Investment Law

PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

Dr. Shakuntala Misra National Rehabilitation University, Lucknow

ASSIGNMENT ON LAW OF INVESTMENTS AND SECURITIES

“ANGEL AND PORTFOLIO INVESTMENT”

(UNDER THE SUPERVISION OF ASST. PROF. SHAIL SHAKYA)

SUBMITTED TO:

SUBMITTED BY:

Asst. Prof. Shail Shakya

Shivali Misra

Faculty of Law, DSMNRU

B.Com.LL.B(Hons.)

Mohan Road,

8th Semester

Lucknow.

Roll.No-

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

TABLE OF CONTENTS

1. INTRODUCTION………………………………………………………………….. 5 2. OBJECTIVES OF ANGLE AND PORTFOLIO INVESTMENT……….………… 6 3. CONSTRUCTION OF ANGEL PROFILE…………….……………………….….. 7 4. CONSTRUCTION OF PORTFOLIO FOR PORTFOLIO INVESTMENT………... 8 5. PROCESS INVOLVED IN ANGEL AND PORTFOLIO INVESTMENT…….…... 9 6. RISKS INVOLVED IN ANGEL AND PORTFOLIO INVESTMENT…………… 12 7. ANALYSIS OF ANGEL ND PORTFOLIO INVESTMENT…………………….. 14 8. CONCLUSION…………………………………………………………………… 16

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

ANNOTATED BIBLIOGRAPHY

1. Dr.Tom MacKaskill, An Introduction to Angel Investing 09(1st ed. 2009) This book is for Angels and potential Angels to help them be more successful at investing in early stage entrepreneurial ventures. Angels are the unsung heroes of emerging company successes. Entrepreneurs may also find advice and comfort in these pages. While the book is written primarily for the Angel investor, the content will shed light on how Angels work and what they look for in an investment. 2. G. Sabarinathan, Angel Networks in an Emerging Economy – The Case of Indian Angel Network

This paper studies the working of one angel network in an emerging economy, Indian Angel Network (IAN). It critically nalyses the functioning of IAN against the findings of relevant literature. The study finds that the IAN organization and processes are consistent with the characteristics of networks reported in literature. At the same time its organizational and governance throw up a few issues that would be of interest for further study.

3. Chapter 1, Introduction to Investments and Portfolio Investment, Shodhganga For most of the investors throughout their life, they will be earning and spending money. Rarely, investor’s current money income exactly balances with their consumption desires. Sometimes, investors may have more money than they want to spend; at other times, they may want to purchase more than they can afford. These imbalances will lead investors either to borrow or to save to maximize the long-run benefits from their income.

4. The Four Portfolio Risks, The Market Oracle

The basic four types of risks are covered in the content. The four types of associated risk are: Purchasing power Risk, Timing Risk, Interest rate risk, Shortfall Risk

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

LITERATURE REVIEW

On the one hand, angel networks help address imperfections associated with angel investing such as high search and information costs by realizing economies of scope and scale. They also provide other advantages such as diversification of portfolio. On the other hand they help preserve the advantages of angel investing which are not available to investors in venture capital funds. Portfolio investment has become a complex and responsible job which requires an in-depth training and expertise. The activities of buying and selling of securities in the primary as well as secondary market are carried out through the mechanism of stock exchanges. There has been a substantial growth of capital market in India during the last 25 years. There are 23 stock exchanges in India and more than 9500 listed companies. There were 56,588 capital issues and the market value of capital was Rs.12,01,207 crores till 2004-05. Portfolio management is still in its infancy in India. Professional portfolio investment started in India after the setting up of public sector mutual funds in 1987. After the success of mutual funds in portfolio management, a number of brokers and investment consultants have become portfolio managers.

