JNU, Rohtak and Crisis of Democracy

India is in rage these days and seems very united against the threats to its unity. Countless messages related to teaching lessons to anyone who dares to attack or break India are getting posted and shared on social media. Yes – as a Nation, we are ready to crush any voice, which attacks the integrity of India. However, this steel-like resolve faced its first encounter with reality and chose to look away when Haryana violence, not very far from JNU, happened and failed to shake anybody except the people who were at the receiving end.

A section from Jat community decided that they have to be treated as a backward class and chose to convey the message in the form of protest but without the usual ways of shouting slogans or doing a foot-march in the Gandhian way. Jats, who are classified as one of the martial races in India, chose to do the protest in their own style, which is a lot of force and show of strength. And the result was indeed something significant, as around 30 people died, a business worth INR 34,000 Crore was destroyed, and much murkier details of mass rapes, violence and arson started emerging from the shadows as the dust settled down. The impact of this event was 100 times more negative than the Pathankot attack or the JNU anti-India shouting or the 26/11 attacks in terms of massive disturbance to society and the common citizen. However, these powerful events were met by equally deafening silence. Photo-shopped planted messages regarding our motherland stopped appearing. All social site activists, who were proclaiming to tear anyone into small parts in case of a threat to the motherland, started forwarding stale jokes again.

In Organisation Building, one of the most important rules is “Hot Stove” rule given by Douglas McGregor. The hot stove never discriminates on the basis of status, rank or caste, and follows a simple rule – “When you touch the hot stove, you burn your hand.“ An effective organization needs to be like a hot stove, which is to treat every employee on the same terms in order to install a sense of fairness and justice. Any organization, which is not fair to its employees, falls apart over a period of time. Organizations constantly face this dilemma about being fair or being subversive to power groups. Nations being a superset of organizations also go through the same dilemma.

India, touted as world’s largest democracy, really falls apart when it comes to the matter of fairness and providing equal rights to all. There are millions who are languishing in jail without any bail or hearing on the most flimsy of cases while the powerful ones don’t even appear in court, let alone be arrested – be it RK Pachauri or Supreme Court judges accused of molestation. India really follows the principle of animal farm where all are equal and some are more than equal.

This method of selective governance has served India’s ruling elite very well so far. The State rules not only through police and judiciary but also by managing media. However, the recent advances in social sites and crowdsourcing of news are disrupting this power equation. Hence, the sense of fairness becomes more critical and important in these uncertain times.

There is no way one can condone the shouting of anti-India slogans and talk of breaking India at an Indian university and it does deserve suitable punishments, but so are the rioters who raped, killed and looted with no worry about consequences. Unfortunately, not a single political party condemned or raised the issue of Jat violence even when parliament was in session. Vote bank politics or sheer contempt for justice?? While Govt machinery was in full motion in chasing and arresting students, it was holding peace talks with the group of Jat leaders showing total oblivion to the violence, which the same group had inflicted on others in the name of Reservation.

If one sees the chain of events and reflects, it becomes very clear as to why a certain class of citizens of India suddenly feels very alienated and persecuted. Would there still be same silence if this kind of looting/arson/rape and goonda-ism was committed by a section of Muslims? Or by a section that is not large in number and politically insignificant? Will we still be forwarding jokes and ignoring violence while going ballistic over some slogans!!

India is facing its moment of crisis and this crisis didn’t start with PM Modi. It started much before when India started to get ruled by a set of people whose moral compass was shorter than a tiny insect! When Indian judiciary tucked in its comfort zone chose to look sideways and focused more on control of its privileges than dispensing justice! When government executives forgot that they have taken an oath to the nation and not to a political class or ideology, and when the ruler sitting on the chair of governance forgot the need to give equal justice to all. The culmination of all this decay for last 60 odd years has created a situation where a statement like “law will take its own course” is met by bored yawns – by the guilty and the victims alike. Supreme Court’s statement that destroying of public property shall be recovered from hooligans is met skepticism since we don’t even remember as to when was the last time justice was dispensed to common people. Nirbhaya rape? Union carbide? Or when?

