Smart investing hacks every startup must know

Subramanya S V

Nirav Karkera

Smart investing hacks every startup must know

Thursday November 19, 2020,

10 min Read

Getting money in the bank after fundraising does taste like sweet victory for startups. But the battle is only half won. The need to optimally manage money is among the first action items that the founders need to address.

“Fundraising is an extreme sport,” said Marc Pitman in his book, “Ask Without Fear”. While he was referring to charity, the saying is equally true for fundraising by startups.

After a series of small excruciating journeys embedded into the larger fundraising process, getting that money in the bank does taste like sweet victory for startups. But the battle is only half won. The fundraising can be compared to procuring ammunition for a long-drawn battle – essential, but not the exact purpose of your startup.

The need to optimally manage money is among the first action items that the founders need to address. And the journey of money management begins with one fundamental question:

“Is there a smarter alternative to a Current Account?”Perhaps a bank fixed deposit? But interest rates have fallen so much. Or will a mutual fund be more efficient? But then what about the “subject to market risk”? But I’ve heard even large companies invest in mutual funds, right? Is all of these meant for larger companies only? Am I better off with the trusted current account and fixed deposit?

Founders often grapple with all these questions. They get advice from various quarters like their bankers and brokers.

Let’s talk about the first leg of money management for startups: Investing freshly raised funds.

Here are a few preliminary factors that you may need to consider before deciding on the right investment avenues.

  1. Visibility on burn: You would have worked on a cash flow projection for your fundraising pitch. It might require some adjustments to reflect the changes in the overall business plan if any. (e.g. change in capital raised, more aggressive competition, need for branding spends etc). The objective is to have a closer-to-reality view of expected cash flow. Your cash flow projection needs to answer, “How much money will I need every month for the next n number of months?” where “n” is the period you expect the raised money to last.
  2. Check on tax applicability: Most venture-funded startups are loss-making and hence there is no tax applicable. However, it helps to be sure about the applicable tax rate under the “Income from Business” head of the Income Tax rules.
  3. Check legal status: Take a note of your Shareholder Agreement to check for clauses around restrictions and preferences regarding the avenues for non-core or non-operating fund deployment.

Once there is clarity on the above pointers, we must move to define the objectives and guidelines of the treasury investment. Drawing upon our experience in managing treasury for several startups, here are the most common guidelines:

  1. Liquidity: Unpredictable is an understatement when it comes to describing a startup’s journey. While parking surplus funds, do not lose focus on liquidity, as it is of paramount importance to startups.
  2. Risk-minimisation: No investment is 100 percent risk-free and don’t let anyone tell you otherwise! Investing is about understanding the risks involved, being cognizant of the value at risk, being aware of possible mitigation techniques, and then making an informed decision. The idea is to minimise perceptible risk. No investor would ever want to see you use the money meant for your core business being utilised to generate capital gains.
  3. Return-optimisation: Return on Investment should be in line with the degree of risk involved in the investment. The risk-reward trade-off should make sense, always.

Now that we have clarity on the essentials to make a sound investment decision, let us dive into the details of the investment process.

Investment managers approach treasury investing in different ways, including looking at choice of instruments, strategy sophistication, and the degree of active management. However, we will focus on a rather simple yet highly effective strategy that startup founders who come from non-finance backgrounds can follow.

We call this the slice-and-match method.

The approach focuses on slicing the period for which you expect the raised amount to last into smaller periods (monthly or quarterly) and then match the most suitable products/instruments for each slice – keeping the guidelines and objectives constant throughout.

Here is an example of the slice-and-match method.

For immediate utilisation (0 to 1 month)

For the amount you require immediately (over the next month), there is no recommended alternative to your good old current account.

For those trying to squeeze every bit of optimisation, Overnight funds could be your best bet. Overnight Mutual Funds invest in overnight securities having a maturity of one day. This segment has negligible risk exposure, typically no exit load and will generate more than the 0 percent that you get on a current account.

The only thing you must be cognizant about is, the typical redemption processing period before the amount gets credited into your current account. Annualised yields in the range of ~2.75 percent-3 percent can be expected, based on current returns.

Contingency Reserve

Carve out anywhere between 15 percent-20 percent of the residual fundraise and invest it straight away into liquid funds, before moving to the next slice.

For very near-term utilisation (1 month to 6 months)

This is where we begin optimising returns on investment. For the money that you require over the next one-six months, liquid funds serve as a great avenue.

Liquid funds invest in fixed income and money market securities with a maturity of up to 91 days. Given the very short-term maturity and typically high credit quality of instruments the category invests in, risk exposure is very low. As on the date of writing this note, it would be safe to assert that no investment in a liquid fund has ever resulted in a negative return, if held for over a month. Annualised returns can be expected to be in the range of 3 percent-3.5 percent for some time now.

