The OS of Start-ups and VCs is updating, dobara (a sequel)

I wrote an article at the start of Covid-19 (Mar/April 2020) “The OS of start-up and VC is updating”. Many of those observations and views you may still find to be relevant. However, a lot has happened since the start of CY22. Russia’s invasion of Ukraine and the ensuing humanitarian crisis. China’s large cities went into lockdown due to the zero Covid-19 policy, disrupting the supply chain even further. The inflation readings in many economies are at a multi-year high and in response central banks are raising interest rates. The above factors have increased uncertainty resulting in heightened volatility and caused deep correction in the public markets, particularly technology growth stocks which are considered as long duration assets.

While I hope all venture capital (VC) backed founders will receive a note from their investors, if it helps, this is what I wrote in the past. For founders, it’s advisable to?cut costs deep and at once. It may seem harsh initially but expect the worst of your scenarios to come true. The runway is all that matters, and it may compress quickly. At one end there is revenue loss with no?visibility on demand graph and on other end some costs are very sticky (contractual in nature, subscriptions) to get off your income statement. The other point is the?mindset of?acquiring v/s keeping. The capital flow generally promoted the acquiring mind-set – more hiring, more funds, moving in large offices, more channels, more geographies among others. In times like this, it is necessary to have a keeping mind-set and it needs prioritization – it could be team, customers, channels, vendors among others to ensure continuity and relevancy in the marketplace. It also matters?who is on your cap table?and how did your investor base build up over your journey. The more valuable you are (as % of investor (s) NAV’s) more support you shall seek and get from those investor (s). You should identify a champion among the board members to help you navigate, raise cash (if needed) and get quick buy-in from shareholders on key decisions. What is the bounty to win if you cross the line? Your company emerges stronger with fewer competition in marketplace for talent, customers and fund raising to exploit growth options including acquisitions.?

Though there is a sample bias by picking only one historical context, it may be worthwhile to revisit still. After the global financial crisis (GFC) in CY07/08, it took 4 years and 7 years for VC flows in the US and India respectively to reach their CY07 levels. Nasdaq performance, in the past, has generally been a leading indicator of direction of VC flows. The correlation between Nasdaq and private flows into VC & PE in India, between CY05 and CY21, is quite high at more than 80%. If that relationship holds true, then the private late stage start-ups, whoever fundraising, will see their valuation drop between 40% – 80% from their last round in line with the public markets. Publicly listed Coupang, the largest South Korean ecommerce with total sales of ~18bn in CY21, has a market cap of ~$23bn (after YTD correction of ~53%) which is now materially lower than Flipkart’s (total sales estimated of $23bn in CY21) last reported valuation of ~$37bn in CY21. Publicly listed Warby Parker, US based online and store-based retailer of eyeglasses with revenues of $540mn in CY21, has a market cap of ~$2bn (after YTD correction of ~61%) which is now materially lower than?Lenskart’s (total sales for FY21 ~$125mn) last reported valuation of $4.5bn in CY21. There are many such examples confirming the disconnect in valuations between private and public tech companies. Up till now, the sticker price for private late stage start-ups was being justified by pointing to ever increasing public market multiples. The re-pricing in late stage start-ups will happen, over the course of next 12 – 18 months, with every incremental $1bn getting invested at a new lower price. The late stage technology start-ups, from being arguably an indicator of success, are now skating on thin ice in the current environment. Even at growth stage start-ups (say Series B’s), if you had raised at 30x - 50x ARR (NTM), that is now corrected to 10x – 12x ARR. So, for a projected $5mn ARR start-up to justify the last valuation of $150mn - $250mn, they must grow their ARR by 3 – 4x times in the next 12 months. We did witness a funding winter in CY16/17, it was a blip when compared to today’s situation. However, even then, Flipkart had seen a dramatic correction in its carrying valuation ?by a particular Morgan Stanley fund, from ~$142 (then price per share) as of 30th June 2015 to ~$52 (then price per share) as of 30th September 2016 (63% drop over 5 quarters). As per this article, Flipkart did subsequently raise a down round at a post money valuation of $11.6bn (announced in April 2017), compared to its prior valuation of $15bn in a round raised in July 2015.?

It takes only one marginal investor to clear the higher price on the way up and probably also on the way down. However, on the way down given the vested interest which runs up & down the capital stack, it becomes extremely difficult to accept a down round for existing investors. Everyone including the founders just wishes that they don’t have to raise a round and somehow pass this storm. More than the ghost of down rounds, in my view, the real issue then and now for many of the late stage start-ups has remained the same – prospect of higher growth, sustainable unit economics and capital efficiency. Every investor will nod in agreement that an investment is worth the present value of future cash flows (including the terminal value), particularly when your investment’s starting point is growth or late stage. But there is a constant distortion to this framework. Each round has been priced off the following round, the whole stack, across stages. How did we manage to consume so much capital? ?I pin it to the collective ill-wisdom, to varying degrees, of VCs, founders and even LP’s. All have misjudged the market size and importantly, what it takes (in time & resources) to realize that opportunity. We have pushed the balance sheet’s capacity to absorb capital just too far and realize the disconnect with the fundamentals too late.?

By the way, VCs in India were relatively small in terms of dollar invested, when compared to PEs, leading up-to the time of GFC. Accel had announced acquisition of Erasmic ventures in CY08 to start operations in India and launched an India fund with a total size of $60mn! So, we in-fact have very few VC investors or operators, going back to GFC, who witnessed steep drawdowns, had an active portfolio back then and navigated successfully through that time. The excess liquidity did result in the rise of newer investors and start-ups to consume and channelize that liquidity. This led to a long stretch of ever-rising valuations. But the real question remains, did it create a secular change in the exit outcomes? I doubt that can be concluded so soon. Hence, the excesses of the top, both capital & talent, must get redistributed to the bottom right tail, from the late stage start-ups to early stage start-ups, which is what we are going through right now

If I were to describe the current situation to Indian founders and VC’s, I will be asking them to replay the 5th day of the 3rd test played in Sydney during 7 – 11th January 2021 between India and Australia. With victory out of sight, half of the batting unit back in the pavilion, wearing 5th day away pitch and injuries, what was needed was tenacity. In that match, tenacity was at display, an ability to deny wickets and stonewall for lengthy periods, session after session. The two batsmen, Hanuman Vihari (HV) and R Ashwin (RA), between them played 258 deliveries to achieve a hard-fought draw and deny Australia a win and the lead in the 4-match series. Ask any cricket enthusiast, for him/her, that draw was a win! India survived that match and eventually went on to win that series. In late stage start-ups, we have entered that 5th day of a test match. We need HV’s and RA’s as founders / managers, who care deeply about the long-term success of their start-up, feel responsible to their stakeholders and who can put their start-up out of the misery, on a 5th day, where most dread to bat.

(Disclaimer – views expressed are strictly personal)