The authorities of this country shall be worried that victims of rape in Haryana chose to go silent than come to State for redressal. If the role of State gets reduced when it comes to security and application of the law, the mere existence and validity of State may become questionable in near future? If the State failed to provide security, food, health and sense of justice, the reason for its existence itself becomes very tenuous.

We may dismiss the Haryana incident as one of the random events. However, another random event, i.e. Gujjar agitation, happened just two years back! So a series of such random events shall be taken as a harbinger of a trend rather than a lone star. Hence, we shall see the occurrence of similar events with higher frequency sooner than later, since declining farm income and jobless growth coupled with hyper media connectivity has created a scenario where expectations are high and patience is very low.

While these agitations are worrisome, authorities shall worry more about the nature of these protests, which are going more & more violent and damaging than anything India has seen so far.

Elites / intellectuals in India have generally dismissed the possibility of a Class War in India on the fact that none has happened so far despite so much victimization of backward classes and scheduled castes. However, the reason is very different this time. The upper class in India maintained their supremacy on the lower strata of the society with sustained violence and constant push down ( social discrimination, violence). Barring entry from temples, forcing to sit on ground and probability of heavy violence in case of any rule violation, etc., for last 1000s of years has created a muscle memory in the lower strata of the society which makes then unable to raise a revolt in such a manner. However, the sudden economic shift has changed the game. Poor returns from agriculture and emergence of cities have turned social equation upside down. The earlier upper class is suddenly in the lower strata of society due to changing economic conditions. Given the historical reasons, they are not able to stomach this sudden change in their status. Hence, the revolt by forward class will be more violent and dangerous as there is no muscle memory. Further given the total lack of justice in India legal system, there is a sense of moral hazard where people no longer care about any rule of law or fear any possibility of punishment. This has created a disturbing trend and hence its even more important that a sense of justice is created and guilty are punished irrespective of vote bank, caste or religion.

India is staring at an era, which is going to become more violent, more chaotic if the powers at the helm don’t see the signs and sense of justice and fairness isn’t installed. Rather than these being some rare events, these protests are going to be more of routine! Beginning of so called civil war at a road near you?

Be afraid, be very afraid!

This article was originally published at “Swarajya Magazine” at this link.

Politics of pollution!

Air is thick in Delhi, literally and figuratively. The winter fog laden with smoke, heavy particulates and dust has not left any scope to think otherwise. Newspapers/ social media and activists are filled with smog and rage. Yes, Delhi air is literally thick.

Not to be left behind in such moments of crisis, Arvind Kejriwal Govt, like any other responsive govt, has initiated actions which as usual have muddied the waters more than to clear it and we are in the thick of actions figuratively.

Truth is, Delhi is dying and dying fast. Pollution levels are 6 to 8 times higher than permissible limits. Bowing to public demand and driven by smart statements like “drastic times need drastic measures”, AAP Govt has indeed implemented a drastic rule curiously named “Odd and Even”.

The rule thought and executed in Mohammad Bin Tughlaq style started in usual Delhi babudom style where more vehicles have been exempted than covered under it except the symbolic inclusion of the Chief Minister.  As per estimates, the total no of vehicles expected to be off road (in this case private cars) is less than 10% of total no of vehicles on the road. So far the evidence is indicating the fallacy of such a plan where the traffic has indeed become better but there is no drop in pollution at all.

While the jury is still out on the real cause of pollution to whether it is dust, crop burning smoke, diesel vehicles’ emission or overall smoke emitted by cars, there is a unanimous view among the citizens for the need to reduce usage of personal automobiles and encourage public transport.

Every Govt. all across the world is working on reducing the no. of private vehicles on road. However, it is easier said than done as this needs massive rethinking as well as state intervention in terms of city planning, redesign, capacity building along with attitude shifting, and will easily take 18 months to 5 years in proper execution.