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

INTRODUCTION

Angels are active investors working alongside the entrepreneur and the management team to make the venture successful. Angel Investing is the act of making investments in the venture asset class. Companies that issue securities within the venture asset class are typically early stage startup companies with the potential to experience, or are currently experiencing rapid growth. Angel investments are inherently non liquid, long-term investments. Because of the high risks associated with angel investing in the non liquid securities issued by a fledgling company, investors demand a much higher return on an angel investment than they would on investments in publicly traded companies. Passive Angels focus themselves on venture screening, due diligence processes and investment agreements and then work with professional advisors to ensure they undertake investments with appropriate terms and conditions which suit their background and involvement. Most Angels enjoy helping emerging firms and gain personal satisfaction from an active involvement in an emerging venture, but they also like to see an adequate return for their investment. On the other hand, “Portfolio means combined holding of many kinds of financial securities i.e. shares, debentures, government bonds, units and other financial assets.” The term investment portfolio refers to the various assets of an investor which are to be considered as a unit. It is not merely a collection of unrelated assets but a carefully blended asset combination within a unified framework. It is necessary for investors to take all decisions as regards their wealth position in a context of portfolio. Thus, portfolio investment is a combination of various instruments of investment. It is also a combination of securities with different risk-return characteristics. The analysis of risk-return characteristics of individual securities in the portfolio is made from time to time and changes that may take place in combination with other securities are adjusted accordingly. The object of portfolio is to reduce risk by diversification and maximize gains.

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

OBJECTIVES OF ANGEL INVESTMENT AND PORTFOLIO INVESTMENT

The most common objective that Angel investment is associated with is helping on startups take their first steps, rather than the possible profit they may get from the business. Accredited angel investment meet requirements set forth by the Securities and Exchange Commission (SEC). Angel investors are also typically interested in spurring business success and economic growth in their communities. Angels have a reputation for developing early stage businesses, putting in much needed discipline and more formal management structures, assisting them to become larger entities and educating them on how to work with external investors. Angels who have good relationships with VC firms can provide a logical path for their investee firms for larger injections of funds, with the necessary groundwork for such investments already achieved. Those who move forward then work together to conduct due diligence to validate the proposed plan, review financial statements and gain an understanding of the history of the entrepreneurial team.1 The objectives of Portfolio Investment are classified as follows: 1) SECURITY/SAFETY OF PRINCIPAL: Security not only involves keeping the principal sum intact but also keeping intact its purchasing power intact. Safety means protection for investment against loss under reasonably variations. In order to provide safety, a careful review of economic and industry trends is necessary. In other words, errors in portfolio are unavoidable and it requires extensive diversification. Even investor wants that his basic amount of investment should remain safe. 2) STABILITY OF INCOME: So as to facilitate planning more accurately and systematically the reinvestment consumption of income is important. 3) CAPITAL GROWTH: This can be attained by reinvesting in growth securities or through purchase of growth securities. Capital appreciation has become an important investment principle. Investors seek growth stocks which provides a very large capital appreciation by way of rights, bonus and appreciation in the market price of a share.

1

Understanding the role of angel investors, available at https://investmentbank.com/understanding-the-role-ofangel-investors/ (Last seen 13/04/2018)

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

4) MARKETABILITY: It is the case with which a security can be bought or sold. This is essential for providing flexibility to investment portfolio. 5) LIQUIDITY I.E. NEARNESS TO MONEY: It is desirable to investor so as to take advantage of attractive opportunities upcoming in the market. 6) DIVERSIFICATION: The basic objective of building a portfolio is to reduce risk of loss of capital and / or income by investing in various types of securities and over a wide range of industries. 7) FAVORABLE TAX STATUS (TAX INCENTIVES: The effective yield an investor gets form his investment depends on tax to which it is subject. By minimizing the tax burden, yield can be effectively improved. Investors try to minimise their tax liabilities from the investments. The portfolio manager has to keep a list of such investment avenues along with the return risk, profile, tax implications, yields and other returns. Investment programmers without considering tax implications may be costly to the investor.

