The coming Unicorn meltdown

This is a piece I wanted to write 2 years ago, when startup funding in India was at its peak and was to reflect my contrary views when talking to people in the startup ecosystem. The current negative news around Byju’s and other Unicorns will make this article dated. While I cannot say `I told you so’, I believe some of the following points have not been adequately covered in the media and are relevant to understand what might happen with Indian startups.

I believe we’re seeing the start of an implosion in the Indian Unicorn world. This has the potential of affecting companies in the real world, rather than only the parallel universe the Unicorns seem to exist in. A google search will have innumerable articles on a `funding winter’, fewer startups being registered and funded etc. However, there are some more sobering statistics which are not reported – instead there is an obsession with valuation.  

There are approx. 90,000 registered startups in India.
About half are active i.e 45,000. 3 in 7 do not last more than 3 years.
Barely 4500 of these got any funding (10%).
There are under 500 startups with a turnover of $10 million and 60 with a turnover of over $100 million.

Only 23 of the 90 Unicorns are profitable. It is unlikely that a larger proportion of companies with a lower turnover than a Unicorn would be profitable. If 25% of startups with a revenue of over $10 million are profitable, we have a universe of just 125 profitable startups of any significant size in India. This is far too small for startups to continue to attract the kind of funding they have.
40% of startups in the US are profitable.

The number of articles that talk of valuation is exponentially more than those that mention turnover (with profitability being almost a taboo subject). While articles on revenue mention how fast Indian startups are getting to $ 100 million (which is mostly a function of how much money they have – to spend on marketing and discounting) but hardly any news on how many get there, or if they are any closer to profitability.  

What we are seeing now in Byju is what has affected many other startups. The blame cannot be confined only to promoters, but all those who have deluded themselves into believing in the Indian Unicorn story.
I think the following are areas the startup ecosystem should introspect over.

Investors: Most funding of Indian startups comes from abroad and is dollar denominated. Because startup funding is more risky than investment in mutual funds, a VC needs to generate a higher return.
The NIFTY in India gives a CAGR of over 10% p.a over any 3 consecutive years. The top quartile of mutual funds gives a 11% return after the investor pays capital gains tax.
The return to a VC would have to consider Rupee depreciation, Tax, carry and management fees. It would need to be a CAGR of 20% in Rupee terms or, in a 8-year (typical) life of a fund generate a 4X return on investment.  

 As a rough calculation, if one looks at total startup funding vs. the valuation of all startups at the end of 2022, the combined value of the investment of the VC has grown to 4.5X in 15 years. As most of this investment has come in recent years, I believe VCs are so far meeting the `hurdle rate’ of a 4X return.

However, after considering the ongoing drop in valuations of Unicorns and the difficulty of getting an exit through the IPO route – because most newly listed IPOs of well-known startups trade below offer price, VC funds who are invested in India are probably looking at a 3X return in 8 years.  This is a 15% CAGR. Even if this return is in Dollar terms, the return net of tax, management fees and carry would be under 10%. This drop in returns would, in my view would be as significant as increased interest rates in the US, which has reduced the flow of hitherto easy money at low interest, into startups in India.  

This is exacerbated by the fact that VC’s are under less pressure to show a profit in the course of their investments, since their investors are in it for the long term. Small bits of bad news accumulate until there is a large drop in valuation in an investee company. For e.g. Byju had a valuation drop by its major investors from $ 22 billion to $ 5.1 billion in a short period. This is a shock to the ecosystem, exacerbated by the lack of negative news, until a markdown happens.  When this is replicated in other Unicorns, there is little appetite for further investments by any investor.
 
Promoters:
The media is now replete with stories of scams, or gross inefficiency around investor money in a number of high-profile companies. For every company where misconduct is reported, there are probably several cases where the promoters have been enriched at the expense of the company, or committee offenses like not paying statutory dues. I have seen a lot of sick startups, but no sick promoters.  

Unicorns are run almost entirely by other people’s money (OPM). It is human nature to be `less careful’ with other people’s money, particularly when there is little supervision and growth (which is easily manipulate, when there is no need to show a profit) is the sole basis on which the investor satisfies himself that all is well with the business.

My sense is Angel and early stage investors are more connected with founders. They typically have experience in the Indian corporate world. The large VCs, based in the US, look at their Indian investments being part of a larger (India) story, rather than get into operational matters in an investee company.
 
I have seen startups where spending a day looking at their monthly report, or last balance sheet, or talking to their staff, would lead to a strong suspicion that funds are being siphoned away by promoters, or growth is manipulated. When the promoter sees that the investor does not have the inclination or the ability - if a review is being done by a kid just out of B school in the US, to take a close look at operations, it is an open invitation to misuse funds.

Lead indicators of lack of integrity of the promoter and top management of startups are often:
Delays in making statutory payments or filing statutory documents, nepotism, promoters taking ad-hoc decisions, bypassing their board or CEO etc. It is fairly easy to check compliance but rarely done by investors. I think it’s ludicrous if investors do not question the ability of a husband-wife team (with a relative co-promoter), to run a Unicorn – rather than just be on the board, while paying a lot of attention to the educational qualifications of managers hired 2 levels below.