However, in this high pitched debate about “Odd / Even”, experts seem to be forgetting that vehicles caught in traffic jams or moving at snail’s pace cause more pollution than a same number of vehicles moving at optimal speed. When traffic is chaotic and is moving at a slow pace, one ends up using 2nd/3rd gear or apply the more clutch/brake and hence release more smoke/unburnt fuel in the air. E.g., 22nd Dec 2015 was No Car Day which saw hours-long massive traffic snarls all across east Delhi due to non-operation of Vikas Marg and that night was the most polluted night in the history of Delhi.

The present implementation of Odd-Even plan did saw an increase in city speed as a considerable number of vehicles were off-road. However, rather than gloating about success, one needs to introspect about the long-term viability of such a plan. At present due to high fine and very high decibel campaign, a lot of travel has been postponed or adjusted in near term as this plan is only for 15 days. Further, this plan has not eliminated demand or made carpooling very popular. Hence in long-term, the demand will come back to a natural meaning same number of vehicles will come back to the road.

While the speed of the city can be impacted by reducing the number of vehicles on road, it can be increased in a more sustainable manner by regulating the speed of the slowest vehicle on the road. And slowest vehicle on road is the politicians’ favorite “Auto Rickshaw” (max 55 kmph) or Goods Carrier (average speed 25 kmph). Dr. Eliyahu M. Goldratt in his seminal book “The Goal” demonstrated that the speed of any system is determined by its slowest moving part.

Hence, Delhi moves at the speed of 30 kmph not because of excessive vehicles on the road but because of the speed of auto-rickshaws or goods carriers, which move at speed of 30/35 kmph. Every day one encounters a fully-loaded Bajaj auto struggling to climb a fly-over at a speed of 25 kmph and a long serpentine queue behind it struggling to get to adjoining lane and thus slowing whole traffic.

So the pollution level can be dropped drastically if the speed of Delhi can be increased by 25/30 kmph as it will eliminate all road jams as well as slow speed. So what’s the solution? Ban auto-rickshaw with a bureaucracy mentality and earn the ire of the middle class as well as erode massive vote bank of auto drivers? Yes, actually!

This solution is quite simple if one moves away from the politics of it. The only thing Govt needs to do is to replace slow moving auto-rickshaw with a car. Cars are safer, faster and are all-weather vehicles unlike an auto. Further, cost of an auto is around INR 2 lakh and with permit / convenience fee, etc., auto-rickshaw cost on the road is around 5 lakh. In comparison, Tata Nano CNG car costs close to 2.5 lakh. So rather than issuing new auto permits, Govt shall launch a massive auto upgrade program which with proper structuring / debt plan can enable all auto-owners to shift to Tata Nano. With a total population of 1 lakh auto rickshaws, the whole program can be done at a cost of less than INR 250 Cr one time cost (Complete makeover cost is 2500 Cr).

Such upgrade will save 10x more in terms of savings in fuel costs / health care and will result in much cleaner air, and on top of that get massive votes from auto owners. However, such a move needs political will and desire to solve issues at the core. Unfortunately, pollution in Delhi is more about politics and a game of one-upmanship where all authorities involved in the affair are looking for scapegoats and opportunities to shame the opponent rather than actually saving the lungs of its citizens. So whether it is pollution or governance, the victim is always the Great Indian Citizen. Ever optimistic, forever cheated!

Theory of Asset Bubbles: Its all about Color of Money! – Part III

Fidelity has marked down value of its investment in snapchat by 25% and there are some other markdowns reported by investors as part of annual/quarterly accounting procedure and it has sent a wave of glee all across globe among all startup watchers/experts and commentators as markdown by Fidelity is sure sign confirmation about the bursting of private tech bubble and like 2001, we will soon be witnessing dead unicorns all around us. However, nothing can be farther than the truth.

The one thing the experts are missing while thinking of 2001, is the fundamental shift happening in the world economy due to mobile/tech and automation which is similar to the social transformation as it happened during the industrial revolution. The impact of the present wave of innovation will be far more severe, permanent and disruptive on society. The change is real and is happening, though a lot of arguments (Luddites, Software taking over jobs) have remained same as they were during the industrial revolution. Unfortunately, we all are looking at this new paradigm through our old colored glasses of Industrial revolution and using the same metrics to measure new dimensions. Hence Fidelity writing down the value of SnapChat only means that Industrial revolution accounting rules are not in sync with Machine age accounting!!

