Thoughts on what ‘venture capital’ could mean for retail investors in ‘capital markets’
In case you’re wondering what Venture Capital has to do with the capital markets when both are different sources of financing for a company, tag along.
I am sure multiple times you’d have come across news pieces mentioning how a start-up has raised money from Venture Capital firms like Softbank, Sequoia Capital, Tiger Capital.
In case you don’t know what Venture Capital is, we have you covered (in case you know, feel free to skip the para). Suppose tomorrow you get a brilliant business idea and get into the market with your own money and some arranged from friends/families. A year later, you see that the business is growing, and there’s some real potential in the plan if it can be scaled. At this point, you need more capital, but individually, you don’t have the resources to arrange for such funds and expertise to scale the business. Enters a VC firm, tells you not to worry about funds and that they see real potential in your business. They would give you money in exchange for some ownership of your business (called equity, remember finance 101?). You can run your business with that money, expand, and the VC company would make money by exiting your company subsequently in further funding, acquisition or IPO.
Figure 1: Structure of VC funding (created by BiFluke)
Now let’s talk about the main story. The last decade has been a golden period for the Indian start-up ecosystem with an influx of private capital seen as never before. As of 2019, we have 24 unicorns (valuation above $1 billion USD) as compared to 1 in 2010 and 6 in 2016. 2019 also saw the highest venture money inflow in India. The figure below showcases the unicorns in India and their valuation as of March 2020. Observe how the unicorns have increased every passing year.
Figure 2: Year of unicorn status and current valuation (created by BiFluke)
With Unicorns not so rare, swelling valuation backed by deep pockets, and new deals made every day, it is a sign of success? (or excess?) What does it hold for folks like you and me?
Lengthened exits periods
Companies fueled by venture capital tend to remain privately held for more extended periods. With the number of funding rounds reaching up to series F and G (Series A means the first round of funding, B means second), the exit periods for the investors have lengthened, increasing the period the company takes before applying to an IPO.
Now, this increasing average listing age could translate into a decreasing number of IPOs/ years. A decreasing number of IPOs mean that retail folks like you and me, who want to put their internship stipends or monthly salaries to take part in the markets, are devoid of these businesses. Traditionally, secondary markets provide the funding impetus to the companies, but without the need of public capital to grow, these companies question the importance of capital markets.
Missed opportunity of being part of growth capital
The theory of the company life cycle states that there are four stages that companies go through in their overall existence – start-up, growth, maturity, and decline. Companies being listed on the markets would essentially go through the stages of start-up, growth, and then IPO for expansion in the growth phase. Investors put money in these new companies to see their wealth growing as the companies grow.
With the influx of Venture capital, as the average listing age increasing, declines the period of post IPO growth stage opportunity for the retail investors. What it means is that by the time these companies list, retail investors are devoid of being a part of the success stories by providing the growth capital. Retail investors can’t jump into the early high-growth stage of the companies where the multi-baggers are made.
It is imperative to understand at this point that the final exit for a VC investor is either an IPO or an acquisition by another company. Assuming that the later will make a firm cease to exist as an individual entity, our concern is what happens when such exits are made through IPOs? The arguments made above about fewer IPOs and not being able to become part of the growth capital are one aspect; the other is looking at what happens to our wealth post listing of such companies?
The troubling game of valuation
Venture capitalists’ whole game is termed to revolve around the ‘Hype’ they create. We see them creating powerful brands, making flashy news, and attract more rounds of funding. The more the hype grows, the better the brand becomes, and people have heard so much about the hype, nobody wants to miss it. This whole process creates more rounds of funding driven not always by value but by hype.
When such VC backed companies go public, retail investors become part of their hype. Markets, wooed by high VC backed valuations might promise a successful IPO, but once the dust settles, you and I are hit while the VCs walk out with attractive exits. You see, thriving in the markets without strong business models and positive cash flows is difficult. One might ask why such a problem exists in the first place? Short answer – Lack of discipline. VC-fuelled start-ups more often than not value growth more than cash flows and operating income. VCs value them on metrics that the secondary markets don’t understand. And the lack of accountability of these companies to the shareholders every quarter (which happens in a public company), feed their quest of growth while burning cash.
But markets are unforgiving; the overvaluation is corrected, eventually exposing retail investors to risks. It has been seen earlier in cases of companies like Uber and Lyft, which still haven’t turned profitable. Look closer, and you’d find the majority of the Indian Unicorns aren’t profitable, with some even struggling to have a positive unit economics model.
What happens when such planned exits by VCs through the way of an IPO fail to materialize? It's then we see VCs taking the burnt. Remember Masayoshi Son and the latest Softbank investor meet? Softbank made a loss of $17 billion on account of companies like WeWork, and Son said investment in WeWork was foolish. WeWork was valued at an astonishing $47 billion before the IPO. Last we checked; it went down to $2.9 Billion (more than 90% drop in value) according to SoftBank, basis discounted cash flows as on 31 March 2020. Had the IPO been successful, this correction would have been in the secondary markets, and there was a chance of retail investors like you and me losing our money in the markets. Scary? You bet.
Earlier when we said that the secondary market doesn’t understand valuation metrics, what we meant was that markets don’t buy into any metric. In the case of WeWork, the first questions analysts asked, was why WeWork valued as a tech company when the model is similar to that of a real estate company?
What do the foreign markets show us?
In the US, the late 90s and early 2000s was the golden period for VC funding. Silicon Valley became a hotspot and delivered some of the biggest tech companies that we see. Recent studies done to show both the average age, as well as the number of IPOs/years, has declined. Indian financial markets haven’t shown such characteristics yet. Still, given that the arrival of venture money India was not until the last decade or so, we might very well see it happen in the next 5-10 years.
Advantages of remaining private
One obvious advantage is the reduced answerability to the market. Consider Tesla, which is trying to drive its growth and scale basis cash burn. It is a good example of a company gone public and struggling to make investors happy (No doubt Musk tweets about taking it private). But there's more to it.
Companies today, need strategic relationships, expert opinions, talented manpower and most importantly business understanding partners as investors, all of which is fulfilled by VC investors. Private investors bring experience and knowledge base, provide strategic insights and help in further fund raising among other things. Hence a case could be made that VC investors are at times a better strategic fit for the companies than the return hungry passive public investors.
India hasn’t seen any of its unicorn listed on the stock exchange yet. Previous successful listing was that of Info Edge, Just Dial, Matrimony.com, Quick Heal, and, more recently IndiaMART. While Ola, OYO, Paytm have expressed their intention of going public soon, it will be interesting to see how the markets treat our first unicorn listing.
The reason for keeping it a story on how this would impact the retail investors is because, for most of the part, institutional and HNI investors can diversify by being a participant of the Venture Funds (refer to figure 1, these categories constitute the LLP - Limited Liability Partners). But I can’t invest my 50k of savings in these funds.
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