Authors : Vikram Ojha | Sanchit Bhatia

 A Unicorn, in simpler terms, is a start-up company with a valuation of $1 Billion or above. India, post 2014, has significantly focused on the ease of doing business within the country. With a favourable shift in investor sentiment, India has encouraged many startups to successfully raise money through subsequent rounds of fundings. Amongst the investors, Accel Partners, Sequoia Capital, Tiger Global Management and Intel Capital are the four major contributors that are shaping this Unicorn boom in India.

Over the last few years, the startup boom in India has witnessed an unprecedented flood of funding that has led to some people questioning the high valuations given to many startups. In the Indian startup industry, there are now nine unicorns - private, venture capitalist backed companies valued at more than $1 billion - namely: Flipkart, SnapDeal, Zomato, One97 Communications (Paytm), MuSigma, Quikr, Shopclues, Inmobi and Ola. There are many other startups aiming for sky high valuations and the unicorn status. Most of the current unicorn firms are struggling to justify their valuations and present a sustainable and profitable business model which has led to many critics calling it another tech bubble that is waiting to burst.

Challenges for Unicorn Startups

• Devaluations: Many startups have been devalued during funding rounds, leading critics to question their sustainability. Even globally, tech giants such as Facebook and Twitter have been devalued. Recently in India, both Zomato and Flipkart have been devalued. HSBC slashed Zomato’s billion dollar valuation by 50% using a Discounted Cash Flow model and asserted that Zomato was not profitable in any of their 23 operational markets. Further, Flipkart has been devalued six times already in 2016, from $15.2 billion to $9.3 billion. Lower valuations have provided a reality check for unicorns and impede their marketing, customer attraction, staffing and pricing strategies. Most of the technology based unicorns have not shown profits in a single quarter and yet have significantly higher valuations than other traditional established firms simply based on customer growth rate, GMV and speculative future earnings. One may wonder that how is the valuation still surging? This question not only questions investor confidence but also warns the players about a potential startup bubble.
• Operational Models: Most of the unicorns in India have achieved this status by burning cash. Growth, Gross Merchandise Value (GMV) and customer acquisition was prioritised over operational profits. Funding has been used by startups with a focus on increasing their market share by way of deep discounts. The deep discount led model is no longer applicable in the current startup ecosystem. Investors are now looking at real value and returns from their investments. Venture capital firms now require startups to focus on effective capital utilization and improve cash flows. This has also resulted in a lean approach to staffing with lesser employees and lower compensation packages.
• Consolidation: Many hold the view that the future of Indian startups is consolidation as the existing business models and multiple competitors are simply not sustainable. There is overcrowding in the technology startup space with many firms offering similar services. Smaller startups are being acquired by the bigger players with the objective of increasing market share and inorganic growth as witnessed by the acquisition of Myntra by Flipkart, Commonfloor by Quikr, TaxiforSure by Ola etc. As per NASSCOM, since October 2015, 65 startups have been acquired by bigger players. Also, many of the cash rich unicorns are expanding their existing lines of business to compete with other technology startups as seen by the food ordering service started by Zomato that competes with startups such as Foodpanda and Swiggy as well as the entry of Ola in grocery delivery competing with Grofers and NatureFresh.
• Key personnel exits: Indian unicorns such as Snapdeal, Flipkart and Ola have all witnessed senior management exits. Some of the key reasons for these exits have been the lack of systems and processes in place at most startups, lack of decentralization, authoritarian decision making by the startup founders, unrealistic and unachievable targets and the high-pressure work environment. None of the prominent indian startups have a professional CEO, having the required experience of leading a company, and are instead run by the founders struggling to match the expectations of future returns by the investors.
• Competition: The entry of foreign players has resulted in loss of market share and is a real threat to future sustainability. Amazon with its war chest of $3 billion for the year has intensified the competition for Flipkart, Snapdeal and Shopclues in the e-retail sector. Uber has also provided stiff competition to Ola Cabs. These foreign cash rich competitors can offer deeper discounts, attract top talent and advertise extensively which leads to erosion of the market share held by the Indian unicorns in the particular sector.
• Location: Currently in India, out of the 9 major unicorns, 5 are located in the state of Bengaluru. Quikr, Flipkart, Ola, InMobi, and MuSigma all have their base in the tech hub of India. With the right talent pool (by the virtue of large MNCs and their R&D operations in the state), large network of investors, peer-learning from other startups and a comfortable weather year-round, Bengaluru provides the right combination of factors, which ideally fosters the growth and expansion of a startup. Further, the level of competence and expertise possessed by the engineers in Bengaluru, which serves as a backbone to the $146 Billion IT Sector of the country, is relatively much higher than the other states.
• Valuation, Funding and “Full Ratchet”: The biggest challenge of them all is that of correctly valuing the firm. The success for every subsequent round of funding depends on the previous round’s investor-valuation of the firm. For instance, a company called ABC Ltd. successfully raises Rs. 2 crores from Bob, an investor, for a 10% stake in the firm. This transaction values the firm at Rs. 20 Crores post-money (i.e. inclusive of the investment amount, so in this case the pre-money valuation for ABC Ltd. is 18 Crores). Now, let’s assume that ABC Ltd. is unable to perform effectively and requires additional funding. Further, another investor Kim decides to invest in the firm but on one condition - the pre-money valuation of the firm should be 15 Crores. Now ABC Ltd. is faced with a problem wherein the second-round investor Kim has a conflict of interest about the firm’s previous valuation. This would mean that Bob’s existing share of 10% at Rs. 15 crores will now be valued at Rs. 1.5 Crores. To protect themselves from such a downside, Investors usually incorporate a (put) option in their original investment contract. One example is that of a “Full-Ratchet”, which suggests that the original investors ( the founders of the company) will compensate the investors of the firm in case of any devaluation faced by the firm in any subsequent rounds of funding. So in our example, if Bob were to have a full-ratchet option in his contract, then ABC Ltd. would compensate the loss in value of his 10% share i.e Rs. 50 Lakh (Rs. 2 Crores - Rs. 1.5 Crores) in the form of additional stake within the firm.

