#Asia India’s big exit mess and what we can learn from it

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There is a huge problem looming over startup investors in India, and not enough is being said about it.

India’s startups have seen a funny turn of events of late, with storied founders asking for government protection, and revered investors making charges of “capital dumping” by foreign companies – only to be torn apart by colleagues in the industry.

Getting lost in this noise is the most important issue at hand – and, according to some, the real reason why these “debates” happened in the first place. It is a story of worried investors, writeoffs, and few exit routes for the money that has gone into building the third biggest entrepreneur hub after the United States and the United Kingdom.

“When the valuation bubble deflates, investors get hurt. Some late-stage investors won’t even get their principal back. Early-stage investors will do better. But they too will have to eat humble pie as they write down their previous mark-to-market valuations,” said Sharad Sharma, co-founder of iSPIRT.

A total of US$8.23 billion was pumped into startups in India in 2015. In 2016, that number fell to US$4.07 billion, according to Tracxn.

While 152 startups were acquired in 2015, the total acquisition amount was of around just US$1 billion, says the startup research firm. (Tracxn only calculated deals that were officially announced.) In 2016, the deal number rose to 160, bringing in about US$1.2 billion.

As valuations get shaky, and profits and IPOs become more elusive, many investors are now stuck, looking for exits via deals and mergers and acquisitions.

Asking more questions

Photo credit: Mike Poresky.

Tech in Asia spoke to multiple investors to gauge their sentiments about possible exit routes. Most of them did not want to be named because either their firms have active investments in the startups we discussed, or because they aren’t officially allowed to talk to the media.

“It is a fiduciary duty for VCs to show an exit path. But at this point, there is none,” said a source at a VC firm. “Big VCs are still raising funds, but investors are asking more questions.”

Herd mentality jacked up valuations.

The problem, they explained, is that business models like online shopping or ride-hailing are highly competitive, with comparatively low barriers to entry. (Read: it isn’t that hard to copy).

“As long as there is money, companies like Flipkart or Ola will grow. But the moment there is another competitor who has enough or more money, it becomes hard,” the VC said. “In this market, as long as people will raise money their companies will survive. It will be dependent on pockets.”

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And it is only going to get harder for consumer-facing startups to grow from here, making those deep pockets all the more relevant.

India’s income distribution falls steeply once we move from cities to towns and villages. Ecommerce companies say they are going after the next batch of customers in small-town India, but purchasing power goes down significantly.

See: HSBC cuts Zomato’s valuation by half, and why the ‘growth’ argument is faltering

“To double the revenue at ecommerce or other [business-to-consumer] startups, the next round of customer acquisition needs to address more than 80 million families,” said Sharad Sharma of iSPIRT.

“If the unit economics are not working for the first cohort of customers, they certainly won’t work for the second cohort. [Consumer goods] players know this. Ecommerce players are learning this old lesson at a great cost to themselves.”

Stuck

Exits were always set to be a big challenge in India’s adolescent startup ecosystem, but hype over valuations has made things harder. Unlike in the United States, there hasn’t yet been any blockbuster payback like with Facebook, LinkedIn, or Amazon. China had its global startup victory with Alibaba.

In 2015, US$8.23 billion was pumped into startups in India. In 2016, that number was US$4.07 billion.

Time is running out. It is true that years of seeing booms and busts have helped Silicon Valley form a mature environment where succeeding fast and failing fast have become a badge of honor, and India is yet to go through that rite of passage. But investors typically allow for a gestation period of seven to 10 years before they get antsy and start looking for returns. Flipkart and Inmobi are turning 10 this year. Snapdeal and Ola will be seven, and Zomato nine.

A total of US$3.15 billion has been invested in Flipkart, Snapdeal has taken in US$1.56 billion, Ola has raised US$1.23 billion. These three companies are the biggest startups in India and considered bellwethers for the entire ecosystem. In the second rung, Inmobi, once said to be a Google Ads competitor (technically so even now, but much of that glory has dimmed), and Zomato, which introduced India to online food ordering, have raised more than US$200 million each.

As recently as two years ago, IPOs in India were being looked at as achievable dreams, as was profitability. There were many reports of Flipkart’s listing, none of which have come to pass. By 2016, founder Sachin Bansal was talking about the benefits of being private for as long as possible.

Snapdeal spoke of IPO ambitions even last year. Now, there are talks of whether the company can go it alone, get merged with Paytm, or be bought out by Alibaba. Snapdeal and Alibaba deny a sale.

Profitability has been equally elusive.

See: Zomato’s losses show profit’s still just a word for startups, meaning zilch

Quagmire

By the end of 2016, there were multiple media reports that Flipkart and Snapdeal were struggling to raise money at the valuations they want.

A Mint report on Wednesday said Flipkart was in talks to raise US$1.5 billion from investors including Microsoft, eBay, PayPal, and Tencent, at a valuation of US$10-12 billion. That is lower than its earlier valuation of US$15 billion, but higher than the US$6 billion suggested by Morgan Stanley and Fidelity. Flipkart did not immediately respond to an email asking for comments.

Investors have marked Flipkart down repeatedly. Reports talk about how Tiger Global has given the task of recovering the hedge fund’s US$1 billion investment in Flipkart to new CEO Kalyan Krishnamurthy.

“Effectively what we (venture capital investors) did is collectively spend US$2-3 billion on educating the Indian consumer on how to use Amazon,” the Mint reported Sandeep Singhal, co-founder of Mumbai-based venture capital firm Nexus Venture Partners, as saying.