There is a greater inclination to misappropriate funds, when the promoter knows the startup is not going to ever be profitable – something the investors usually realize after the promoter.

Instances of misconduct by promoters, reported in the media, has reached a tipping point – in terms of how Indian startups are viewed. When more time is spent on due diligence (as it should be), there may be more cases uncovered of a promoter in his previously failed venture, not (for e.g.) paying statutory dues, or misleading investors, or faking customer reviews etc.

This coincides with VCs starting to see that India will not give them their assumed returns.

The market size (too big is also a problem).
There are plenty of examples of startups misreading the size of the Indian market, but it is also a problem when the market is so large that either the govt intervenes to level the playing field (rather than cede the market to 1-2 players) or someone else offers a cheaper service. For e.g. payment through UPI is free, so the established players like PayTM & PhonePe can’t charge for it. No surprise that they make staggering losses (cumulatively 13,000 Cr for PayTM and 8000 cr for PhonePe)   

Consider for e.g. this alternative to Byju: If the Govt (either the Central Govt for CBSE schools, or the State govt), knowing that they cannot fund school infrastructure to the desired levels, decide to improve quality by the cheaper option of putting lessons on the cloud and letting any student with a smartphone access them for free. There would be any number of NGO’s (e.g. Teach for India) who can provide thousands of volunteer teachers, to help with students doubts – either Govt teachers can do so for say an hour a week for a small fee, or thousands of young professionals could volunteer to do so. The cost to govt would be a fraction of their education budget, while providing a 0 cost alternative to Byju. Moreover there is no evidence I'm aware of, that children have benefitted from Byju’s. Whatever happened to `proof of concept’ when pitching to investors?

Similarly ONDC is resulting in reduced margins for order aggregators like Swiggy and Zomato, as will
travel aggregator apps, run by auto or taxi unions.   

The turnover of the Govt’s e-marketplace – GeM, (something few people have even heard of) was 200401 cr for the year ending Mar 23. This was a 100% growth over an already high base in 2022.  
This was double of Flipkart, the highest valued Indian e-commerce company, valued at $ 20 billion despite being loss making.

The Indian railways ticketing portal IRCTC is consistently profitable while the biggest private travel portal in India is, more often than not, loss making, though it is no longer a startup, having been around for more than 10 years and listed.  There’s nothing stopping IRCTC to sell bus or air tickets, or low-cost hotel rooms, on their portal, cutting into the revenue and margin of already struggling travel portals.

In basic economics once is taught that in a perfect market i.e. when all buyers and sellers can access each other (which is what e-commerce enables), margins are lowest. However, investors assume 
margins will be abnormally high, without a drop in volumes, which is what assumptions on future earnings (and therefore valuations) are based on.  

The media (finally) wakes up.

It seems to me that the media coverage given to startup CEO’s was directly proportional to the loss their company makes. Google any Unicorn and stories about their valuation, or promoters lifestyle or `secrets of success’ (if getting a higher than deserved valuation is a success), will be far more than its revenue, while profit (or lack of it) will barely be mentioned.

A recent report about a startup in the Quick service restaurant category mentioned that its sales had doubled, while its loss reduced 10%. A close look at the numbers showed that its revenue increased because they almost doubled their number of outlets. The sales per outlet, adjusted for inflation remained the same. The restaurant was supposed to have a gross margin of 75% and even after restaurant overhead, should have generated enough of an operating profit to cover its corporate overhead. In reality there was only a 10% reduction in losses. This kind of reporting is, sadly, the
rule rather than an exception.  

Have any of the sharks on the very popular Shark Tank India have actually built and run a profitable company? If being a shark is all about the valuation and not profit, it’s not a good role model for a new entrepreneur.

Many business magazines have `startups of the year list’. Having featured in them, my impression was it was about PR than any serious study of the startup. I wonder if it is just incompetence, or the realization that they got it horribly wrong, that prevents these publications to do a follow up `what they are doing now’ story, or report on their business performance instead of obsession with valuation. 

Many startups have reduced losses through non-operating income (not deploying funds that were raised). Losses of Unicorns are approx. 12% of revenues and would be higher for smaller companies of the same vintage. 12% may seem low, but this is after these companies have already reduced losses by tackling the low hanging fruit (reducing marketing spend, high-cost hires and overhead etc.) The time taken to overcome the last 10% may be longer than the investor is prepared to wait.

What will probably happen is that many of the Unicorns will cut losses enough to just survive and either conserve what cash they have left, while the investor hopes for an exit, or be marginally profitable, with a valuation to reflect that reality. 

The reason for my concern and what prompted this post, is that in the process of trying to grow and meet investor needs, the `brick and mortar' business face unfair competition. A large proportion of sales on Amazon and Flipkart for e.g. are not items in the `long tail' (that brick and mortar retailers don't stock) but items like mobile phones available at a lower price than any other retailer and which no one can match without incurring a loss. 

As I have argued in an earlier post, if Swiggy and Zomato have to grow, it will be at the expense of the (already very low) profitability of restaurants, or (if there is no sustainable competitive advantage) by cutting margins to fight competition - as true of a samosa chain as it is for a giant e-commerce company.