Venture Capital: 2023 and beyond

Mon, 10 Jul 2023

Three decades after the first Venture Capital (VC) firm mushroomed in the US, in 1975, risk capital found its way to India. Even though there were several instances of accidental VC underwriting businesses before 1975, the first formal VC scheme in India was through Industrial Finance Corporation of India (IFCI) interest-free loans. It then took another decade and a half before ICICI and UTI came together to launch a formal Venture Capital Scheme in 1988. In the formative years, VCs in India were structurally very different to the firms we have today, but it was risk capital nonetheless.

With all that was happening in Silicon Valley around the time, Indian entrepreneurs were arming themselves to go into battle. They believed they could ride the wave of the internet and build businesses around it. VCs followed them and nudged them. So by 1999, India doubled the number of VC firms to ~20 from around 8 at the start of the decade. In case you are wondering, we have 1500 active VC firms in India today.

While the late 1990s was all about the dot-coms, as India rang in the new millennium, everything came crashing down. The dot-com crash reset the startup ecosystems globally, very much so in India. A reset similar to the one we saw in 2022, sans the dot-com crash.

Fast forward to today, while we all look forward to what lies ahead - which seems promising, we must pay attention to the chinks in the armour. Sure, some of the boldest solutions in the past have been funded by VCs, and this continues to hold true to date. But let’s not pretend that everything is just fine. The past few months have been all about how startups (both Indian and globally) facing an existential crisis. While the jugalbandi of startups and funding has played an essential role in every economy, there have always been unpleasant aftereffects of excesses. This has all happened before, just like everything else in finance - just how cycles work.

Yet we have again slipped up. here is the why,

India is ‘maybe’ the next China?

You can go back and read through all of the historical analyst reports pumping up startup investing in India. The commonality is the first page is plastered with the same old data on economic indicators - GDP, inflation, and per capita income increase. The macro experts have led the warcry for the army of VCs setting up shops in India since the 1990s. But what has dumbfounded me is how often we have heard the slogan ‘India being the next China’. Sounds familiar? Of course, it does. Because we’ve been hearing it for the past couple of years, very prominently. Just like we did in the 1980s, the late 1990s, and around 2007. Never gets old, and this narrative sells. But a deeper look past the headlines has been quite the contrary. It hasn’t really played out as well as everyone predicted or, should I say, hoped.

While you cannot really blame foreign investors for being speculative about the Indian market, several Indian investors have decided they would want to participate too. Pay to play. The search for elusive Unicorns (yep, multiple) begins. But while you could fool some of the people some of the time, it would never be possible to fool all the people all the time. They were all found out. Or, in a few years’ time, they can all say we were too early - if that sounds better.
Economic cycles are a long-term phenomenon, taking longer than 50 years to turn around economic fortunes. And who better to explain this than Ray Dalio.

Over the past few decades, everyone has been hoping India can fast forward progress and growth to somehow match up to our northern neighbour. The hope is kept alive and fueled by media and analysts looking at cherry-picked data points. Clickbaity articles do the trick, everyone goes away thinking a revolution is at hand. But they ignore the noticeable differences. This is why we gave it a shot to compare and share the merits of this argument.

So here we go - India and China do have a comparable population of 1.4 billion people. But unfortunately, the similarities end there. The stark difference in social demographics in the image below speaks for itself,

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India is the 5th largest economy in the world, where local consumption forms the cornerstone of our growth in GDP. We are geopolitically a critical partner to various economies and have earned that over a period of time. And the journey to where we are today has been anything but easy. But the stark difference in the consumer class numbers between India and China is daunting.

China has been a powerhouse for manufacturing and infrastructure, whereas India is a service and IT focused behemoth. China’s urban consumer class has an estimated 700 million people, whereas India has 241 million. Both countries are at different stages of technology adoption, both have different cultures and consumer behaviour, different education systems, and different levels of political stability, to name a few more differences. And I can go on, but you get the gist.

Let’s also look at funding availability between both countries for VC investing. And this is where you will see the deep divide between the two countries. China, obviously, has had a head start. But the sheer scale of funding availability in China, compared to India, is why most articles you are reading focus on the growth % of capital than the actual dollar value of funding available. Despite funding value doubling between Q1 of 2021 and 2022, India’s total funding was still a staggering 3 billion USD lower compared to China.

