Understanding the risks and rewards of startup equity investing

Equity investments in startups can be rewarding. However, such opportunities have long been reserved for venture capitalists or angel investors with deep pockets. That’s not the case any longer. Several crowdfunding sites and digital platforms have made it possible for retail investors to invest in startups.

But startup equity investing involves taking high risks, experts say. “Startups are highest in the risk-reward ratio,” said Ram Kalyan Medury, founder and CEO of Jama Wealth, a Sebi registered investment adviser. Mint tells you how this alternative investment works and the risks associated with it.

How does it work

Digital platforms such as Tyke and Grip list startups that are looking to raise funds. While Tyke lets retail investors start with as little as ₹5,000, Grip requires a minimum investment of ₹2 lakh and opens opportunities only to accredited investors (AI).

According to the Securities and Exchange Board of India (Sebi) guidelines, investors qualify to be an AI if they meet any one of these three criteria: annual income of over ₹2 crore; or net worth of over ₹7.5 crore, out of which at least ₹3.5 crore is in financial assets; or annual income over ₹1 lakh and net worth of ₹5 crore or more with at least ₹2.5 crore in financial assets.

On Grip, retail investors have to invest through a Sebi-registered alternative investment fund (AIF), Anicut Grand Capital. “The additional requirement is that the investor has to commit ₹25 lakh over the next five years from the date of the first investment made in the startup,” said Vivek Gulati, co-founder of Grip. This amount is committed to the various schemes launched by the AIF. Failing to make this contribution can lead to the units held by the investor getting forfeited or suspension of the right of the investors to receive distributions with respect to the units held.

Tyke allows everyone to invest through their platform. “The investment collected from investors goes through an escrow account authorized by a Sebi-registered debenture trustee, and once the deal is complete, the money gets transferred to the startup,” said Karan Mehra, founder of Tyke.

For smaller amounts of up to ₹50,000, investors get CSOPs, or Community Stock Option Pool, in return for their investment in Tyke. “CSOPs are phantom stocks or financial contracts which have the same financial rights as equity shares, but they don’t influence the cap table and don’t come with voting rights,” Mehra explained.

For higher investment ticket size, in most cases, investors are allotted compulsory convertible debentures (CCDs), which are bonds that are converted into equity on maturity (IPO or acquisition).

In the case of Grip, since the AIF is the transaction vehicle, shares equivalent to the total amount invested by all retail investors are allocated to the AIF, which then allocates partial units to each retail investor.

Risk and reward

Jyoti Prakash Gadia, managing director of Resurgent India, said the success rate of startups is only 10% to 20%.

“About 80-90% of Indian startups fail within the first five years of inception.” A startup going bust would mean that you lose all your money.

To ensure that investors understand this risk, Mehra said they declare upfront to investors that they should only invest an amount they can afford to lose completely without the loss impacting their lifestyle.

Further, investors can mitigate the risk by diversifying the total amount they intend to invest across several startups. Startup equity investing also scores low on liquidity as the shares are private.

Exit options available to retail investors are the same as angel investors, in the form of mergers and acquisitions, initial public offerings and secondary sales.

However, investors going through the AIF route should know that the exit decision in the form of selling the units to other investors lies solely with the investment manager in the AIF.

Currently, no platform facilitates the sale of shares in secondary markets in startup equity investing.

As for taxation, CSOPs are treated similarly as ESOPs or employee stock ownership plan.

“For taxpayers’ understanding, the difference between the fair market value (FMV) and exercise price may be taken as a benefit arising from business or a profession and taxed as business income at the time of allotment of shares. Further, gains arising on subsequent sale of shares should be taxable as capital gains – long term or short term, depending upon the period of holding of such shares,” said Sachin Garg, Partner, Nangia Andersen LLP.

“In the absence of any specified regulation regarding the head of income under which it should be taxed, it is suggested to report it under the head “other sources”,” said Maneet Pal Singh, Partner, I.P. Pasricha & Co.