CONSTRUCTION OF ANGEL PROFILE

The term angel is used for individual investors that range from successful, cashed-out entrepreneurs on the hand to individuals with little or no experience with venture investing on the other. Angels appear to be extremely diverse.2 Business angels are wealthy individuals who invest their own money in start-up firms in which they have no family connection. Most often angels are middle aged and well educated man, they acquired their wealth from being an ex-entrepreneur. The average investment size seems to differ per research paper, but the median investment is between 100.000 and 150.000 dollar. Although this amount is smaller than the investments of venture capitalist, angels tend to invest in approximately 20 times the number ventures. The angel market is said to match or even exceed the venture capital market.3

Scott Fruchter, Angel Investing Handbook – VC Broken Down for Investors, Seed invest available at https://www.seedinvest.com/blog/angel-investing Last seen 13/04/2018 3 Mylene van Dartel, A case study on the possible protection measures of angel investors available at http://arno.uvt.nl/show.cgi?fid=106667 last seen 13/04/2018 2

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Angels invest primarily for financial reasons, non-financial motives emerge as a very strong secondary reason to invest in a start-up company. Business angels are not just investing money; they spend money, time and knowledge. They like to invest in industries in which they have some experience and only invest in one or two firms a year. Angels are patient investors, the investment time is usually between 5 to 7 year, although the exit strategy is often included in the initial investment agreement.4 Angel groups cooperate to “consider investments opportunities, share opinions and expertise about investments, pool their capital, and negotiate investments.” Even though most angels groups leave individual investment decision to the angel, the rise of angel groups makes coinvesting easier. The main difference between angel group and individual angels is that they are not so difficult to find.

CONSTRUCTION OF PORTFOLIO FOR PORTFOLIO INVESTMENT

Portfolio construction means determining the actual composition of portfolio. It refers to the allocation of funds among a variety of financial assets open for investment.Portfolio theory concerns itself with the principles governing such allocation. Therefore, the objective of the theory is to elaborate the principles in which the risk can be minimized subject to a desired level of return on the portfolio or maximize the return subject to the constraints of a certain level of risk. The portfolio manager has to set out all the alternative investments along with their projected return and risk, and choose investments which satisfy the requirements of the investor and cater to his preferences.5 It is a critical stage because asset mix is the single most determinant of portfolio performance. Portfolio construction requires a knowledge of the different aspects of securities. The components of portfolio construction are (a) Asset allocation (b) Securityselection and (c) Portfolio structure. Asset allocation means setting the asset mix. Security selection involves choosing the appropriate security to meet the portfolio targets and portfolio structure involves setting the amount of each security to be included in the portfolio.

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Ibid. Introduction of investments and portfolio management, available at http://shodhganga.inflibnet.ac.in/bitstream/10603/9430/9/09_chapter1.pdf Last seen 13/04/2018 5

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

Investing in securities presupposes risk. A common way of reducing risk is to follow the principle of diversification. Diversification is investing in a number of different securities rather than concentrating in one or two securities. The diversification assures the benefit of obtaining the anticipated return on the portfolio of securities. In a diversified portfolio, some securities may not perform as expected but other securities may exceed expectations with the effect that the actual results of the portfolio will be reasonably close to the anticipated results.

PROCESS INVOLVED IN ANGEL AND PORTFOLIO INVESTMENT

Angel funding decision process consist of five stages, however not all of them are assigned to the actual decision making process: ‘familiarization’’, ‘screening’, ‘bargaining’. ‘managing’ and ‘harvesting’ and ‘application’, ‘pre-screening’, ‘screening’, ‘due diligence’ and funding’ the early stage of the investment process entails only the ‘familiarization’ stage. Through this stage one can gain a quick overview whether the opportunity is worth further investigations or should be dismissed immediately. In this phase, it is common for the angels to read a summarized business plan or look at a pitch deck.6 Once the investment opportunity has been found, the first step the angels take is to consider if that fits with their own investment criteria. This holds for both the investments found through the formal and informal network. If the opportunity fits the investors and the investment is found through the informal network of business associates and friend, angels place less weight on financial expectations and place greater emphasis to subjective factors and “gut feeling”. Consequently the angel his personal gut assessment of the entrepreneur is the most important factor while evaluation.7 After the entrepreneur has been approved, the business plan and the management are the essential criteria. Lack of confidence in the management team is a common reason for angels to reject an investment deal. Just like with entrepreneur, it is important that the management team comes across as trustworthy, passionate and committed and the management board possess a good track record.