For near-term utilisation (6 months to 12 months)

For the amount required for utilisation in the next 6 to 12 months, an investment can be made into a combination of ultra-short duration funds and low duration funds.

Ultra-short and low duration funds invest in fixed-income securities maturing in approximately 3-6 months and 6-12 months, respectively. Duration risk (risk due to change in interest rate; also see note below) is a possibility at this juncture. But it can be mitigated if the amount invested is held for appropriate periods. An appropriate period would be to stay invested in the ultrashort funds with the amounts required in months 6 to 10 and in low duration funds for the amount required for month 11 and 12.

Expect returns for ultrashort and low duration funds to be in the range of 3.5 percent-4 percent for some time now. The fund is subject to minimal intermittent volatility due to duration risk.

What is duration risk?

Duration risk is also known as interest rate risk. Here is a rather simplified version — Fixed income or debt securities’ prices are inversely proportional to the interest rate movement. When key interest rates like that of benchmark government securities or RBI’s repo increase, the price of other fixed-income securities fall resulting in a temporary loss, known as “mark-to-market” loss and vice versa.

The duration risk increases as the maturity of the debt instrument increases. The risk can be mitigated if the investment is held till maturity or in case of mutual funds, closer to aggregate effective maturity of the fund.

For short-term utilisation (1 year- 2 years)

This bucket is the sweet spot for bank fixed deposits. Given the current interest rate scenario, banks are willing to offer the best they can for deposits willing to be committed for a period of 1 to 2 years. Typical rates offered by the large public sector or private scheduled commercial banks should be in the range of an annualised 4 percent-4.5 percent.

You can consider investing in FDs of smaller banks like small finance banks which give a higher interest rate, but they come with greater risk as they might not be able to weather a rough economic cycle.

If you are looking to optimise through relatively higher interest rates offered by small finance banks, try not going beyond the Rs 5 Lakh as deposits up to Rs 5lakh are insured by RBI under Deposit Insurance.

An alternative to bank fixed deposits for the same period could be continued investment into a combination of ultra-short, low-duration and the more flexible money market funds. Annualized blended-average return for the three categories could be in the range of 3.7 percent-4.2 percent. Also, mutual funds offer more liquidity, unlike bank fixed deposits which are typically non-withdrawable or withdrawable with foreclosure penalties of around 1 percent.

While we’ve been presuming no tax implications, there’s merit in understanding the tax laws on debt mutual funds and fixed deposits and considering post-tax returns before making an investment decision.

What is the taxation on debt mutual funds?

For investments held up to 3 years, the gains are taxed as Short-Term Capital Gains at a rate equivalent to the applicable income tax rate. For holding period over 3 years, the gains are taxed at 20 percent with indexation. However, unlike bank FDs, no TDS is deducted on debt mutual funds.

For medium to long-term utilisation (2 years and above)

Bank fixed deposits continue to be an optimal choice for this bucket as well. The next best alternative is to explore what debt mutual funds have to offer. Within debt mutual funds, it is imperative that we restrict to liquid, ultra-short, low duration and money market schemes; moving into any category beyond it could go against the guidelines we defined at the beginning.

For those willing to hold some amount beyond 3 years, Banking and PSU debt funds could be a good category given very less vulnerability to credit risk (the risk that the investor may not receive the principal and the interest), but some degree of duration risk. A blended average of the portfolio with around 25 percent allocated towards the Banking and PSU Debt Fund should yield an annualized return in the range of 4.2 percent to 5 percent for some time now.

Do not even worry about optimising this amount any more, as any attempt to over-optimise will push you down the alley where risk will outweigh the benefits.

Founders may be tempted to give into fancy cash management schemes, corporate fixed deposits, direct debentures, NCDs and a variety of products pitched by various agencies as high-return alternatives, but we strongly recommend against such investments.

A word of caution:

The number of mutual funds available and choice of fixed deposits could be overwhelming. While the above strategy is pretty much do-it-yourself, it is advisable to avail professional advice from a domain expert on the choice of fund and deposit to optimise further.

A few things to keep in mind when considering products other than what has been discussed so far.

  1. Instruments reward you for the degree of risk you are willing to take. If someone offers too good a return, be sure to understand the degree of risk involved.
  2. Unless you are in the business of investing, the funds you have raised is primarily meant to be deployed in financial assets for capital gains. There is no reason for you to chase a couple of extra basis points.
  3. Whenever in doubt, be conservative.

Case-in-point: Investment profile of TCS (Source: TCS Annual Report 2019-20):

Major allocation to Mutual Funds and Government Securities

Case-in-point: Category-wise classification for applicable financial assets of L&T (Source: L&T Annual Report 2019-20)

Key allocation to Mutual Funds