However, the single reason why this startup bubble won’t burst despite questionable business models of many players is nothing related with massive machine revolution, or new business paradigm but a simple technical matter that is “Color of money” or simply put “type of capital” being invested in these startups. In 2001 dot-com bubble, that continues to overshadow all the advances made by internet business, almost 90% of the companies were listed and were funded by public money while in 2015 the numbers have just reversed as almost 90% of the companies are funded by private capital or the alternative investment pool. This private capital coming from alternative investment pools seems quite high but still is a tiny fraction if one considers the overall investment capital pool.

In recent times, AUM with alternative investment pools has been growing at a healthy pace, however, it still constitutes less than 25% of all asset class. Further this 25% constitutes Real Estate, Hedge Funds, Buy-out funds, Energy & Commodity funds, Private equity (Venture capital is a tiny subset of Private equity), and hence money invested in tech companies (through venture capital and some hedge funds) is tiny compared to overall investment pools. ( to give some perspective, Venture funds in US invested close to $48 billion in 2014, and all over the world the total capital deployed in a year is less than $60 billion while in 2008, the money allocated by USA Govt for bailout of banks was $700 billion ( actual amount came to $460 bn). Hence liquidity is not going to dry up very soon, as money flowing in the venture / new tech space is still very marginal and even few losses here or there won’t shift the needle.

The second big reason or rather main reason due to which probability of a bubble burst is negligible is that on account of investments by VC/PE industry, these companies are remaining private without any need to access public markets and as of now there is enough capital waiting on the sidelines to keep these companies private for foreseeable time.

So how is this private capital is impacting the bubble burst? A bubble burst in any economy is defined when there is a sharp contraction in the value of an asset and when this contraction is happening all across the sector with the majority of assets. This sharp contraction in value is generally driven by liquidity crisis as survival of a business generally is not a function of business model but rather that of liquidity in the system (some may argue that liquidity is a function of business model but that is not always the case).

Now, this liquidity crisis is created either by debt call or a sudden crisis in the environment which creates panic and overall negative sentiments and thus end up choking money supply to a company.

A liquidity crisis can hit any company, however, a privately held company is in a much better position than a public listed company in handling it. Since listed companies are under intense public glare, quarterly earnings and disclosure norms sometimes perpetuate a liquidity crisis as any miss in revenue/profitability estimates or cancellation of a large contract create a run on the stock and in turn leads to a crisis with an already struggling business. Disclosure norms/insider trading rules create inherent disadvantage to a public listed company in the following manner a) Other than management, nobody has access to financial performance and hence a bad quarterly result can create massive shock/panic due to sudden drop in stock value b) As almost all data, especially negative ones are in the public domain, management has not much room to maneuver/ hard bargain with investors and  c) short sellers /option traders perpetuates the crisis by short selling thus creating a further run on the company stock. All these actions lead to a sharp drop in share prices which in turn create a panic among all stakeholders i.e suppliers, creditors, clients, customers employees, and investors.

These kinds of shocks further put pressure on other companies in the same sector and many times lead to a contagion effect if that sector is facing strong headwinds and may result in re-rating of sector thus leading to the massive drop in asset value. These actions lead to chaos as mob mentality takes over the rationality and completely chokes the money supply resulting in an unwarranted fire sale or financial crisis.

In comparison to public listed companies, a privately held company is generally protected from all the trauma caused by the pressure of quarterly earnings, disclosure norms and public glare. All this restricted public info is given an inherent advantage to unlisted companies when it comes to negotiations for the capital, terms as well as in managing information flow etc. Moreover, as  the investors are much aware of the direction and performance of companies and are generally in knowledge of the crisis in advance, they are able to work out solutions while closely working with management be it fundraising, M&A or right pricing the company stock as we saw it happening with startups like Myntra, LetsBuy, TaxiforSure etc

Hence the possibility of a large-scale panic where the majority of startups will go bust is remote for the reasons mentioned above as investors/founders will continue to negotiate and create liquidity situations in case of strong headwinds without external panic. They will also be helped by the fact that the amount of capital deployed & the value of business is not more than 25% (Uber valued at $50bn+ has raised  $ 8.2 billion (16%), Flipkart valued at $15 bn has raised $ 3.15bn (21%)) and emboldened by LP clause, more and more hedge funds are waiting at sidelines to enter these markets.

