated. When a company decides to raise capital, it approaches the platforms where all enrolled investors can then look at the opportunity together. There are also many angel funds that have been launched where if the investor can put in some capital but does not have the time and inclination to research investment opportunities on her/his own, they invest into these funds which are professionally managed and do the due diligence as well as invest into early-stage companies.
The point to note about angel investing is that it is a very high-risk/ very high-return option. It may not suit everyone, and even if it does, it would be prudent to invest only a small allocation into this category of investment, that too spread over several investee companies, either directly or through an appropriate fund, so that even if some do not do well and the others do perform, the overall return would be more stable and manageable.
(The author is the founder of Five Rivers Portfolio Managers)