17 Jun 2016

Funding the Small Folks

Peer-to-peer lending platforms let you lend to any of the people listed on their site. But I want diversification: I want to be able to lend to a hundred people at once. That way, when (not if) one of them defaults, it won’t hurt me. Whereas if I’d lent to just one person, and they default, I lose money. Diversification reduces risk, without reducing return. There’s little reason not to diversify.

Peer-to-peer lending sites should make diversification easier by grouping loans into different baskets based on interest rates and risk. I may choose a bucket consisting of loans that pay 20% or more, and then, with one click, lend money to a hundred people in that basket. There would be one transaction from my bank account to that of the peer-to-peer site, and then a hundred transactions from the platform’s site to the individual borrowers.

This is like investing in a mutual fund, rather than individual companies’ stocks, which you generally shouldn’t do.

Loans paying 20% or more are also a substitute for equity in your portfolio. If you want high risk and high returns, instead of or in addition to equity, you can invest in high-yield debt. The long-term return from equity in India has been around 18%, so debt that pays 20% can give you higher returns. While being easier to model and analyse, because you know the expected return ahead of time [1]. In addition, debt probably has a consistent return throughout the economic cycle, instead of swinging wildly from 40% to -50%, as equity does. So, high-yield debt can substitute equity.

Just as diversification helps loans, it helps early stage equity lending as well. Early stage can mean IPO, venture capital or seed capital.

For example, I would like there to be a “startup fund” that invests only in startups that are going or have just gone IPO. Just as we have large-, mid-, small- and micro-cap funds, we can have a startup fund.

This goes for venture capital as well. I should be able to invest money in a fund that invests in many VC firms.

This goes for seed capital as well. I would rather invest a thousand rupees each in a hundred startups than a lac in a single startup. This means intermediation — it’s worth it for neither for me nor the startup to discuss and negotiate an investment of one thousand rupees.

Perhaps small companies can rely on the public market for all this, if the government were enlightened enough to reduce the barriers to listing on the stock market. Companies that have less than say 10 crores in annual revenue should be exempted from most of the bureaucracy imposed on public companies. Listing a company shouldn’t require a minimum paid-up capital of 10 crores or three years track record, as it currently does. Any rule that excludes a startup should be eliminated. Forming a company and listing it should all be free, rather than costing 6 lac just to form a company.

With these changes in the stock market, companies can rely on equity crowdfunding. Nothing prevents them from having a meeting with venture capitalists or other investors who can then invest in the company via the stock market. If you invest, you know that nobody else is investing at a better price than you — the market is a level playing field, fair and transparent. If you’re a startup founder, you can get money from whoever in the entire country or world wants to invest, rather than being at the mercy of a few people you happen to meet. In the age of the Internet, does it make any sense that only people you meet in person can invest in your company? Openness also prevents a “the rich get richer” situation where the top VC firms and angels get the best deals because of their connections as opposed to making great decisions. If you’re a startup founder, you can get money from whoever lends it to you quickest or on the best terms. If a round is oversubscribed, you get the money you want from whichever investors offered you money on the best terms, like at the highest valuation or the least interest rate.

Mutual funds can also form that invest in early-stage companies. One can have a seed mutual fund that invests no more than a crore in a given company, for example.

Crowdfunding needn’t be limited to equity. Startups should be able to raise money via convertible notes, for example, again on the stock market.  The advantage with convertible notes is that you don’t have to agree on a valuation.

Or even plain bonds. The public markets shouldn’t exclude startups from using any options that are available to big companies. If a big company can issue new shares, or sell bonds, or raise money via convertible notes, startups should be allowed to do so as well. The capital market should be a level playing field, as opposed to tilted in favour of big companies.

[1] It’s easier to model a loan that pays up to 20% than a share that can pay anything at all.

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