In late February this year, Anirudh Damani, Managing Partner at Artha Venture Fund, sent out a message on the WhatsApp group he shares with the founders of his investee companies, predicting “a tough winter lasting for two to three quarters”. The advice was sound and it spoke of conserving cash, and if a company was close to raising funds, “the deal had to finish quickly”. For at least eight years, the flow of money into India’s start-ups saw no abatement, leading to astronomical valuations, often without a robust business model. Damani, who runs an early-stage thematic micro-venture capital (VC) fund, says the indicators were clear much before he sent the missive. “There has to be a collaborative relationship between the investors and the founders with high levels of transparency,” he says.
While all this would sound obvious, the real challenge in several start-ups has been the inability to sustain the frenetic pace of growth. Pressure from investors, coupled with promoters’ unbridled ambition to hit unicorn status at any cost, has led to poor decision-making. This is the point where anything goes, which lays the ground for corporate governance coming apart. In short, it comes down to business practices being compromised. In the recent past, one has seen a serious eruption of this in various forms at BharatPe, Trell and Zilingo, with an apprehension that many more will follow. It is a tough situation to be in and a few (but large) rotten apples can quite effortlessly play havoc with an industry that, in many ways, is an indication of India’s vast talent pool.
Conversations with VCs throw open the issue. The credo is “grow fast at any cost” and that, in many instances, was followed blindly. Over the past decade, interest rates were low in overseas markets, and money came like an avalanche into India. “Everyone looked at growth here, and with abundant cash, it made for a heady cocktail. That model was never sustainable since it ignored the quality of growth, and the fundamentals of a business to generate free cash flows,” says Siddarth Pai, Founding Partner, 3one4 Capital, an early-stage VC firm based in Bengaluru.
The interesting part is not so much about the landscape being dominated by the biggies—Tiger Global, Sequoia, Lighthouse, Matrix and Accel—but rather the limited presence of Indian investors. Pai thinks the public markets, to Indian VCs, are more comfortable for obvious reasons. “Apart from having a privileged position in terms of taxation and regulations vis-à-vis the unlisted market, investment decisions could be based on metrics they are comfortable with such as profitability, PE ratios and earnings per share. Startups on that frenetic growth path rarely make the cut here as these metrics would come later on in their journey, provided they have strong fundamentals and margins.”
The tremors had been felt globally for a couple of years. Messy cases of start-ups such as Uber, Snap or WeWork came to the fore. “We have seen valuations doubling in a year in India for some entities without a remarkable change in the business model,” says Umesh Uttamchandani, Co-founder and Principal at DevX Venture Fund that mentors entrepreneurs to bring their products/services into the market. The obsession for maniacal growth is a direct consequence of what is promised to the limited partners (LP) in a fund. “Private equity funds work towards delivering 14-15 per cent IRR (internal rate of return) over a five-to-seven-year period. VCs investing in India commit 17-22 per cent [IRR] for the same time period,” he adds.
So, where does the stress build up? According to him, it follows a pattern. “The VC will get the promoter to spend a lot on marketing to get more customers, since they have put in the money. You then end up doing things not necessarily in line with internal ethics,” he explains. Everything is fine till the start-up delivers. “The problem is when it fails to.”
For the VC, most often with limited time, a decision on the investment is made on the basis of comparing a start-up here to one in the US or China. As one Indian VC wryly puts it, “Paytm was ambitiously compared to Alibaba and we know what has happened since then.” Besides, the start-up’s founders, being largely techies, come with a limited understanding of finance. Top that up with an investor who can’t see beyond the top line. “Sitting in Singapore or wherever, a VC will only run roughshod over the promoter,” he says.
I am on my own
Left alone and with little accountability, the promoter runs riot. Poor governance spirals out of control and instances of funds being siphoned and misappropriation of funds become commonplace, along with the books of accounts made to look better.
There is one other point here on compensation. As a start-up keeps its investors off its back with high growth numbers (profits rarely matter), the promoters reward themselves on salary. In the US, the thumb rule is a conservative number on salary along with massive stock options. In India, though, it is generous on both counts.
