How did we get here today? (Part 2 of 2): Of Telescopists and Investment Nihilists

This is the second part of my two-part essay, laying down my observations on India's start-up ecosystem in the past four years. You can read Part 1 here.

If I have a telescope, do I need a microscope as well?

One of the things macroeconomics does well is to predict the general, population-level trends, but is very ineffective when it comes to forecasting the specific ability of a company to outperform/ underperform its peers. Despite this fact, all the reasons that coerced marquee investors and high-profile employees to latch their fortunes to India’s unicorns and soonicorns were based on multiple mutations of a single basic macro fact - that India was a trillion USD market with hundreds of millions of customers’ wallets ready for capture. As I have written before, there are serious downside risks in themselves around India’s ability to graduate from a lower middle income economy to a high middle income economy in a generation (here and here). Thankfully, we have had a belated acknowledgement that the near and mid-term TAM for most new age start-ups in the Indian markets as of 2023 is an order of magnitude smaller than what it was estimated in 2021. But even a collective contrition today doesn’t address the scale of the problem.?

The fallout that we have seen in the ecosystem, in my view, also came from the fact that nobody asked the next natural question that one should ask. Granted that your telescope has been able to spot a favorable high tide to lift the boats that you have invested in, but have we also used a microscope to look at the bottoms of our boats to ascertain if there aren’t any big structural flaws that would sink them in these waters? Truly, in acknowledging our misjudgment about market size, we apologized for a lesser sin, just in order to stop introspecting and meeting this bigger sin of omission in the eye.?

The bigger sin was - once you set your entire investment thesis or create employee incentives simply around the market opportunity, any kind of emphasis on product or operational expertise goes out the window. A good leading indicator of this systemic blind spot was the disproportionate number of slides in investment decks in the past few years that I had the opportunity to see were focused entirely on the market opportunity. There was little or nothing to say about market rollout, actual traction or the risks that their business strategy would fail.?

The outcome - even before they solidified their hold in one market vertical, start-ups would roll-out plans to target another market vertical so long as its TAM was large enough to add to their market opportunity deck.?

As one of the many illustrations of this malaise, I remember speaking to this cutting edge tech start-up (AR/VR space) for a potential Series A round whose founders were running pilots for healthcare and edtech. The reason - their seed investors had insisted that they show use cases for these two sectors because that is what was hot in early 2022. We passed on them because we realized that they had no IP. Their entire tech, right from the hardware to the code, was either imported or open source. Last I knew, they closed their Series A with? participation from a reputed early stage VC fund. It is hard to impute culpability here. But if we wring our hands at the gaping holes in the financials of Byju’s or ask ourselves where companies in the Dukan Tech sector went wrong, we have ourselves to ask - as VCs, as vendors and as employees - why didn’t we stand up and ask the right questions about the expertise or walk out if we didn’t like them.?

Investment Nihilism

Let me tell you a story. I had a friend who was too righteous as an investment analyst back in my days with Credit Suisse (notice the irony here?). After having worked with a prestigious consulting house for 2 years post MBA, he applied to a top-tier private equity firm based out of Mumbai. As a case study for recruitment, they asked him to do a fair value analysis for one of the unicorns that got listed in public markets during the go-go days of 2021. He brainstormed, married his consulting chops with his punctiliousness for numbers and came up with a? 3-year ahead fair value for the stock. It was almost 50 percent below the price at which it was trading in August 2021. The PE firm was already an investor in the unicorn. So, obviously, he wasn’t selected for the job. Additionally, he was given a parting lesson that he went wrong in his process because much of the value within the company was buried deep in the future (Terminal Value) and that splitting one’s hairs about numbers was often not the best mental framework to analyze new age tech companies in India.?

He is not alone. VC investing is a Moonshot Game-? I have been often told. You cannot do any numbers around it. The most important thing that you need to rely on is your gut feeling and what is hot in the market. All these models, these frameworks for valuation are all mental constructs. In the extreme cases, some of the investors admit that all due diligence approaches have flaws and that the best way to think about these things is to raise a lot of capital and spray and pray.?

If this abandonment of any responsibility for due diligence, because nothing is perfect, isn’t the investment world’s analogue of philosophical nihilism, I wonder what is. Indeed, this nihilist approach has given us start-ups with no respect whatsoever for financial and operational reporting frameworks. Because we can know nothing perfectly about a company, should we also stop asking questions that can at least be objectively answered? The poster child of such nihilist investment thesis has been the crypto space.? But we also have suspects elsewhere - creator economy companies, two-sided digital platforms among the notable ones. In short, wherever there was a long, uncertain path from user-growth to revenues to profits, hard due diligence was dropped in favor of riding the wave. In short, we have parodied the term moonshot to give us the license to pile on to the latest investment fad in the private markets. As if nobody doing their homework absolved everyone from doing theirs.?

A guide to avoid the "Hustle Trap"

So what are my takeaways from these four years for my future career.?

If a founder approaches you for a job in a start-up next time - judge them, as far as you can, by their actions and traction rather than their words. Excessive attendance in thought leadership conferences, industry events and a greater time spent on social media than getting stuff done is a big red flag. An even bigger warning sign is if they are not elevating operators and executors to co-founder roles or not rewarding them generously with equity/ ESOPs. Earlier the stage the company is in, the more time you should spend dating the founder - especially if you are joining anywhere higher than three levels below them.?

If you are an investor in private markets, know the obvious. And the obvious is that India is perhaps one of the most attractive markets on the near side of the Solar system. Beyond that, the bigger question is - so what? Spend a good amount of time understanding a business and its moats - IP or otherwise. Just because a market is lucrative doesn’t mean that traditional incumbents will fail and start-ups will win. We just need to look at how nimble Reliance Jio has been - in OTT and Retail - to know that this market is open to anyone. Start-ups usually have a steeper learning curve than traditional corporate firms. If these moats aren’t twice as strong and foolproof as those for traditional companies, that enterprise isn’t worth your time.?

Third, for investors,? let me paraphrase Ganesh Gaitonde from Sacred Games here “ Bade VC ke due diligence ke sahare mat baitho. Kya pata wo tumhare due diligence ke sahare baitha ho.” (Don’t depend on top VCs' due diligence when you are looking at an opportunity. You never know they might just be depending on yours to make theirs!)

In these markets, just because a large VC is backing a start-up doesn’t mean that you shouldn’t ask questions around risks that are pertinent to you. Aside from the prevailing nihilism that is a problem, each investor might be playing a different game in private markets. Some might raise a large fund, quickly deploy it, ride on a fad, exit in the next round and raise an even larger fund again. Others, most likely you, might be willing to buy and hold the company until it goes public. When the tide of easy money recedes and numbers take over narratives, it might be you who could end up eating the bitter pill.?