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And here are the annual numbers on the total dollar value of funding between both countries and the difference in scale,

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While these differences are clear, what are VCs aiming for? Well, if you look back at all the other periods of exuberance in VC funding, the same sequence of events plays out. It starts with the hope that India has emerged to replace China. Investors then play along and double down and go berserk with funding. Because investors are in an arms race, they rage and try to outbid anyone else investing in the company they feel will make it past the initial valley of death. So investment rounds in startups become more frequent, and valuations inch ever higher. And then, when the music starts slowing down, they will find someone else to hold the bag. While foreign investors woo local startups, homegrown VCs take it upon themselves to perpetuate the rally of private markets. They all buy in and feel can time the exit to avoid corrections.

And then the reality dawns. But then Most startups affected by inflated valuations riding on the China narrative, devoid of any semblance of correlation to business fundaments, either are written off or shut down. You must wonder why startups would raise capital at unrealistic valuations even though we have learnt of eventual consequences like the dot-com bust.

Well, the simple answer is that it’s quite difficult to pass on some of these funding opportunities. Short-term gains seem too attractive. The long-term view takes a backseat. But startups probably do not realise they are at a handicap in this whole charade.

VCs play a different game. They are always looking to not miss out on the winners - the act of omission is unforgivable. That is how they operate, by making the most outlandish bet possible and hoping it sticks. And the hope is out of the portfolio of startups, just a few bets stick - this is called Power Law. And therein lies the conflict of interest. While VCs can afford several outlandish risky bets, companies cannot. There is no backup for a founder if the company fails in a typical situation. Yet, the founders gang up with VCs and believe that investors walk with them all the way to an IPO.

But hopes soon give way to reality. Investors, by nature, will try to maximise their returns and carry out their fiduciary duty. It’s what they are paid to do. So while they all desired to help startups, they decided to help themselves more. It was always a transaction at best.

Inflated valuations mean that startups now need to force-fit their business around this imaginary number that served no purpose. It made no sense all along and won’t fix itself now. Everyone blames the narratives. Founders scramble to shore up the data room to suggest why the growth is commensurate to the valuation. Stressful times.

But the investors walk away, This is because, if we know one thing about VCs, it’s that they will stop, drop and roll the moment they see fire a mile away. And while they do, they share the next destination that they are certain will be worth their time. Sigh.

While in the past few paragraphs, I described events that have played out in the recent past, it is not too far away from what happened around 2000 and 2007.

All the VC shenanigans from 2020-2021 mean that genuine startups and entrepreneurs now feel the brunt of a slow funding market for the next few years atleast. For dramatic effect, ‘The lost few years’ it will be called a decade later, maybe.

And what we are seeing today with a rejigging of valuations, down rounds, and governance issues are all mostly a function of this, as it always has been. VCs selling an opportunity extensively while there were always a few doubts as to what would play out eventually. Nobody really paid any attention. Expecting India to replicate China as a market will be a long and arduous journey. Not impossible, of course, and with all the advancements in India over the past few years - think of UPI, GST, Aadhaar and other accomplishments, we are in better shape today than ever in our history to have a go at becoming the next China. But the comparison to China is not fair today. And the funding that follows the comparison is based on opinions rather than actual data.

Limited Partners(LP) or investors of the VC funds who bought the story, though are slowly but surely finding this out, again. Yet, they will buy this same story once more as the new cycle begins in a few year’s time. Blame our collective short memories. And yet again, investors will walk away scot-free. While the startups are left to fend for themselves.

Public market bubbles

While the pandemic raged in India throughout 2020 and 2021, the public markets almost ignored all that was happening around us. We hit new all-time highs! Yep!

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Historically, whenever public markets rally, VC funding follows - pick 2000, 2007 or 2020, all these periods exhibit the same behaviour. Through a public markets rally, investor sentiment improves, risk tolerance improves and expectations for returns inch higher. The safer government bonds and bank deposits dont cut it anymore - everyone’s looking for multiples. They all try to find alternative asset classes to cash in and queue up to get exposure to VC/PE and other speculative vehicles. This phase can be defined as greed. Here is why this directly affects startups and VCs. A rallying public market is the perfect opportunity to take private companies public at sky-high valuations. An IPO, they call it. Essentially, VCs decide that they have had enough and would like to now hand over the company to other investors. All while spending the past year or so dosing startups with steroids in the form of frequent capital infusion rounds and glorious valuations. The ask is just to grow as fast as possible and as quickly as possible.