G.Sabrinathan, Understanding Angel Investing in India – An Exploratory Study based on Publicly Available Data, Working Paper 453, Indian Institute of Management, Bangalore 7 Supra 3 6

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PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

For deals that are found through a formal network, the angel does not know the entrepreneur personally, his first focus will be on objective selection criteria. The angel cannot rely on his “gut feeling” and therefore the business plan and the management team track record are more important than the entrepreneur. Then the growth potential and exit routes are even more focused by the angels because of the problem of moral hazard and adverse selection. The proper pre-investment screening of the investment and performing due diligence can decrease asymmetry of information and as a consequence can lower the agency problem ex-ante.

Portfolio Investments can span a wide range of asset classes such as stocks, government bonds, corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds (ETFs), mutual funds and certificates of deposit. Portfolio investments can also include options, derivatives such as warrants and futures, and physical investments such as commodities, real estate, land and timber. The investor undergoes following set of stages for investing in portfolio: 1. DECISION TO INVEST IN PORTFOLIO OF SECURITIES: Investors choose to invest in a portfolio of securities rather than investing in a single security due to the reason that prudent investors are averse to putting all the eggs in one basket. So, investors attempt to spread the risk by investing in different securities consisting of shares of different risk-return relationships and bonds of different nature and characteristics.

2. PORTFOLIO ANALYSIS: A large number of portfolios can be formed by combining the securities that are considered worthwhile to invest. While security analysis identifies the securities that are worthwhile to invest, portfolio analysis consists of identifying all possible portfolios that can be formed by combining some or all of the worthwhile securities and studying their risk-return characteristics. 3. PORTFOLIO CONSTRUCTION: While an investor can identify, with the help of security analysis, a set of worthwhile securities that suit his/her risk bearing capacity, deciding on the securities that can be included in the portfolio and the proportion of investment in each of the securities contained in the portfolio is not an easy task. This 10

PROJECT ON ANGEL AND PORTFOLIO INVESTMENT

exercise should be done in such a way that the portfolio so constructed is an optimal portfolio for the investor. An optimal portfolio is one that offers the highest return at a given level of risk. The optimal portfolio for different investors will be different since it depends on the risk bearing capacity of the investor. Construction of an optimal portfolio can be done only through scientific analysis of the characteristic of the securities. 4. PORTFOLIO EVALUATION: A portfolio of securities once constructed can not be left alone. The performance of the portfolio is to be assessed over a selected period of time in terms of the risk and return. A quantitative assessment of the actual return realized and the risk borne by the portfolio over a period of time shall be assessed and compared with the objective based on which the portfolio was constructed. The actual performance of the portfolio, relative to its objective is studied. This will throw light on the defective/deficient areas, if any, that need to be attended in order to improve upon the portfolio performance.8 5. PORTFOLIO REVISION: Portfolio evaluation will throw light on the things to be done to improve upon the performance of the portfolio. The required revision of the portfolio is to be done in order to ensure that the portfolio continues to remain as the optimal portfolio for the investor. Revision of portfolio is necessitated due to the following reasons: 

Security market being dynamic, many new securities enter the market continuously.



The risk-return characteristic of some of the securities that were originally included in the portfolio might have got altered.

6. REVISED OPTIMAL PORTFOLIO: After the process of revision of portfolio, defects are removes and the optimal portfolio is prepared for the investors to invest.

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Investments, available at https://www.newagepublishers.com/samplechapter/001960.pdf Last seen 13/04/2018

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RISKS INVOLVED IN ANGEL AND PORTFOLIO INVESTMENT

The following are the risks associated with the Angel Investment: 1. FAILURE OF MANY BUSINESS VENTURES: Angel investors keep looking for ventures that become the next big thing. If an angel investor backs a venture which can fast become a profitable company, the investor can become very wealthy due to the large returns. However, the reality is that many of these ventures fail within the first five years of their coming into being because even though they get the seed money from the investors, they are unable to get a second round of financing.