See: India’s beloved Flipkart had a crappy 2016

Earlier this month, Japan’s Softbank wrote off US$$475 million in the value of its combined shareholding in Ola and Snapdeal, two of its largest investments in the country.

Forbes describes a writeoff as “a failed investment, a necessary aspect of the inherently risky business of venture financing.” Before that, Softbank had written off US$555 million in the two companies.

“For the most part when you talk about VC investing in India, IPOs are still extremely rare,” said Shubhankar Bhattacharya, a venture partner at Kae Capital. “So when VC investors go in, the de facto understanding is that the exit, for the most part, is likely going to be through an M&A. Or when a large [private equity firm] comes in they buy out our stakes when a very large round happens.”

See: Fidelity joins Morgan Stanley, cuts Flipkart’s valuation to $6 billion

The catch here is that there very few (some say, none) buyers available because of the high valuation fundraises of the past few years. Flipkart, at one point, was said to be valued at US$15 billion, Snapdeal hit US$6.5 billion last year, Ola was at US$5 billion. Inmobi, Zomato, Quikr, and a bunch of others were all touted unicorns – worth a billion or more. Now those lofty numbers have come down somewhat, but they are still too high. This means investor money is stuck.

“This can sometimes spur talks of IPOs – but again, here the question is does the company have a story that it can sell to a retail investor? [Listing] can’t be for a company where its very existence is being threatened. So is there a clear exit path? I am afraid not,” Shubhankar said.

Reputation

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This uncertainty has in turn given rise to some mergers and acquisitions in the industry, many of which, sources say, are investor-led because they wanted to cut their losses.

Tracxn said while there were about 138 undisclosed deals in 2015 (in which they do not make financial details public, or sometimes, don’t even officially announce the deals), the next year, that number rose up to 144.

In 2014, Jabong was thought to be worth US$1.2 billion, and Housing was pegged at US$250 million. Both companies eventually got sold for around US$70 million. Meanwhile, Quikr bought CommonFloor in a US$200 million stock deal, said to be prompted by common investor Tiger Global.

Talks of capital dumping are seen as last-ditch PR efforts.

The only way out of this mess seems to be by current investors taking a cut and allowing (or if needed, pushing) for major markdowns that will allow others to buy them out.

This is all the more important for India-focused VCs today, multiple investors told Tech in Asia.

“Tiger Global may have a big investment in India, but Flipkart is a very small percentage of their overall investments. Plus they have put money in Amazon. So they are hedged. The problem is for those who have not hedged their bets,” a VC pointed out.

Tiger Global declined to comment for this article.

The thing to consider for VCs is that if there are no solid exits, they are likely unable to raise more funds for much longer. It is also a question of reputation.

“There is liquidity in the market, but not at the levels they want. It is also your reputation as a VC on the line. It isn’t necessarily that your funds shut down, but a question of being able to manage all your balls in the air,” another VC said.

Lessons

Photo credit: Dan Gribbin.

How did Indian startups and investors come to this point? The answer seems to be rooted in the most basic of human traits – herd mentality. A fear of missing out made VCs look for the next unicorn, sometimes offering money where there was none needed, various anecdotal evidence showed.

“In retrospect, it is ridiculous that a business needs US$3 billion to prove its worth,” seems to be the refrain.

There is liquidity in the market, but not at the levels they want.

Others blame big money from private equity companies. “The late-stage PE firms came looking for quick wins. This hot capital has retreated as quickly as it came. In retrospect, it was wrong for our VCs and entrepreneurs not to be cautious about this casino money,” iSPIRT’S Sharad said.

From all available evidence, it looks like India’s tier one startups are heading for a big correction. Investors and founders will have to make tough calls that might include cutting employees, scaling back drastically, and making other moves that will require some swallowing of pride and tunnel vision. Some of it is already happening. On Wednesday, Snapdeal announced layoffs and major changes in its organisation. Grofers, Zomato and a bunch of others have either scaled back ops, let people go, or even changed business models to survive.

See: Snapdeal founders to take 100% pay cut amidst layoffs. Here’s their letter to employees.

“We believe that with profitability an enterprise earns its right to grow … and in the process create immense value for its existing and prospective investors,” a Snapdeal spokesperson told Tech in Asia.

Here are a few learning points that Sharad Sharma and other industry experts said the ecosystem will benefit from:

  • Founders should know that raising money at very high valuations is as bad as raising money at too low valuations, sometimes worse. (Watch HBO’s Silicon Valley if you don’t believe Indian experts).
  • Don’t raise money around a hype, because then you won’t have the discipline to find the product-market fit you need. “We started growing our business much before the right economic model and market fit was figured out,” Snapdeal founders accepted.
  • Private equity funds need to accept that despite India’s booming internet and smartphone market, India is not China. Local versions of Amazon, Facebook, or others have grown in China for complex reasons that do not apply to India’s open market.
  • Founders control the destiny of a company. The question is, are you prepared to swallow your pride, accept realities, and make the changes needed to make the company see another day?
  • Seek help. Hyper-growth requires professional managers who have done it before in traditional companies like Airtel and Indigo Airlines. Strategy consultants are not the answer. Management schools should have played a role here by bringing out relevant case-studies but they were missing in action.
  • Don’t declare victory before actually winning.

    This analysis includes the opinions of the author.

    This post India’s big exit mess and what we can learn from it appeared first on Tech in Asia.

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