However, it does not mean that no company will go down under as the private markets work in a discrete manner showing bursts of activity, then freeze and then again hectic activity. The evidence of this can be seen from the investment pattern as seen in Indian e-commerce market where after showing initial euphoria in 2011/12, funding market just froze for e-commerce in 2013 and then again became super active in the latter part of 2014. Hence rather than bubble burst, we will continue to see these cyclical investment patterns and any company with not enough cash to survive these short bouts of nuclear winter will go down irrespective of business model, insane consumer happiness, superior unit economics or growth as we have seen with IndiaPlaza.com and host of other businesses. If there would have been a bubble, all of the companies would have been able to raise money at their terms but we are yet to see evidence of this.

It will be good for experts to remember that an asset bubble is more a function of the nature of capital deployed rather than that of business logic.

This behavior probably explains why Indian real estate bubble never burst so far and in fact will never burst despite noises being made about this burst since 2006. In India, debt by PSU banks is almost like quasi-equity which is permanently structured and can never be recovered due to over friendly regime of bureaucrats, policymakers, politicians and Indian courts (lender to Kingfisher can very well attest to that). As the debt is never called, it does not create liquidity pressure and all we witness is cyclical movements market (hectic activity and total freeze) while maintaining the asset prices at the same level.

Hence contrary to common perception, no bubble is going to burst but a Darwinian world will continue to evolve in the true sense given the nature of capital as well as of the market. For experts, keep writing and voicing opinions; after all, what is life without talk and gossip, only a few vices allowed without any medical warning.

The Other two parts of this articles are at this link

Part 1: Anatomy of coming Startup bubble: The missing argument – Part I

Part 2: Startup Bubble: Case of misplaced Schadenfreude – Part II

Startup Bubble: Case of misplaced Schadenfreude – Part II

The great Startup bubble has burst finally or so the Experts would like us to believe as the evidence (as per them) is mounting day by day. Around 1500+ employees at various startups in India have been laid off. One of the Founders was held hostage in Pune and the worst of all, the biggest proof, a certain CEO had to send a strong email to his sales team on missing their quarterly sales target. No, it’s not any ordinary sales target, it was QUARTERLY SALES TARGET. Generally, in other sectors, companies fold up when they miss their targets, but damn this VC money, such non-performers are still in business despite missing their top-line goal.

So missing sales targets, 1500 jobs lost and angry employees laying a siege of the CEO!!!  What more proof do these moron VCs need, wonder our expert commentator(s) / analyst(s).  Interestingly, all these armchair experts, with all their analysis, comments and advice are nowhere involved with startups/VC world in any manner, (barring few angel investors) but nonetheless have great insight/perspective on everything startup, be it business models, path to profitability, unit economics or any other thing under the sun except probably as what makes these dumb VCs from la la land to give millions of dollars to these kid entrepreneurs who are still learning ABCD of business. ( signs of time, our experts will tell you).

The bubble discussion is no longer a matter of perspective but has now acquired the shape of definitive reality, where judgment has already been delivered. Now everybody in the crowd is just waiting with bated breath for big bang slaying of the unicorn, while the experts like seasoned matadors are taking their time and using data to bring the Unicorns down, with noises getting louder and louder with chants of “End is nigh” filling the air.

