MONEY BUYS HALF?
Before money became cheap, ideas and sweat got no more than half the business.
In the brave new world of start-ups, we investors are lucky if money buys us a fifth. Over the last couple of years, the share of the angel is trending lower and lower; today, funding an idea for the next year will typically buy you only 15% of a business.
If the relative valuation of any two goods or services changes this radically, it means that the dynamics of demand and supply have shifted. In the start-up eco-system, there doesn’t seem to be a scarcity of ideas - quite the opposite in fact - so one can only conclude that money is flooding into the market. Partly, this is the demonstration effect of start-ups like Ola Cabs becoming unicorns at the speed of white magic, tempting lots of people with spare cash to try on the garb of angels. The other ingredient of the start-up fever is the flood of cheap money washing over the globe ever since the 2008 crash.
Much as the macro-economist in me rails against monetary inflation, I am hugely excited by the role it has played in sparking thousands of dreams of new businesses, getting bright young people to quit their jobs and take to the road of entrepreneurship. It is a journey of great learning for these young founders, and even the tiniest start-up creates a few jobs. The successful ones create employment by the thousands, and could be the job engine our growing nation desperately needs.
Exciting as this start-up fever is, it is poisoned by the danger of over-blown expectations. A large number of young people have hit the road with little more than a business idea and the beta version of an app, and believe they need a crore of rupees (often stated as 200,000, meaning USD) to take them to the next stage of their business. The word on the streets of start-up town is that founders shouldn’t dilute too early, so this kind of money won’t buy more than 15% equity, which means that the business idea, plus a few lakhs worth of time and money, is being valued at more than 6 crores.
For an angel, investing at these valuations must be compared with returns in public equity. Given my historical returns on equity, I would set this hurdle at 18% per annum. If the new businesses I invest in continue to attract high valuations based on the prospect of growth, I could see profitable exit opportunities at every successive funding round - from Bridge to Series A, Series B… etc. Series F is not unheard of. At the same time, one must remember that both founders and early investors are going to get diluted at every stage.
The number of mathematical scenarios is literally infinite. The one that I generated looked at angels being diluted to half their initial stake by Year 5, and a valuation at 4 to 5 times turnover. For my hurdle rate to then be achieved, the business needs to scale a turnover of 1 crore in Year 2, double in Year 3, and grow by 50% each for the next two years. From the perspective of founders, this is chicken-shit, and no young IIT-IIM team with stars in their eyes is looking at less than 50 crores by Year 5.
In the days of boot-strapped start-ups, growing a business from 0 to 5 crores in 5 years was well-nigh impossible. Start-up funding should - and does - vastly improve the odds, by providing financial fuel and sage counsel. As a result, many new businesses will hit that number, or more. But for every multi-bagger success, there will be several which run into execution problems, unforeseen competition, or a need to drastically reassess their business strategy (‘pivot’ as it’s called). Addressing these issues will require more money (read dilution), time (while my hurdle meter is ticking away), and a slowing, or even reversal, of growth. And even though I hate to admit it, the fact is that less than one new business in five returns its capital.
All considered, the start-up environment is at the far frontiers of high-risk, high-reward. Assessing the abilities of the start-up team will help mitigate that risk, as will the involvement of seasoned managers with major business decisions. However, till I have more experience of this eco-system, I am going to strictly limit my financial exposure to what I can afford to lose.
We don’t know how long the flood of cheap money facilitates the current scenario. If it ebbs, valuations at every stage will drop, and businesses with weak growth will hit the wall in terms of further funding. Clearly, this is not a development I would welcome. But is one we must all consider, especially founders who are writing business plans with rounds of successive funding, into the blue horizon.