Individuals Should Be Allowed to Invest In startups

Morgan Housel, in an excellent post on Collaborative Fund, writes that VC-funded startups have the same returns as the share market, just 5x faster, so you earn more, but only if you can stomach the bigger falls.

As of today, startups typically raise money from professional investors like VCs, who in turn raise money from institutional investors. Retail investors like you and me are excluded from investing in startups, thus missing out on these higher returns. And the satisfaction of funding the future, and of supporting our homegrown startups. After all, investing is not just about risk and return, but also about the satisfaction of making the impact one wants to make on the country or the world.

To fix this, retail investors should be allowed to invest in startups, by permitting equity mutual funds to invest in unlisted companies, which they’re technically allowed to, but the regulations are so onerous that funds typically don’t [1]. These should be relaxed. It’s fine for the regulator to require some diversification, like no more than 1% of a fund’s money should be invested in a single startup, and no more than 25% in a single sector. But again, use a light touch, rather than trying to micromanage companies, as the Indian government likes to do.

Equity MFs should also be allowed to invest in VCs, in addition to investing directly in startups. That way, we get two levels of diversification, one between companies and another between VCs.

Looking at it from the other side, startups should be allowed to list on the exchange, either shares or convertible notes, whichever they prefer. It should take no more than a few hours. Compliance barriers should be lower for companies with less than (say) a million dollars a month of revenue. Maybe there should be no more compliance required than making their tax returns available publicly, or a subset of the information in it. No new information should be required, and disclosure shouldn’t be needed every quarter, only once a year. Or if new information must be disclosed to investors, it should be easy to obtain, such as how many employees or customers the company has. It should take no more than an hour a year for the startup to comply with the burden of disclosure. An error of 10% should be accepted, unlike typical rules of accounting that don’t tolerate an error of even 1 paisa. If a startup is reporting a revenue of 80 lac, does it really matter if it was 87 lac or 75 lac? Investors are just looking for a ballpark here. This strikes a balance between transparency and overhead.

Of course, founders who deliberately lie to investors about revenue, or anything else, should be punished harshly, such as making both the company and them personally liable for 10x the money the investor invested. Likewise for founders who guarantee a certain return, or that investors don’t lose money.

In any case, conducting transactions on the market ensures transparency and a level playing field for everyone. When I invest in a startup, I want to ensure that the startup doesn’t give me worse terms than other investors investing at the same time. Prices should be disclosed transparently. Listing on the market also tends to standardise and simplify terms. From a startup’s point of view, listing opens up the pool of investors, making the market more efficient. An additional investor the startup may find because of the discoverability enabled by listing may very well be the difference between life and death for the startup. Or the startup may be able to raise money on better terms. And it may result in the investor earning a great return on his investment by investing in a startup he may not have otherwise heard of. On top of all these benefits, listing also provides an exit option to investors, as opposed to having to be locked in for years. This, in turns, draws in more investors like me who would never invest in an illiquid investment. Having publicly disclosed information will also reduce transaction cost, thus enabling more transactions.

In fact, retail investors can also be permitted to invest directly in startups, without going through an MF. You lose the benefit of diversification, and the due diligence a professional investor like an MF or VC would do, but it should be there for people who need it.

This opens up more possibilities for fraud, but the solution to that is effective prosecution of fraudsters, not stopping investment. Investors should see a clear warning like:

Don’t invest in this company. This is not an established company. It may disappear, taking your entire investment with it. Even if it does generate a return, it’s not known when. This is not a prudent investment. If you must invest in startups, it’s less risky to invest via a mutual fund.

[I’ll take a risk] [Cancel]

This strikes a good balance discouraging but not preventing investments. Yes, it will cause some fraud, but we don’t want to go too far down the road of a nanny state. If the state should protect us from doing things that are harmful to me, should we be allowed to buy cigarettes, alcohol or junk food? Should we be allowed to buy cars that go faster than 100km/h? And so on.

Going via a public market will also prevent a lot of fraud as compared to people transacting between themselves. For example, a friend of mine offered to invest in my startup. It would be safer for him to invest via the market, because I can’t give him worse terms than I do other investors. I can’t later deny that the money he transferred to my bank account was not an investment at all. In this case, going via the market protects him.

Going one step further, India should also make it easy for foreign startups to list and raise investment from Indian investors, investors in the startup’s home country, and any other country.

[1] In fact, we’re regressing, with an approved list of companies that mutual funds are restricted to investing in.