2. STAKES IN THESE BUSINESSES ARE TOUGH TO SELL: Another great investment risk is that even though an investor may have stock in a company, it cannot be publicly traded to minimize losses. They cannot sell their stakes in any public market and therefore have to bear the losses alone. This is one of the reasons that investors usually prefer making investments in business of which they have some experience.9 3. BEING AN ANGEL INVESTOR: Though there are a lot of advantages of being an angel investor, the investment risk and the expensive nature of investment can often deter the investors from investing. The expensive nature of being an angel investor, only attracts those individuals who have high personal net worth. Smaller angels tend to join accredited groups or networks where they can invest in a shared sum. 4. INVESTMENTS MAY TAKE A LOT OF TIME TO SHOW PROFITS: The angels have to regularly go through the annual reports and may make personal checks to ensure that the business is on the right track. It can also be some time before the business starts making profits. This means that an investor may have to wait for about 5-7 years before the investment realizes any profits. This is another investment risk that can deter many people from investing in such ventures. 5.

IT IS EASY TO GET CARRIED AWAY: Some investors, who are extremely excited about the prospect of earning a lot of money, may get carried away and ignore

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Dr.Tom MacKaskill, An Introduction to Angel Investing 09(1st ed. 2009)

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the pitfalls of a business plan which has been presented in a manner that makes it appear extremely profitable. While it is the mandate of an entrepreneur to sell their idea to an investor, it is equally important for an investor to understand and consider the proposal very carefully before putting in their own hard earned money. To reduce investment risk, the investor should ideally analyze the business plan very carefully. Ideally, the investor should also seek professional help to get inputs on the potential of the business plan.10

The risks associated with the Portfolio Investment are as follows: 1. MARKET RISK: Market risk is the possibility that a portfolio will be affected by the overall activity of the market as a whole. For example, the financial crisis of 20082009 resulted in the market values (stock prices) of even profitable businesses decreasing significantly. 2. BUSINESS RISK: Business risk is when a particular business' management may be incompetent or product and/or service becomes obsolete. As a result, they go out of business. 3. SOVEREIGN RISK: Sovereign risk is associated with changes in the environment that businesses operate in. These can be changes in regulations, or laws or in extreme example a complete change (many times violent) in the government 4. LIQUIDITY RISK: It is the ability of an investor to convert their investment(s) into cash when necessary. In short, it is the risk that when an investor is ready to sell there is no one willing to buy. 5. INTEREST RATE RISK: It is the result of central banks attempting to manage their country's economy. Through various mechanisms central banks can provide or reduce the amount of money in an economy. These efforts generally cause interest rates to move up and down. Changes in interest rates affect the value of income generating assets such as bonds, CDs, real estate and the stock market.11

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Risk in Angel Investing, Investment UK.net, available at http://www.investmentuk.net/risk-in-angelinvesting.php Last seen 13/04/2018 11 Portfolio Risks, Market oracle, available at http://www.marketoracle.co.uk/Article23590.html Last seen 13/04/2018

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6. INFLATION RISK: Inflation risk is when the purchasing power of an investment can be significantly reduced. Fixed income assets such as bonds are more susceptible to inflation risk than stocks are. 7. DURATION RISK: It is associated with fixed income producing investments, such as bonds. Because bonds prices have an inverse relationship with their yield, meaning as the price of a bond goes up its yield goes down. The longer the duration of a bond the greater its yield and a result these longer duration bonds have a greater sensitivity to price movements.12

ANALYSIS OF ANGEL INVESTMENT AND PORTFOLIO INVESMENT

The analysis of the following investment would basically point towards the need of such investments for the economy and their role in accomplishment of the need is satisfactory or not. With regards to angel investment, Angel investors tend to invest in small and middle enterprises (SMEs). This structure of economy pointed that potential needs of companies might face the possibilities angels possess. The needed capital should be adjusted by taking in consideration the profile and stage of development of SMEs. Angel investors needed to expand their activity while supporting the broad economic development as well. The experience and other managerial support Business angels are able to provide, might be very welcomed by SMEs as in line with financial resources entrepreneurs seem to welcome managerial related support as well. Another issue pointing the potential Business angel relevance to market is concerning firm ownership – strongly leaded by family or entrepreneurs’ ownership and followed by firms owned by one owner only, Business angels have place to step in. Decreasing bank provided landings, it can be assumed, that no great incensement in bank landings can be expected. On the other hand, while existing firms struggle the lack of finance and face the need for investments, Business angels could step in handy. As the last but not

