From Vulture Capital to Victim Capital: Mahesh Murthy's Take on VCs in India

Do this.
First, make a list of India’s best-known start-up names: from Zilingo, BharatPe and GoMechanic to Trell, ShareChat, CRED and even Zomato, Nykaa and Paytm.
Then, go talk to investors and make a separate list of India’s start-ups that somehow screwed them over.
Both lists will have many of the same names. Here is the untold story why.

I have been a venture capitalist investing in India since 1999. I have seen our industry go from being welcomed to being reviled as vulture capitalists.

But founders have figured out that they now hold the cards. They have been giving VCs terrible returns and now, for a first, the VCs are slowly backing off.

You may have read that the capital invested in India is down 40% this year from $40 billion to around $25 billion. This is not from a shortage of money. There is some $10 billion or more of dry powder available, but VCs are not signing cheques in a hurry.

This is a warning sign that the India story is being re-examined. While the story itself is almost too big to fail, this recent trend is something that is sure to hold things back for a few years. In the long run, it might make things better for all of us.

From Pop to Fizzle

What do the charts on the right have in common?

They all show terrible performance in the market. These stocks are down 50% to 80% from their recent highs. The eagle-eyed may have discerned that these are some of India’s most feted start-ups to go public: Paytm, Zomato and Nykaa in that order.

One common reason blamed is the ego of the founders to take their companies public at unjustifiable valuations. Paytm had some $120 million in revenues and losses when it went public at a market cap of almost $20 billion: a multiple of over 150X of revenues and infinite times of profits.

Zomato showed $250 million in revenues and enormous losses for a $12 billion market cap—a 50X multiple on sales and an infinite multiple on profits—while Nykaa showed $20 million in profit on $300 million in revenues for a $13 billion market cap, a sky-high multiple of 40X on revenues and 650X on profits.

All of this while the Indian market typically supports a multiple of sales of between 1X and 5X and a multiple of profits between 10X and 25X.

On a sobering note, post the crash, these multiples have come down to aggressive, but not insane, levels of 5X, 7X and 9X. This is more affordable, one would think. But investors who lost their shirts on these stocks earlier do not trust them now and are not ready to come back into them.

But it is not just the ego of the founders that led to this situation. It was also the high prices they forced all investors to pay who had come in the layers of the pyramid before.

The Pyramid Scheme

What you see is the dunce cap—or topi—practice in the start-up business. Here is how it works.

At the bottom of the investing pyramid are the minnow angel investors who might put in anything from $15,000 to $150,000 to get into a start-up. They might invest via syndicates like the Mumbai Angels or the Indian Angel Network, which collate money and put in the first $1 million or so at a valuation of around $5 million to $10 million. This 10% to 25% dilution is typical at every round.

Not many realise that a company typically takes 20 years to hit an exit-able size. Angels and others cannot wait for 20 years to get their money back. So, they try to sell their stake to someone else as soon as they can. As a result, valuations for essentially loss-making companies start ballooning.

Up the slopes of the pyramid from angels are early-stage VC funds which have $50 million to $350 million under management. (Disclosure: I have run a couple of such funds.) They put in $5 million to $20 million at a valuation of $20 million to $100 million in each start-up.

VCs typically buy out angels and give them 5X to 10X exits. But not every investee can be sold to a VC, so angels may make this big profit in two out of 10 investees, which gets them overall, perhaps, 10% to 20% annualised returns in the long term. This ratio and return is common all the way up the investing pyramid.

VCs also have the same mismatch with the start-ups’ time horizon. They need to return money to their investors—the limited partners—in eight years. They too cannot wait till the end and look to put the dunce cap on late-stage VCs, who typically manage $400 million to $1 billion or more.

This topi happens at valuations of $100 million to $1 billion, the latter magical number being the “unicorn status” all founders, business papers and, now, politicians like to crow about.

But remember, the unicorn or soonicorn is still likely losing money at this stage. Its valuation is not justified at any fundamental level.

It is all minnows selling to salmon, and salmon selling to sharks—pardon the new metaphor—because each needs to show an up-round.

A Whale of a Problem

The sharks have to sell to whales for similar reasons. They do not have the patience to wait till the IPO either.

There have mostly been two whales in India: the baby whale Sequoia and the blue whale Softbank. These folks have been writing cheques of $200 million and upwards for valuations in the multiple billions of dollars. Most unicorns have come from their stables.

