Musings on the venture world for 2024

For the past few months in India, VC investors have started speaking of profitability. Makes no sense, though. The entire VC model is built on VCs subsidising early losses so that the company can eventually capture a significant market share and be sustainable financially. Why are we speaking of this now and now for all this while? We have had two years of crazy valuations and funding rounds, yet we are only being made privy to this elixir of business building now. I have some thoughts around this.

But before that, check out this transcript of a recent interview with Reece Duca, Founder and Managing Partner of the Investment Group of Santa Barbara (IGSB), a private investment company. His outlook on investing is simple, straightforward and non-ambiguous.

Bob Casey: Any thoughts on what the next decade might look like?

Reece Duca: Hesitant to give you any thoughts because predicting those kinds of things are tricky. But this is what I’d say, is, I think the last 14 years have been a real anomaly. I don’t think… if someone were to ask me, What’s the likelihood you’re gonna see NASDAQ up six fold and you’re gonna see S&P up three fold, I would say, Very, very low probability. Is it possible that the market is essentially flat or maybe it’s up over the next 14 years? Maybe it’s up one time. That’s possible, also. But I think that there’s a lot of factors that make the the future more difficult. I also think that, from an investing standpoint, things that were ignored for the last decade or more, basic fundamental performance of companies where there was an interest in funding early stage companies with very large amounts of money, very vision-driven with essentially, the strategies that probably were going to be very difficult to develop into profitable, sustainable [parts] of business. And so I look at the importance of cash flow. And I would say that over the next decade, I think people are going to look at cash–particularly for exceptional companies, they’re going to look at the companies that can continue to grow, but the most important thing is how do they convert it to cash. And they’re gonna look at real earnings of companies. That adjusted earnings and stock-based comp that that is clearly an expense to the company, I think investors are going to understand those need to be factored in in a different way than they have in the past. But I think the biggest thing is, the companies that have exceptional models are going to be the ones that are going to be throwing off a lot of free cash flow. And investors are going to pay for it. Again, the same sentiments and outlook on business - if you make money, we will give you more to scale operations. And if you are not making money now and still need capital, you better have a plan to make money.

This is familiar, though. It is a basic investing principle that applies to all businesses out there - public and private. Yet, for the past couple of years, many companies without a clear path to sustainable operations found investors willing to pump in money at insane valuations. We know why, specifically from an Indian context - but works for global VC market too.

1. The exuberance of the public markets meant that private markets also picked up, and more fund managers, investors and founders got down to making use of this opportunity.
2. The near-zero interest rates in the US throughout the best part of the past decade meant more risk capital was available and hence VCs found investors willing to partake in risky investing behavior more readily.
3. Slight misunderstanding of the market size and revenue potential.

Sidebar - I love the memos from Howard Marks. Especially this one, which explains the transition of the US economy and financials markets through his Sea Change Memo, and since most of Indian VC funding relies on the US, it is important to understand the historical context of the US markets too before we speak about some of the issues we see today.

All of these factors mean that FOMO and growth at all costs took the front seat but look like things of the past where we stand today.

Could VCs have done things differently all this while?

Futile pursuit of sectors and hunting of the unicorns

Let’s examine a few examples of how the funding exuberance killed the market for years for a few sectors.

Check out this article from Morning Context on the digitisation of Kirana stores in India and how mountains of capital invested in the space have little to show. Startups in this space are either on the verge of shutting down or are actively scaling down operations. The need for tools and solutions offered by Kirana Tech has evaded everyone and seems elusive.

Below is a snapshot of the funding that found its way to Kirana Tech. A billion dollars might be miniscule compared to the overall VC funding amount of around 60 billion dollars across the crazy years of FY 21 and FY 22, but it is significant given how average VC funding in India has been hovering around 10-15 billion dollars/year over the past decade.

As Anuj Suvarna from Morning Context says,

Not too long ago, several firms set out to bring neighbourhood stores online, hoping to fix pandemic-disrupted supply chains. Today, there’s a pervading sense that they misread the market.

Here is what Janane and Bhumika from The Ken said,

Startups have it hard in the Kirana ecosystem. Bookkeeping offers slim margins, lending is risky, and nothing has come of digital storefront initiatives—Khatabook and OkCredit have already shut theirs. Convincing Kiranas to pay for tech is a tall order, but Kiranatech’s troubles go beyond monetisation.

So, writing was on the wall for the sector and companies in this space. Profitability and viability were never in sight.

Kirana tech is just one of the sectors we can be critical about. Several startup sectors like lending (cough regulations cough), health tech, edtech, brand roll-ups, SaaS and others are going through similar phases of winding down.