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Types of Portfolio risks, Bright Scope, available at https://www.brightscope.com/financialplanning/advice/article/9799/Types-Of-Portfolio-Risks/ Last seen 13/04/2018

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least, Angels are the first choice of entrepreneurs and angel capital as most preferable source of fulfilling the financial needs in order to realize growth ambition. It is pointed out that in case proper informative platform for entrepreneurs, explaining the roots, pros and cons of alternative investors is provided, the real interest of entrepreneurs in alternative investment market possibilities might enhance significantly.13

With regards to portfolio investment, the saving rate in India is as high as 32% of GDP per annum and investment at 34% of GDP. High levels of investment could not generate comparable rates of growth of output because of poor investment strategy, high capital output ratios, low productivity of capital and high rates of obsolescence of capital. The investment in capital market instruments is around 6% of the total financial savings. Their objectives are capital appreciation, safety marketability, liquidity and hedge against inflation. The investors should follow proper strategy for investment management. Therefore, portfolio management becomes desirable. Harry Markowitz's analyzed Since there is overwhelming evidence that risk aversion characterizes most investors, especially most large-investor's rationality in portfolio management demands that account be taken not only expected returns for a portfolio but also of the risk that is incurred. Although the expected return on a portfolio is directly related to the expected returns on component securities, it is impossible to deduce a portfolio's riskiness simply by knowing the riskiness of individual securities.14 Another reason for the need for portfolio management is that it depends upon the preferences of individual investors. The output of security analysts taking personal preferences into account is essential for portfolio management or at least portfolio managers make use of security analysts output but this output must be analyzed with reference to the tastes and financial circumstances of individual investors when building portfolios. There is a need for proper money management in terms of investment as a basket of assets so as to satisfy the asset preferences of the investors and to reduce the risk and increase the returns on investment.

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Alina Dobrava, Business angel investments: risks and opportunities, 10.1016/j.sbspro.2015.10.097, Procedia Social and Behavioral Sciences 283 http://www.cnlu.ac.in/2016/Notices/MOOTS/SILC%20Format.pdf (13/4/2018) 14 Ibid.

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CONCLUSION

Most Angels are linked either formally or informally to networks of Angels. This has come about because of the need to band together to share deal investigations, the time required to undertake due diligence and the costs of administration and professional accounting and legal services associated with investments. Angels still remain somewhat private about their activities, often using an Angel Network, Angel Group or Angel Fund to shield their identities. Often they will work through advisors or local professional service providers and only become involved when a potential deal has been thoroughly checked by a known colleague. This lack of public exposure has its advantages for the Angels but unfortunately it also means that little is known about them. Portfolio investment is a process encompassing many activities of investment in assets and securities. It is a dynamic and flexible concept and involves regular and systematic analysis, judgment and action. The portfolio is reviewed and adjusted from time to time in tune with the market conditions. The evaluation of portfolio is to be done in terms of targets set for risk and returns. The changes in the portfolio are to be effected to meet the changing condition. Angel investment can also be an item included as investment in securities in the portfolio created by the investors and so while investing in startup of a company via being an angel investor; if the business fails the portfolio can invest in other securities depending upon risk return relation, nature and characteristic of securities. They provide advantage such as diversification of portfolio. An angel investor can make a positive difference to the success of an emerging business though an active mentoring and coaching role while at the same time achieving a good return from their investment portfolio. Diversification can be made by the investor either by having a large number of shares of companies in different regions, in different industries or those producing different types of product lines. Modern theory believes in the perspective of combination of securities under constraints of risk and returns.

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