But whales need a topi victim too. Once whales come in at these stratospheric prices, the next topi is on you, the retail investor, in an IPO. Which is why these unprofitable companies we talked about come at insane IPO valuations.

These IPOs crash and burn, quite rightfully so. They will take many years, if ever, to come back to even their listing valuations. Let alone grow from there. This is bad news not just for retail investors but also for the whales. Many of them are locked in and cannot sell their stake for at least a year, while the companies continue to show huge losses.

Softbank and Sequioa have recently taken massive write-downs from their work in India. Softbank declared a $27 billion loss on its first $100 billon fund. This. Really. Hurts.

While whales are hurting, they stop picking up deals from the sharks. The sharks, once happy to keep feeding upwards, are now in a fix.

Now because sharks cannot give topi to someone above them, they stop getting topi-ed by someone below them. The salmon are in a fix. Eventually minnows are, as well.

Suddenly founders are being asked uncomfortable questions. Now they are expected to make revenues, and, in some cases, even real profits. This is not what they are used to do at all.

And the pyramid begins to crumble.

The Founders’ Flounders

The founders are not innocent bystanders. In the spirit of behti Ganga mein haath dho lete hain, they also partake in the journey. They figure that they will not lose out when everyone is reeling it in.

Founders take money out. Some do it legally, and some not so illegally. In my opinion, in either case, taking oodles of money out from your company while it is unprofitable is deeply unethical to the investors who funded you.

Some who did it illegally are well-known: one lady ran a popular fashion portal and took Sequoia’s money. She got her firm to pay her lawyer some Rs 70 crore as fees and—it is rumoured—got a lot of that amount directly back to herself as her cut. She also got her firm to pay Rs 10 crore a year to a public relations agency to have her profile appear as a glamorous CEO type, jetting in business class from one fashion show to another. All this happened while her start-up failed to earn even Rs 10 crore of gross income on farcically inflated revenues of Rs 300 crore while it was valued at over Rs 8,000 crore.

Men are not far behind either. There is the gent who got thrown out of BharatPe and wrote a book saying that the world is double-faced. His reasoning? Sure, he defrauded the company by having his wife’s human resource firm collect three months’ salary as fee for every single employee the firm hired, even though none were hired through her firm—all this while the company racked up Rs 6,000 crore a year in losses. His complaint is that it is hypocritical to call only him a thief when others in the ecosystem are small-time thieves as well. This is doglapan, we are told.

There are more examples. Trell is one. GoMechanic is another: its founders apparently “forgot” that they were actually making just a small fraction of the revenues they claimed and apologised for the tiny mistake in a LinkedIn post, while firing 70% of their employees and retaining themeselves at full salaries.

Another golden boy, ShareChat has taken Rs 14,000 crore from Google and other investors and currently earns Rs 29 crore a month while losing Rs 250 crore a month. This is slightly tragic for an eight-year-old company. The founders of these firms probably know where they are qualified to go next. To be judges of start-ups on Shark Tank’s next edition, one supposes.

Those Who Can’t Do It Become Angels

It is unusual that we celebrate such founders. TV show Shark Tank features as judges mostly folks who have never managed to turn a profit in their companies and are living off investors or daddy’s money. Shaadi.com, Mauj, Lenskart, Sugar Cosmetics, CarDekho and Mamaearth are loss-making companies. Their founders—who are start-up judges—are apparently the heroes our entrepreneurs should emulate.

But Shark Tank is not the only place where our loss-making, but rich, founders go. They also take their investors’ money and put it in other companies, not in the investors’ names, but as their own.

Among India’s top angels are Kunal Bahl and Rohit Bansal of Snapdeal, who burnt through $1.8 billion of VC money to show nothing for it. But somehow, they have loads of money to put in start-ups under their own names. There is also Ramakant Sharma from Livspace, who burnt through $400 million with—you guessed it—nothing in the way of profits.

There is Kunal Shah from CRED, which raised $800 million from investors to produce funny ads and lose $150 million of it last year. Anupam Mittal is from loss-making Shaadi.com and Mauj. Peyush Bansal is from Lenskart, which raised $1 billion to also make celebrity-laden ads while losing money.

Another prominent angel, Hemant Gupta, took Rs 900 crore in Yulu to make revenues of Rs 3 crore a month but has taken money out to put in other start-ups. Not to be left behind, Varun and Ghazal Alagh from Mamaearth are doing the same and rising up the tables of angel investors who, as entrepreneurs, cannot make money in their own companies but can take money out and squirrel it away elsewhere.