Therefore, it is imminent for startups to devise a stringent set of policies and procedures to correctly value the firm in order to avoid such conflict of interest between its investors and thereby not hit a “valuation wall” i.e. Investors refusing to put up money at existing headline valuations.

While the Indian startup ecosystem is showing signs of increasing maturity, the days of unlimited growth by burning cash seem to be over, with investors keep on realising returns on their investments and calling for efficient cash utilization. Unicorns need to start justifying their high valuations through operational profits, growth in key markets/segments, scaling businesses through global expansion and providing enhanced customer experience. They need to focus on innovation with an eye on sustainable growth. That is when they will truly establish themselves as solid business enterprises.

References

CBS Insights (2016), “The Unicorn List: Current Private Companies Valued At $1B And Above”

Harvard Business Review (Jan-Feb 2016), Entrepreneurial Finance “How Unicorns Grow”

Livemint (2016), “The true value of Indian unicorns”, “Have Flipkart, Snapdeal hit a valuation wall?”, “Unicorns: The new normal”, “The battle of Indian Internet unicorns”, “India’s e-commerce start-ups are setting a dangerous precedent”, “Flipkart valuation marked down by Morgan Stanley fund to $9.39 billion”

Times of India (2015), “Bengaluru is home to 5 of India's 8 unicorn startups”,

Economic Times (2016), “How startup funding is consolidating in India”, Merging Flipkart, Snapdeal the best way to beat Amazon”, “Indian creators of global unicorns to come calling”,

Nasscom (2014), “Tech Start-ups in India: A Bright Future”

Financial Express (2016), “Startups: Consolidation, customer experience to be key in 2016”, Flipkart, Snapdeal, Amazon: As competition intensifies, investors turn cautious”
Financial Times (2016), “India’s newest unicorn targets price-conscious", “Unicorns: Between myth and reality”

Yourstory (2016), “The great Indian VC challenge – more angels, more early-stage investments”

CNBC (2016), “Amazon plans $3 billion investment in India to challenge Flipkart, Snapdeal”