Anatomy of the coming Bubble Part 1 and 2
From
Bay Area to Bangalore, if there is one word which is stirring the fancy of the
masses in general and analysts in particular, “Startup Bubble” seems
to be that word! It doesn’t matter if you are in the crowd or away from the
crowd, bubble is bound to get into your radar, be it at a conference, Twitter
feed, newspaper columns or random article forwards.
At
one end of the spectrum, there are the believers, led by big bulge VCs
riding their unicorns, chanting data and waving neatly presented big graphs
showing mobile phones’ sales growth, internet data usage, volumes of WhatsApp
messages, number of photos clicked and other mind-numbing metrics and
speaking loudly as to why it is not 2001. However as it generally happens, the
other side, consisting mainly of newspaper columnists, accountants, finance
professors, out of work CEOs and some missed-the-boat-VCs/entrepreneurs, is not
amused by all this mumbo jumbo and looking wryly at daily funding news and
murmuring loudly to anyone who cares to listen, about these crazy valuations,
lack of profitability and unsustainable business models. For them, the 2001 dot
com bubble is very much here and that too in a 10 times bigger format. Not to
be left behind by the VC crowd, they have their own set of anecdotes,
stories and data graphs though from 2001 era.
This
war between valuations and sustainable business is not new or started this year
or last year but has always happened whenever there is a significant shift in
asset prices. In fact the talk of startup bubble stared way back in 2011,
when Uber, leader of the present Unicorns raised $12 Mn at a valuation of
$60 Mn and Wall Street Journal published an article with title, “In Silicon Valley, Investors Are Jockeying Like It’s 1999”.
Four
years later, with Uber valued at $50 Bn, the noises have only grown louder
and bigger though Uber has not shown any slowdown in growth or in its ability
to raise billions of dollars while growing by a whopping 800 times in less than
5 years.
Interestingly
the division is deep and lines are clearly drawn as each group has its own
set of believers, followers and relative data to back.The whole argument has
slowly turned into a debate of the deaf where each party is consumed by their
own arguments without understanding the counter point.
The
main reason as to why the general public, commentators and all those business
leaders are wrong in prediction of the Startup bubble burst is mainly due to
their limited or rather skewed understanding of the way venture capital world
operates and how the dynamics of the VC world has evolved in the last 2 – 3
years.
These
jaw dropping valuations splashed everyday around business dailies are fuelled
by mainly two set of investors in the venture space – the early stage investors
investing just after Seed round or late stage investors investing at 500
million plus valuation rounds. Interestingly both parties are feeding to each
other in a self fulfilling prophecy.
In
recent times, the availability of liquidity and declining gap in innovation has
created a scenario where investors believe that capital, rather than
innovation, has the edge in building a leadership position.
In
recent times, the availability of liquidity and declining gap in innovation has
created a scenario where investors believe that capital, rather than
innovation, has the edge in building a leadership position. This belief in
primacy of capital over innovation has fundamentally changed the usual
performance based investing model.
Hence
in a scenario, where there is no technical edge or technical risk in the
product, the investors are trying to eliminating market risk by investing 100s
of million dollars in these ventures as they believe that capital will create
entry barriers and will give the invested company enough power to scale to
formidable heights.
This
fundamental shift has changed the way earlier VC rounds used to work. The days
of of multiple venture rounds based on the performance / execution capability
of company, have been replaced by much simpler three main rounds. First round
of $300K to $500K happens at MVP (minimal viable product) stage, which is
followed by Seed round of $2 Mn to $4 Mn and is done for validation of
hypothesis and building some traction. However post validation of hypothesis /
execution capabilities, the third round is happening in the range of $20 Mn+
and going upto $100 Mn.
This
round of $20 Mn to $100 Mn range is also called as the ‘Scare Round'
This
round of $20 Mn to $100 Mn range is also called as ‘Scare Round’ as it
scares the competition, chokes further supply of money to competitors and aims
at a land grab in a validated market opportunity. As one can easily see, this
scare round of capital/ valuation has hardly any correlation with the revenue
of company and thus gives a crazy sense of valuation to the usual public which
does not understand that this large round or scare round is not related to
performance of the company but rather related to the size of opportunity and
ambition of investor in owning the particular market opportunity.