If business is defined as making a profit from a commercial enterprise, none of these judges of business is perhaps really doing business. If some of the participants on Shark Tank seem like flaky scammers, do not blame them. See their inspiration.

Who Loses? VCs Do. Founders Do as Well

The world has smelt a fish. The Hindenburg disclosures on Adani opened eyes of Western investors to what any good Indian chartered accountant and businessman knows: how to cook the books, fake the revenues and bump up the market cap while taking money out sideways.

Every tactic the American short-seller talked about is well-known to our businessmen, whether it is over-invoicing to sell goods from one’s private company to one’s public company and pocketing the difference; hiding losses off the books in companies owned by one’s friends; or, even having benami companies owned by oneself come in to pump up the stock price and then using the inflated stock price to raise loans from banks to pay for the over-invoiced goods.

There are few large companies in India which have not used at least one or more of these schemes. This is the art of doing business in India that you will not learn inside IIM, Ahmedabad, but can pick up outside the campus.

Sadly, all this has now become widely known globally. “Governance issue” is just another way of saying “shameless theft”. First the world saw governance issues in China and moved to India. Now, it is seeing the same in India. It is wondering where to move to next.

The whales in the investing world are also learning this about Indian founders. A few whales have moved out of India and are redirecting their stash to other countries where they believe the laws and governance are sounder.

When the Food Chain Broke

When things crashed, the biggest funds slowed down their investing. Tiger Global left India. Softbank washed its hands after wringing them. Sequoia moved its head office out. More of these funds also brought in investigative firms like Kroll to find the “governance issues/theft” in firms before they put any money in.

One point of view is that this is terrible for the ecosystem. Money is not flowing any more. A founder I met a few days ago was desperately looking for cash flow for operations as his signed-and-sealed VC funding had vanished into thin air. Byju’s is facing similar issues at a larger scale. If there is no topi buyer at the top, every level below slows the flow of deals.

My view is that it might be a good thing. Financial detectives like Kroll are auditing more deals. Consulting companies—once paid for selling start-ups to VCs—now believe that they can earn fees for un-selling start-ups to VCs as well. At the top end, the Securities and Exchange Board of India is waking up to take recognition of shady practices that are well known but only now brought to light.

I have run a couple of early-stage VC funds. We were small and low on the totem pole. We personally got into operations of our investees to see if we could help them. Often, we found things we did not like.

One founder insisted on leasing computers, instead of buying them, and renting more office space than needed. He said that it was for “business flexibility”. Till we discovered the computers and office were being leased from his wife, and they were bleeding the company and our money dry. We sacked him the same day. It meant that we had to take over the firm ourselves and work really hard to manage it till we could find a buyer—and we still booked a 75% loss on it.

Another investee had expensive people on its payroll. We went to its offices and asked to meet these CXOs. It turned out that they were the founder’s mother and wife and had never ever turned up at work. We shut it at a 100% loss.

A third was bribing senior people at its distributor to grow revenues by fraudulently billing poor people. We got out of that right way, amazingly, at a profit actually.

We called our limited partners in each case and told them that we screwed up and these investees were “non-compliant”. The limited partners backed us each time.

We have heard of extraordinary malfeasance at other funded firms and wondered if we were hopelessly obsolete in our beliefs and if it would have been better to keep quiet and just sell those firms to someone up the line.

We eventually settled on the point that our beliefs would lead us to make less money than other stars in the ecosystem—but that was okay.

It’s not all Bad

In all fairness, though, there still are honest founders out there. When I talk to them, they wonder what the new boys have done right to get unicorn status while they are still at cockroach status. All I can says is “soldier on”.

Some leave the country to find a better ecosystem elsewhere. And some do, too. This is a loss for India, for sure. Some stay on and hope for change.

Overall, this crash-and-burn-and-rebuild-better is a necessity for us. Too much money has come to us too easily. Too much “misgovernance” has happened. This hurt is necessary. This pain is healthy.

It may encourage better behaviour from all parties—from founders, investors, investment bankers to consultancies or even the retail investing public—over time.

There are many victims now. But hopefully, there will be fewer in the future.

The author is a marketer, entrepreneur and investor who has managed Seedfund 1 and Seedfund 2. The views are personal