Between 2020 and 2022, in India, a rallying market, deep pockets, and greed formed quite a potent combination for disaster. As markets rallied, more funding flowed into startups with the hope that by the time markets were correct, private investors would have left the scene of the crime. Easy and simple, for the investors atleast.

But as we have seen in 2000 and 2008, the public markets always reach a tipping point, and then it all unravels at breakneck speed. As Warren Buffet once quipped - only when the tide goes out do you see who’s swimming naked. And what does the tide hold today for startups at the doorstep of late-stage rounds and IPO while the public markets corrected themselves in 2022? A slow and painful correction, layoff, inability to raise more funds - a vicious cycle of despair. This pushes the startups to force-fit valuations again, unsuccessfully, that is.

The public market performance post the 2008 crash to date has been all zero interest rate policy (ZIRP), that the US central bank adopted after the subprime mortgage crisis in 2008. For the uninitiated, in a nutshell, in 2008, some of the largest banks became insolvent in the US due to reckless lending and securitisation of these debts. The US government then decided that it was the right time to bring out the money-printing machine. They printed more money, bailed out larger banks and insurance companies, lowered interest rates to near zero to stimulate the economy, and kept it there until 2022. Everything felt wonderful. It felt great!

But this was obviously not going to last. All the money infused into the economy started to find riskier and riskier assets to buy. Speculation creates bubbles, and the bursting of the bubbles can never be good, even though necessary. And as bubbles burst, the public markets correct first. And so it did in 2022. VC markets followed.

While the public markets raged, VC investors had little incentive to avoid risk throughout. They propped up a bull market in private markets too, devoid of underlying fundamentals. And as the public markets crashed, it was the cue for them to cut their losses. Insane valuations, faster follow-on rounds and unprecedented search for growth hacks were the norm the past two years. While a few years ago, it took companies years to hit the 1 billion USD valuation, 2021 had companies do that in a span of months. Staggering.

Where are we today? So, since all the money in the system led to ‘transitory’ inflation, central banks and governments have decided it’s time to rein in the money. Over the past few months, we have witnessed one of the fastest rate hikes across central banks, especially the US Federal Reserve. Risk capital is no more the norm. Govt bonds do the trick.

And again, nobody paid any attention throughout - for this has happened before. Yet again, the startups are on their own. And the results are for all to see.
Tiger on the loose It’s 1980 in New York, and With $8 mil USD in capital, Julian Robertson founded Tiger Management. The ripples would still be felt last year, 4 decades later.

Unless you are living under a rock, you have certainly heard of Tiger Global, one of the ‘Tiger Cubs’ as they called them. While Robertson shut down Tiger Management in 2000, he bankrolled several of his employees to start out on their own. Chase Colemen founded Tiger Global being one of them. Starting out with $25 mil USD in 2001.

Having gotten a taste of China and then the US, Tiger started a frenzy of investing in India around 2015. And guess what happened in 2016 - yep, the hyperlocal startup market bust. Excesses. Funding rounds, funding value and valuations kept soaring. Tiger accounted for 15% of funding in India between 2014 and 2016. Seemed like they had enough of the Indian market after 2016, with very few deals up until 2019. And they left, and in a blink of an eye, they were back.

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Between 2020 and 2021, Tiger dusted off the playbook and got to work. They supercharged the round sizes. Offered sky-high valuations. Priced everyone out of the markets. And as investors tried to compete, TIger upped the stakes and went at it harder.

Again, the problem was that these startups claiming valuations in the billions were still a far cry from any meaningful monetisation and self-sufficiency. But since investors needed these startups to grow, founders obliged. They spent the moolah and tried to buy their way into the market. Valuations kept correcting upwards. And Tiger continued to snap up companies at higher valuations, everyone else did the same as they felt they were missing out on all the fun. And we know what happened next. Unrealistic expectations have weighed heavily on some Indian startups in the past year.

While investors just looked at each other and kept going. Nobody spared a thought for the companies they were putting at risk. Trouble has always followed Tiger to India. Not to say there have not been beneficiaries of funds like Tiger Global, but the rewards are not commensurate with the damage inflicted. But again, a lot of this is a function of how good an opportunity it is to pass on. As the saying goes, when Tiger comes knocking - you either join them or pivot. Because if it’s not you, they are definitely bankrolling someone else in the same business. They get what they want. Brutal.

