After calling food-tech the second coming of the Indian start-up, the community has sort of taken a U-turn. As highlighted in my previous post – Act 1: Boom–The Opportunity, there is enough depth in the market for companies if they focus on chasing the right metrics.
We are experiencing the second phase of a Boom that I’d like to call: The Shakeout. Simply put, it’s a reduction or elimination of competing businesses or products in a particular industry. Or as Investopedia defines it: a situation in which many investors exit their positions, often at a loss, because of uncertainty or recent bad news circulating around a particular industry.
Here is what I think led to the shakeout:
Wrong valuations: Many investors argue that young companies cannot be valued. Perhaps, but you could pick-up a thing or two from a company’s early success and failures, like: an investor could at least estimate expected earnings and future cash flows. One may argue that valuation in these circumstances is only a tug-of-war between speculation and fatigue but the best way to overcome this, is to focus on the short-term and ensure that the company delivers on the near-term results. It appears that many investors had not articulated the short term metrics of evaluation to the founders when they funded them. The shakeout is perhaps an opportune time to have those conversations.
Not all money that a company raises is raised in one go or at the same valuation. A ‘Series A’ investor, who participates in the company's first round of venture capital (VC) financing, pays a significantly lower price than the ‘Series B’ investor, who participates in the second round. This can be attributed as the price of growth. So, if there is a price of growth, is it difficult to assign a value to this growth?
Most investors develop a tunnel-vision and believe that technology can be scaled indefinitely. In some cases lofty valuations have only led founders to dilute their stake to protect old investors against dilution by new investors. This gives old investors access to the founder’s shares for free. Founders are far less incentivised due to the reduction in value of shares and the potential upside opportunity. This is where most of the founders who diluted early on in the funding game are going to find themselves very quickly.
Fundamentals: It’s possible that this shakeout is driven by compromising fundamentals. We all understand that growth needs to be funded and new businesses consume cash; but at the end of the day, a business needs to generate profits and cash. No company can expect the investors to fund the losses indefinitely. And at times, entrepreneurs’ mistake funding as revenue. No matter what changes, true business fundamentals that lead to success do not change. All lines of businesses or all markets may not turn profitable but every transaction at some point should be profitable. Start-ups are now forced to meet break-even in certain markets or lines of businesses before they can expand further.
Bad unit economics: Milton Friedman said, “There's no such thing as a free lunch”, but one after another, there were companies lining-up giving discounts to the customers using VC money.
Let’s assume the average commission of every online ordering service to be 12.5 per cent and the average cost of an order to be Rs 500. So, it is too less to pay from Rs. 62.5 that a start-up earns for the deliveries (Rs 20–40) and offer discounts (Rs 50–150). This leaves very little or no money with the start-up to fund its costs. The customers lapped away the best deals, redeeming free lunches while the VCs are now left cleaning-up the mess. The start-ups were also spending ridiculous amounts of advertising money chasing customer acquisition and market share. These start-ups had failure written all over them right from the start. This needed course correction.
Little Differentiation: The later entrants didn’t have a different strategy and business models. A me-too product with few differences makes no sense. Start-ups today are forced to think about what makes them unique for customers and restaurants to use.
Aping the US and China: VCs who looked at the US and China believed that start-up ideas that are successful abroad are bound to be successes in India. However, as of today, Yelp has lost over 75 per cent of its market cap and GrubHub has lost 40 per cent from their peaks. There is plenty to learn from them and start-ups need to re-evaluate their business models.
But let’s not lose hope. A shakeout as early as this in the game is only good. A lot of careers are protected and little value destroyed. This is an opportune time for larger start-ups to explore acquiring great teams and an amazing time for smaller entrepreneurs to learn from the mistakes of others. As for investors, they can roll-up their sleeves to get their house in order.
(The author of this article is Pradeep Prabhu – Co business head, BURRP. The views expressed here are solely those of the author and do not in any way represent the views of the publication)