Most startups stuck in the rut are shutting down, and those that aren’t are using whatever shortcut they can find to survive. From borrowing money to mass layoffs, startups are resorting to desperate measures.

Since the onset of the funding winter in 2022, an estimated 34,785 employees have been laid off by 121 Indian startups As many as 24 Indian edtech startups, including six of the seven edtech unicorns, have fired 14,616 employees since last year As many as 15,247 employees have been fired by 69 startups so far this year, highlighting the fact that the situation around job cuts has hardly improved

Source

As Buffett said, “When the tide recedes, you will find whoever is swimming naked. True to the aphorism, we have seen massive corporate governance scandals.

So, even though VC capital amounts looked amazing on graphs and reports, a few layers underneath, things were not pretty. But as more risk capital looked for opportunities in an already saturated market, investors pumped capital into sectors that were never going to make it - not that they knew this when they invested. Still, it did become apparent after a while. The lack of opportunities plus the pressure to return capital + returns to investors of the VC fund meant this was always going to happen in some form or another.

The unmissable Power Law

Many public investors focus on cashflows - heck, even Warren Buffett spends 30-45 mins speaking about Berkshire cashflows during the annual investor conference. So, in some sense, it is the holy grail of investing. But sadly, it has fallen out of favour with private market investors at both early and growth stages. But yeah, not having free cash flows is a feature of startups. The model of private investments is different to public investments anyway. Growth and market potential take prominence over profitability and sustainability in operational profitability, with the implicit assumption that the business becomes profitable and sustainable in the long run as revenues grow. Manifesting the scale of economies. This means that VCs subsidise businesses while they profit and gain a market monopoly.

While this works occasionally for private market investors, it does not work most times - cue Power Law.

At its core, the VC power law dictates that a handful of investments typically drive the bulk of returns. A few successful investments can recoup the losses of many unsuccessful ones. This isn’t restricted by sector or geography; it’s universal.

This also means that without free cash flows, companies take longer to mature and become real structured businesses. Always at the want of investor capital. But if I was to take you all a few years back, it was a best practice that while a company reached Series B (around 10-15 million USD raised), it was fit and proper to do an IPO and have structures in place like a listed company. But times have certainly changed since 2020, as startups have been in the burning money phase for longer - not only because of the money flowing to the private markets space but also because of the tolerance of investors to ride the “potential” growth wave.

So if you have a boring business growing 2-3X revenues every year with meagre profitability vs a 20x revenue growth business with no profitability, VCs/PE will choose businesses with 20x growth in revenue. The expectation is that as income grows, there is potential to capture market share and maybe earn profits eventually, but the focus is to ascribe higher valuations within the next few years while the revenue keeps growing and sell the investment to the next person (or fund) wanting to take a bet on the business. For example, VCs who invest in Series A at X valuation will eventually sell to VCs in a further round at 4X valuation. These new investors might again resell the company at a higher valuation to other investors or take the company IPO. The idea is to ride the wave of growth while valuations go north and benefit from it. This is still the idea with public investments, but the screening factor for investing also lies in profitability and operational efficiency. This is why VC/PE investments are different. Sajith Pai explains the valuations in the VC/PE space here.

But what about 2021 and 2022? The startup world was flush with cash, founders were coming up with ideas every day, and VCs were doing 1-2 deals daily, but then the music stopped. And this would not have been an issue had startups focused on free cashflows from the get-go.

Suddenly, there is more focus on cashflows, which is a good sign, but a significant shift in approach: lots to unwind and lots to change. Conventional wisdom on investments begins to seep into VC deals, as they should. While there will be sectors where risks are warranted and cashflows might not be the focus, the large section of sectors where VCs invest will need some predictability and visibility of cashflows. It’s also important to note that while a focus on cash flow is increasingly recognised, the stage of investment and the industry can still influence the priority given to profitability. In earlier stages, VCs might prioritise growth and market presence, with a shift toward profitability in later stages. Therefore, VCs will align their investment thesis with the stage and nature of their evaluating businesses. But the macro trend is to focus on cashflows.

A shift to profitability and sustainability will have several implications - not only does the company or startup have a higher probability of surviving longer, but it thrives and makes fewer mistakes. The startups will also be pretty insulated from VC funding volatility and be self-sufficient. The VC model of returns will also move away from a short-term to a long-term gestation period, which means rejigging of LP (investors in VC funds) expectations.