So
if it is early stage investors who are creating this false sense of bubble
through their scare round commitments and by giving valuations with little
correlation to present revenue numbers, the late stage investors are creating a
sense of bubble by taking very large risky bets at crazy valuations. These
monster rounds are creating a sense of euphoria as well as a bubble where it
seems to the army of commentators that investors are a bunch of morons who are
again driven by greed and ignorance and are being icarus. However unfortunately
our commentators don’t know that all these investors are deriving their
happiness and courage for investing at such crazy valuation from a quite
standard legal clause hidden in voluminous share holder agreement (SHA) knows
as LP or “Liquidation preference right”.
Liquidation
preference clause (LP), a standard VC industry legal clause, is used to protect
investors from pre mature exits as well as downsides given the risky nature of
business. However hedge funds have discovered a totally new use of the LP
clause. LP clause gives investors a huge downside protection while guaranteeing
return in upside thus converting an equity instrument into more like a superior
debt paper which has strong downside protection but unlimited upside. This
unique scenario where very large companies are staying private and needs loads
of capital has attracted hoards of hedge funds who are using the LP clause to
ensure healthy returns even in the case of a downside e.g. if a company
raised $ 300 Mn at a valuation of $5 Bn with 2x participative LP clause, the
investors will make $600 Mn (2x return)even if the company is sold at $600 Mn (
a steep 88% drop in value), a rare probability for large companies. Hence the
large amount investing is becoming like capital protection betting where one
can gamble as much as one can with capital guaranteed.
This
clause along with the fact that a large number of companies are choosing to
stay private while consuming loads of capital has created an ideal play ground
for hoards of hedge funds, which are anyway flush with liquidity and looking
for new areas for investments.
No
wonder this kind of utopian scenario is getting capital by drove and every week
we are witnessing announcements which are much bigger and audacious with
Unicorns becoming the new normals in the startups hinterland.
However
if the general public is missing the argument due to lack of understanding of
basic dynamics of the VC industry, the VC community is not far behind in
mis-calculating the fail safe nature of their investments by over estimating
the capability of capital, underestimating the human spirit and assuming
deterministic solutions to a problem.
Overestimation
of capability of capital is creating a scenario where investors are led to
believe that capital will breed innovation as well as help in scale and build
walls of defence. However as it happens in the laws of nature, the best laid
plans go haywire and works counter intuitive as its not the capital but
generally lack of capital which breeds innovation and creates focus.
Housing.com is a perfect example of capital going nowhere in building a powerful
business and hence walls created by capital will only force the sharper
downfall of the business due to the very weight of the wall.
Walls
created by capital will only force the sharper downfall of the business due to
the very weight of the wall.
Further
by underestimating human element there is a false sense of belief in first
mover advantage in low innovation fields. History has shown that first mover
advantage is the worst advantage in low innovation fields as traditional
players are able to catch up with the first mover by copying the low threshold
innovations in the long run. As venture investments are not a sprint race
but a marathon of 7-8 years, a lead in first two years is of no significance as
founders of FashionandYou can attest. Hence the no brainer sectors which are
attracting capital by droves will also see the maximum casualties in the long
run – be it hotel room aggregators, food delivery market places or asset
leasing models – as traditional corporates will play catch up or new solutions
will emerge. The other problem with large ticket investments over a very short
time period is the folly of taking a deterministic approach to a problem as
solutions are still in the evolution stage.
Remember
mobile pager market or a taxi operator like Meru Cabs which is perfect example
of low innovation field challenges as well as changing business dynamics. At
one spectrum, Meru faced constant challenges by new players due to low entry
barrier where capital was the only wall of defence while at other spectrum it
has been obliterated by new solutions like Uber which just made the classic
business of leasing cars and renting them out totally unviable.
Hence,
only time will tell if this massive shift in asset prices is going to be a type
I error (a false positive) or a type II error (false negative) and whether VCs
will have the last laugh to the bank or will end up facing analysts with
a smirk on their faces!! Till then enjoy the irrational exuberance of
these interesting times. Ah the coupons!!
Anatomy of the Coming Bubble-Part 2: Its all
about color of Capital
The
great Startup bubble has finally burst or so the experts would like
us to believe as the evidence (as per them) is mounting day by day. Around 1500+
employees at various startups in India have been laid off. One of the
Founders was held hostage in Pune and worst of all, the biggest proof, a
certain CEO had to send a strong email to his sales team on missing their
quarterly sales target. No its not any ordinary sales target, it was
the Quarterly Sales Target. Generally in other sectors, companies fold up
when they miss their targets, but damn this VC money, such non-performers are
still in business despite missing their top-line goal.