After all this, investors decide to meaningfully value a company and not mindlessly compete for greed? Time only will tell.

Profitability - the path that must be trodden

While I write this, there are startups out there hurting. Quite a painful period. The funding winter is real, after all. All the make-believe valuations are a thing of the past. Down rounds are in.

The last year and a half have been tough times in the truest sense. Layoffs were announced almost every day last year and continue to happen. Much of that pain is hidden in plain sight, masked by numbers in news articles and tweets. Everyone becomes a statistic in the form of # of employees laid off.

While we have realised all the bust in the startup space has caused pain for Founders and to a certain extent, the investors. Spare a thought for all the employees at these startups. As the markets correct, many will lose their jobs. Many will be sitting on ESOPs that are now maybe either worthless or worth way lesser than what it was when they decided to give their blood and sweat for their startup.

Expectations that maybe get the better of them all. Yet, it dint have to be this way.

If you look at what could have helped startups avoid this, the answer is right there in front of them. One does not need an MBA or any other education to know a business must keep expenses lower than revenues. It’s as simple as that. Sure, might not be easy when you start out, but has to be the goal in a couple of year’s time.

The focus must be on the path to profitability and not the path to a higher valuation. Not EBITDA profits, but real profits before tax. Sure, this might sound old school, but throwing money at growth has never worked and will never work. It has always been a combination of good products, the utility of the product or service, a great team and the stickiness of paying customers that matter.

Startups should raise capital only if that helps the company grow and expand sustainably. And while they do, they must think of all that can go wrong and make peace with it. Businesses that expand and burn money eventually have to repay the debt that accumulates. Dependence on capital availability through VCs is a ticking time bomb. Everything is great until it’s not one fine day.

But this does not matter if startups have the wrong expectations of what defines a successful business. Maybe that is the issue. The normalisation of ‘unicorn’ status as a marker is perhaps what is driving all the wrong decisions. Everyone missed the forest for the trees.

What lies ahead

Well, we have seen a few instances of startups fighting for survival, and there will be more over the next few years. But there this does not mean all is lost.

We have seen several startups build amazing products for India and the world. We need more of these startups to think of building companies as building better products that solve a problem. They must now know not to depend on VCs and not to aim for higher valuations as opposed to a sustainable business.

And there is a reason why a Founder is so romantic about building a business - they revel in the journey of problem-solving. It must be the pure joy of solving problems. Not valuation and funding headlines based on nothing.

India today is at its strongest as an economy. There is digital and physical infrastructure coming to life that makes it easier to build a business. And this inherent advantage will not vanish as funding dries up. All the founders out there wanting to build businesses must take comfort in the fact that distribution is solved. The opportunity is still there.

Startups are now building not just for urban centres but also to solve the pain points of other suburban towns and districts in India. As startups move towards the hinterlands, more younger folks from our villages and districts will be inspired to start out on their own. We are also seeing concerted efforts from the Govt to support this ecosystem and encourage founders and startups from all walks of life and all economic backgrounds. All of this will bear fruit in the coming years. But if we are to mainstream entrepreneurship as a career path, we should avoid the mistakes of the past, and that starts acknowledging the misses.

It is also important to remember the lingering effects of successful startups. Like the PayPal Mafia, Flipkart Mafia went on to seed 253 more companies, including some marquee startups operating today. So as India grows and more entrepreneurs make it on their own, there will be more startup mafias as the liquidity of a successful startup exit supercharges the ecosystem. So not all is lost indeed in the chase for the next Flipkart or PayPal.

And by no means is this a rebuke of VCs who have taken it upon themselves to collaborate on some of the wildest ideas ever. They help founders and the startup team chase their passion. And they have also supported startups across the smaller towns and cities in India. Startups are a legitimate career choice today. So there are silver linings, but the clouds that have accumulated in the process do not look pleasant.

Through Rainmatter, we have always said that to truly have a prosperous economy, we need domestic capital to back entrepreneurs in India. I always think of Infosys as the OG of the Indian startup space - Mr Narayan Murthy started out with Rs 10,000 from his wife Sudha Murthy. The most romanticised startup story. They proved it is possible to build a good business without needing VC funding every year. And there are so many others who conservatively raised funding and have still made it.

The lessons of 2021 and 2022 will linger around for a few more years. And then it will be forgotten again. Tiger will be back, India will be asked to replace China again, and the public markets will rally again - and when that happens, we will see if the pain of the past two years were worth it.