While we are on this, here is a wake-up call,

A total of 80 Indian new-age tech companies reported combined operating revenues of INR 1.92 Lakh Cr in FY23 Of the 80 companies, 53 incurred a combined loss of INR 36,770 Cr in FY23 Source

The future of VC funding

Given all that is happening on the expectations front, how have investors changed?

From whatever little I have learnt, this is what I see happening, and maybe this will be helpful for all the new founders in the market,

1. Investors are happy to invest in founders who are passionate about the problem statements they are solving. This translates to teams who understand even the tiny details of the business they are building. Especially teams that understand the market and have a grasp of the opportunity.

2. Investors would like to see some traction and adoption. Ideas won’t cut it anymore for most sectors. This translates to startups walking the talk and working towards acquiring the first 100 or 200 customers. And going from there. But the first step demonstrates the execution capabilities, which becomes essential.

3. The dreaded path to profitability means you will have a predictable path to a point when the business will not keep needing external capital to cover costs. Even if that means breaking even for longer, it helps build conviction among investors. But as we noted, just a long-term view of business sustainability financially would only add more value to the startup and founders.

4. Investors will seek founders who resist the temptation to grow at all costs and focus on standing out through core comptencies. While everyone can chase growth with marketing dollars and whatnot, concentration on business ethos takes more effort - could be as simple as being excellent at customer service, for example. While people can copy business ideas, they will rarely be able to copy business ethos.

5. Investors will be careful of the valuation game - while it is pretty tempting to get drawn into it, investors will stay away from it as much as possible. While things seem rosy when capital is plush, things won’t be when capital is scarce.

The optimist in me

While speaking of all things going wrong, it is not all dire. VCs are changing their approach, and check out what Palak Agarwal from YourStory shared,

Having played an important role in propelling the growth of startups and contributing to the emergence of over 100 unicorns, VCs like Fireside Ventures, Kedaara Capital, SIDBI Venture Capital, Aavishkaar Capital, Everstone Capital, and others are now actively looking at these small businesses which are profitable, possess a rich legacy and reputation, often being family-run enterprises. These businesses are capturing the imagination of VCs as they seek to further expand their horizons.

Another aspect of the Indian venture industry is how we so desperately try to emulate the Western VC risk-taking model. While a few things have worked, and there have been sparks of success in the past - cue Flipkart - not all of the aspects of the VC industry from Silicon Valley have translated to the Indian ecosystem. So a lot of Indian VC activity over the next few years might revolve around founders solving the toughest problems and doing it well for longer periods of time.

We have also learnt that market sizing for India is more complex. Nithin has also mentioned this in the past, and I think a lot of this has to be ingrained in the businesses that start operating so that expectations are set from the get-go,

Focus on cashflows must be the responsibility of not only the VCs but also the founders. If there is one lesson for all the founders from the past few years of VC exuberance, it’s that when the times get tough, capital is tough to come by. This has not only helped startups be more prepared to be independent but also focus on core business metrics from day one. It helps. And while we are hurting today with all the drop in venture funding, maybe the lessons are quite worthwhile.

Also, the most important of the lessons has been how internal and external expectations of the startup must align for progress. Here is an excellent illustration - with two bars of the ladder representing the internal and outer workings of the startup. Any deviation means destruction.

The scale at which India’s startup ecosystem is growing is also a testament to how VCs have contributed to the larger goal of building tech capacity, innovation and skills in the country. Today, India has about 100k registered startups and 1500 AIFs, all pulling in the same direction. While a few years ago, only a few sectors found investors in India, things are vastly different. Investors are focusing on almost all sectors.

And as investors set the right expectations and guide startups to look at businesses the right way - of course, balancing the LP expectations on the way - we are bound to do well.

I would like to end this blog with this fantastic excerpt from a Byrne Hobart article, which describes the life of a startup founder in all the tough times.

A fun paradox of history is that leaders who preside over generally good times get few, short books written about them; the big topics are the people who are in charge during, or are the direct cause of, absolute chaos. Similarly, there’s not much to say about the business acumen of someone who rides a trend when it’s a good trend to ride: they were either very lucky or very smart when they chose their life’s work, and after that choice made one fairly obvious decision after another. Things get interesting when the future gets murky, and when the best option is to choose among differently disappointing alternatives—one high-risk plan to reduce one constraint, another operationally-intensive effort to mitigate some other problem. But that’s ultimately what growth is; the straightforward, single-variable part is brief, but in the long run, the real world is multivariate and uncertain, and every well-run great business is diversifying into a merely good or actively mediocre one just to stay alive a bit longer.

So yeah, not all is lost.