So
missing sales targets, 1500 jobs lost and angry employees laying a siege
to the CEO!!! What more proof do these moron VCs need, wonder our
expert commentator(s) / analyst(s). Interestingly, all these arm chair
experts, with all their analysis, comments and advice are no where involved
with startups/VC world in any manner, (barring few angel investors) but
nonetheless have great insight / perspective on every thing startup, be it
business models, path to profitability, unit economics or any other thing under
the sun except probably as what makes these dumb VCs from la la land to give up
millions of dollars to these kid entrepreneurs who are still learning the ABCD
of business. (signs of time, our experts will tell you).
The
bubble discussion is no longer a matter of perspective but has now
acquired shape of definitive reality, where judgement has already been
delivered. Now everybody in the crowd is just waiting with baited breath for
the big bang slaying of the unicorns, while the experts like seasoned matadors,
are taking their time and using data to bring the Unicorns down, with noises
getting louder and louder with chants of “End is nigh” filling the air.
So
is the bubble really bursting or are we all over analysing things? An email or
for that matter any communication by a CEO to his sales team about missing
quarterly or annual sales target is not a bubble. It is a routine dressing down
or pumping up of teams as any sales director or CEO will tell you and missing
of sales targets or decline in numbers, don’t bring doom as GAIL or NIIT CEOs
can attest (GAIL profit dropped by 66% in second quarter this year and NIIT has
also seen some swings in its quarterly numbers in last 15 years, and no bubble
has burst yet). Same way loosing 1500 jobs is a sad but routine affair and is
almost a tiny drop in a big country like India where one startup is setup
everyday and some 600+ startups have raised capital in the last 18 months.
Loosing
1500 jobs is a sad but routine affair and is almost a tiny drop in a big
country like India where one startup is setup everyday and some 600 startups
have raised capital in the last 18 months.
Hence
these incidents are not a sign of the bubble but signs of the next phase in the
life of these startups as they meet reality of the business world and enter the
adolescent phase of life. Some will flourish, some may die and some will just
hang around but that is the usual darwinian world about survival of fittest,
not a bubble burst!
The
one thing the experts are missing while thinking of 2001, is the fundamental
shift happening in the world economy due to mobile / tech and automation which
is similar to the society transformation as it happened during the industrial
revolution. The impact of the present wave of innovation will be far more
severe, permanent and disruptive on the society. The change is real and is
happening, though a lot of arguments (Luddites, Software taking over jobs) have
remained the same as they were during industrial revolution. Unfortunately, we
all are looking at this new paradigm through our old coloured glasses of the
Industrial revolution and using the same metrics to measure new dimensions.
However
the single reason why this startup bubble won’t burst despite questionable
business models of many players, is nothing related with massive machine
revolution, or new business paradigm but a simple technical matter that is “Color
of money” or simply put “type of capital” being invested in these startups. In
2001’s dotcom bubble, which continues to overshadow all the advances made by
internet businesses, almost 90% of the companies were listed and were funded by
public money while in 2015 the numbers have just reversed as almost 90% of the
companies are funded by private capital or the alternative investment pool.
This private capital coming from alternative investment pools seems quite high
but still is a tiny fraction if one considers the overall investment capital
pool.
However
the single biggest reason why this startup bubble won’t burst is because of the
simple technical matter of the “Color of money”!
In
recent times, AUM with alternative investment pools has been growing at a
healthy pace, however it still constitutes less than 25% of all asset class.
Further this 25% constitutes Real Estate, Hedge Funds, Buy-out funds, Energy
& Commodity funds, Private equity (Venture capital is tiny subset of
Private equity), and hence money invested in tech companies (through venture
capital and some hedge funds) is tiny compared to overall investment pools. To
give some perspective, Venture funds in the US invested close to $48 Bn in
2014, and all over world the total capital deployed in a year is less than $60
billion while in 2008, the money allocated by USA Govt for bailout of banks was
$700 Bn (actual amount came to $460 Bn). Hence liquidity is not going to dry up
very soon, as money flowing in the venture / new tech space is still very
marginal and even few losses here or there won’t shift the needle.
The
second big reason or rather main reason due to which probability of a bubble
burst is negligible is that on account of investments by VC/PE industry, these
companies are remaining private without any need to access public markets and
as of now there is enough capital waiting on the sidelines to keep these
companies private for the foreseeable time.