How involved the investors need to be is critical in the backdrop of how the Indian start-ups story has evolved. 3one4 Capital’s Pai thinks the larger cross-over global players are in many cases hands-off after having made the big-ticket investment. “That approach will work for mature businesses or late-stage companies that have been around for a while. But for start-ups, especially in the early phase, a lot of guidance and handholding is required, where the investor needs to play a strong role in setting up processes and standards in conjunction with the founder.”
Given the proliferation of unicorns (which often is more than what mid-caps are valued at), there is a good chance that promoters get carried away and the cases of excesses become prominent. Be it expensive cars, palatial houses or very fancy offices, the individual is in the news for the wrong reasons and, inevitably, crosses the line. One prominent VC speaks of how presentations are made over video calls and money wired right after. “It is not hard to understand why promoters start to believe they can do no wrong.”
The part on maturity does make a difference, with most founders being relatively young. Saurabh Tandon, Co-founder and COO of BetterPlace, a technology platform for blue-collar workforce management, speaks of how he and his partner had worked for a decade and a half across continents before they decided to turn entrepreneurs. “We constituted our board at a pre-revenue ideation stage, and within the first six months, brought in independent directors with great business backgrounds. Besides, the support functions were in place early on with a focus on compliances, financial controls and filings,” he says, adding that once the company scaled up, execution was done well from a corporate governance perspective. On the role of investors, he is clear that while they need to deliver a certain IRR to their LPs as that increases the ability to raise their next fund, “they need to closely monitor their portfolio investments from a corporate governance perspective as any lapse impacts their reputation.”
Ashish Kumar, General Partner at The Fundamentum Partnership, an India-based Series B/C focussed VC fund, points to the commitment on irrational growth rates as the challenge. “When that does not happen, you start burning cash, and become less capital-efficient. That is when it spirals out of control, and the companies start having temptations towards incorrect behaviour,” he says, calling the phenomenon “self-induced growth pressure.” Great companies are built in 7-10 years, he says, and “to be fair, 99.99 per cent of promoters are genuine”.
Serial entrepreneur K. Ganesh, Promoter of bigbasket, Portea Medical, HomeLane and BlueStone, says the past five years have been unprecedented in terms of the number of start-ups, funding, valuation and the emergence of a host of unicorns. The maturity needs to step in early. “Once professional investors come in, there should be a focus on corporate governance. For instance, the auditor should be from one of the Big Four apart from having independent directors on the board,” he says. The latter, adds Ganesh, is not mandatory for start-ups today.
To be fair, the cases of BharatPe, Trell and Zilingo (all Sequoia investee entities) are still a minuscule part of the universe but not without a big learning. Ganesh maintains that start-ups cannot look at themselves as a fledgeling industry anymore. “It is a big sector and failure affects a lot of people, be it customers, vendors, suppliers or the full ecosystem. When the entity crosses a certain size or scale, the implications have to be understood clearly.”
Deena Jacob, Co-founder and CFO at Open, a fintech start-up offering neobanking services for SMEs, says investors must understand the complexity as well as the potential of the sector. “That means being patient and realising that there is no place for 5x or 10x growth each year. Ideally, promoters must ask why an investor is coming in as that helps in working towards a common goal.”
While the reasons for corporate governance lapses are many, the fear of missing out on an investment stands out. Often, that leads to a frenzy. Damani, however, speaks of around 150 deals coming to him every month. “Of all the leads we receive, we convert simply one per cent of them. We usually take up leads that come through references, instead of ones that come from cold leads.”
He swears by the rule of patience. Citing the case of an investment made in 2013 in Purplle—a beauty products e-commerce start-up—on which his fund is sitting on “a giga-return”, his view is “you have to let the founders be, and only look for ways to help them build a strong foundation and that will set the stage for exponential growth”. The sweetest returns, he adds, start in year nine and 10.
Without a doubt, corporate governance is a systemic issue driven by numerous reasons. It is left to the promoters and investors to ensure that the line is not crossed. Fundamentum’s Kumar says that we are in the “teenage phase” of the story, and this learning exercise could last for at least a couple of years. To Ganesh, it is an opportunity. “Now, we can put good systems in place,” he says. Hopefully, that will take place with start-ups doing nothing but creating good businesses for the long haul.
Copyright©2022 Living Media India Limited. For reprint rights: Syndications Today
Add Business Today to Home Screen