Startup India is a flagship initiative of the Modi Sarkar. It should give confidence that government is serious about this. But I am afraid it is blowing it. It totally babufied (bureacratized) the initiative and mucked with the market and played favorites. It celebrates the the totally silly “Unicorns”.
It is time to get serious here. India can’t afford to miss this boat too. Next one may be long time coming.
With WeWork, UBER and Lyft fiascos, people are starting to wonder what is going on. Here is my assessment…
In the beginning, there were founders, angels and VCs. Their job was to create a robust fast growing and a profitable company with proven markets. They needed more capital than the VCs could provide to scale up the company. There was also a need to provide liquidity to early players and establish a market value of the company. Hence, an IPO!
Underwriters were needed for an IPO to firmly underwrite an offering. They assessed the market and came up with a market price that they could get behind . They created the demand and built the book of customers.Stocks were then floated at a price which satisfied only half of the demand so there will be demand if somebody flipped the shares. Underwrites were required to stablize the market by stepping in if there was no demand and price started to sink.
I saw this process first hand and it worked like a charm. All this was great as the company’s had a lot of growing to do and a lot of value creation was still to be done. Public investors expected to see a rapid value creation and stock appreciation.
Then came the massively funded Unicorns. They took all the available VC money, then took the wall street money to fund further and they sold in the secondary markets to individuals. The price of the stock had no real meaning as the late stage deals were highly structured and had huge downside protection.
Companies are not proven and are still incurring huge losses. Founders and employees have already been cashed out and are living the rich life. The fire in the belly is extinguished. No more money is available from current investors so stock has to be foisted on the unsuspecting public!
How do you sell such a stock in an IPO? Current and future value is unknown and is very dubious. Stock is already widely held and there are really no buyers left in the market; everybody is waiting to sell!
Is it a fault of Wall Street bankers? VCs? Founders?
VC economics is very dire and requires a disciplined approach to provide satisfactory returns. The dirty little secret of the VC business is that most of the returns are made by top 10% of the funds, remaining 90% funds barely return the capital back after 10 years. Let’s do some math here…
Assume an early stage VC fund of $100 million, with typical 2% annual fee and 20% carry. It has a 10 year life, so it siphons off 20% fee over 10 years and will invest only $80 million, unless it recycles the profits from the early winners. A typical early stage fund invests in about 20 companies, and in this case on average about $4 million each, and will easily lose all its capital in at least half of its investments. So for it to return 5X to its investors after the carry, a good but not great return, it must produce 6X overall or 12X on its winners. But, since only 80% of the money is invested, it must produce 15X on its 10 winners. That means each have to produce $60 million return to produce $600 million so, $500 million can be returned to investors.
It is hard to imagine that all winners will produce that kind of uniform returns. As a matter of fact, fund returns are driven by a few winners, producing outsized returns. History shows that one or two winners producing 50 to 100X produce all the returns in the fund.
A good fund manager starts to starve its early laggards and nurture its winners. The goal is to deploy most capital in the emerging winners to maximize returns. This requires VC to watch their investments like hawks for early signs of trouble. IT requires discipline to make hard decisions of not spending limited resources of time and money, on your troubled investments. Resources are much better spent on your emerging winners to increase their odds and size of winning.
VC business is simple but heartless. You push your losers to fail fast without consuming much capital and you push your winners to achieve their full potential.