So
how is this private capital impacting the bubble burst? A bubble burst in
any economy is defined when there is a sharp contraction in the value of an
asset and when this contraction is happening across sectors with the majority
of assets. This sharp contraction in value is generally driven by liquidity
crisis as survival of a business generally is not a function of business model
but rather that of liquidity in the system (some may argue that liquidity is
function of business model but that is not always the case).
Now
this liquidity crisis is created either by a debt call or a sudden crisis in
the environment which creates panic and overall negative sentiments and thus
ends up choking money supply to a company.
A
liquidity crisis can hit any company, however a privately held company is in
much better position than a public listed company in handling it. Since listed
companies are under intense public glare, quarterly earnings and disclosure
norms sometimes perpetuate a liquidity crisis as any miss in
revenue/profitability estimates or cancellation of a large contract create a
run on the stock and in turn leads to crisis with an already struggling
business. Discourse norms/insider trading rules create inherent
disadvantage to a public listed company in the following manner:
a)
Other than management, no body has access to financial performance and hence a
bad quarterly result can create massive shock / panic due to sudden drop in
stock value.
b)
As almost all data, escpecially negative ones is in public domain, management
has not much room to manoeuvre/ hard bargain with investors.
c)
Short sellers /option traders perpetuates the crisis by short selling thus
creating a further run on the company stock. All these actions lead to sharp
drop in share prices which in turn create a panic among all stakeholders i.e
suppliers, creditors, clients, customers employees and investors.
These
kind of shocks further put pressure on other companies in the same sector and
many times lead to a contagion effect if that sector is facing strong headwinds
and may result in re-rating of sector thus leading to massive drop in asset
value. These actions leads to chaos as mob mentality takes over the rationality
and completely chokes the money supply resulting in unwarranted fire sale or
financial crisis.
In
comparison to public listed companies, a privately held company is generally
protected from all the trauma caused by pressure of quarterly earnings,
disclosure norms and public glare. All this restricted public info gives an
inherent advantage to unlisted companies when it comes to negotiations for
capital, terms as well as in managing information flow etc. Moreover, as
the investors are much more aware about the direction and performance of
companies and are generally in knowledge of the crisis in advance, they are
able to work out solutions while closely working with management – be it fund
raising, M&A or right pricing the company stock as we saw it happening with
startups like Myntra, LetsBuy, TaxiforSure etc were acquired without.
Hence
the possibility of a large scale panic where majority of startups will go bust
is remote for the reasons mentioned above as investors / founders will continue
to negotiate and create liquidity situations in case of strong headwinds
without external panic. They will also be helped by the fact that the amount of
capital deployed & the value of business is not more than 25% (Uber valued
at $50 Bn+ has raised $ 8.2 Bn (16%), FlipKart valued at $15 bn has
raised $ 3.15 Bn (21%)) and emboldened by LP clause, more and more hedge funds
are waiting at sidelines to enter these markets.
However
it does not mean that no company will go down under as the private markets work
in a discrete manner showing bursts of activity, then freeze and then again
hectic activity. The evidence of this can be seen from the investment pattern
as seen in Indian ecommerce market where after showing initial euphoria in
2011/12, funding market just froze for ecommerce in 2013 and then again became
super active in the later part of 2014. Hence rather than a bubble burst, we
will continue to see these cyclical investment patterns and any company with
not enough cash to survive these short bouts of nuclear winter will go down
irrespective of business model, insane consumer happiness, superior unit
economics or growth as we have seen with IndiaPlaza.com and host of other
businesses. If there would have been a bubble, all of the companies would have
been able to raise money at their terms but we are yet to see evidence of this.
It
will be good for experts to remember that an asset bubble is more a function of
the nature of capital deployed rather than that of business logic. This
behaviour probably explains why the Indian real estate bubble never burst so
far and in fact will never burst despite noises being made about this burst
since 2006. In India, debt by PSU banks is almost like quasi equity which is
permanently structured and can never be recovered due to over friendly regime
of bureaucrats, policy makers, politicians and Indian courts (lender to
KingFisher can very well attest to that). As the debt is never called, it does
not create liquidity pressure and all we witness is cyclical market movements
(hectic activity and total freeze) while maintaining the asset prices at nearly
the same level.
Hence
contrary to common perception, no bubble is going to burst but a Darwinian
world will continue to evolve in the true sense given the nature of capital as
well as of the market. For the experts, keep writing and voicing opinions;
after all what is life without talk and gossip, only a few vices are allowed
after all without any medical warning.