So is the bubble really bursting or are we all over analyzing things? An email or for that matter any communication by a CEO to his sales team about missing quarterly or annual sales target is not a bubble. It is a routine dressing down or pumping up of teams as any sales director or CEO will tell you and missing of sales targets or decline in numbers, don’t bring doom as GAIL or NIIT CEOs can attest (GAIL profit dropped by 66% in second quarter this year and NIIT has also seen some swings in its quarterly numbers in last 15 years, and no bubble has burst yet). Same way losing 1500 jobs is sad but a routine affair and is almost like a tiny drop in a big country like India where one startup is starting every day and some 600 startups have raised capital in the last 18 months.

Hence these incidents are not a sign of the bubble but signs of the next phase in the life of these startups as they meet the reality of the business world and enter an adolescent phase of life. Some will flourish, some may die and some will just hang around but that is a usual Darwinian world about survival of fittest, not a bubble burst!!

The Other two parts of this articles are at this link

Part 1: Anatomy of coming Startup bubble: The missing argument – Part I

Part 3: Theory of Asset Bubbles: Its all about Colour of Money! – Part III 

Anatomy of coming Startup bubble: The missing argument – Part I

From Bay Area to Bangalore, if there is one word which is stirring the fancy of the masses in general and analysts in particular, “Startup Bubble” seems to be that word! It doesn’t matter if you are in the crowd or away from the crowd, the bubble is bound to get into your radar, be it at a conference, twitter feed, newspaper columns or random article forwards.

At one end of the spectrum, there are the believers, led by big bulge VCs riding their unicorns, chanting data and waving neatly presented big graphs showing mobile phones’ sales growth, internet data usage, volumes of WhatsApp messages,  no of photos clicked and other mind-numbing metrics and speaking loudly as to why it is not 2001. However as it generally happens, the other side consisting mainly of newspaper columnists, accountants, finance professors,  out of work CEOs and some missed-the-boat-VCs/ entrepreneurs, is not amused by all this mumbo jump and looking wryly at daily funding news and murmuring loudly to anyone who cares to listen, about these  crazy valuations, lack of profitability and unsustainable business models. For them 2001 dot-com bubble is very much here and that too in a 10 times bigger format.  Not to be left behind by the VC crowd, they have their own set of anecdotes, stories and data graphs though from the 2001 era.

This war between valuations and sustainable business is not new or started this year or last year but has always happened whenever there is a significant shift in asset prices. In fact, the talk of startup bubble started way back in 2011, when Uber, leader of the present Unicorns raised $12 million at a valuation of $ 60 mn and Wall Street Journal published an article with the title “In Silicon Valley, Investors Are Jockeying Like It’s 1999”.  Four years later, with Uber valued at $ 50 billion, the noises have only grown louder and bigger though Uber has not shown any slowdown in growth or in its ability to raise billions of dollars while growing by a whopping 800 times in less than 5 years.

Interestingly the division is deep and lines are clearly drawn as each group has its own set of believers, followers, and relative data to back. The whole argument has slowly turned into a debate of deaf where each party is consumed by their own arguments without understanding the counterpoint.

The main reason as for why general public, commentators and all those business leaders are wrong in the prediction of Startup bubble burst is mainly due to their limited or rather skewed understanding of the way venture capital world operates and how the dynamics of VC world has evolved in last 2 – 3 years.

These jaw-dropping valuations splashed every day around business dailies are fuelled by mainly two sets of investors in Venture space – the early stage investors investing just after Seed round or late-stage investors investing at 500 million-plus valuations rounds. Interestingly both parties are feeding to each other in a self-fulfilling prophecy.

In recent times, the availability of liquidity and declining gap in innovation has created a scenario where investors believe that capital, rather than innovation, has the edge in building a leadership position. This belief in the primacy of capital over innovation has fundamentally changed the usual performance based investing model.

In recent times, the availability of liquidity and declining gap in innovation has created a unique scenario where it is capital and not the innovation which is becoming the edge in capturing the leadership position in a validated marketplace.  Hence in a scenario, where there is no technical edge or technical risk in the product, the investors are trying to eliminating market risk by investing 100s of million dollars in these ventures as they believe that capital will create entry barriers and will give the investing company enough power to scale to formidable heights.

This fundamental shift has changed the way earlier VC rounds used to work.  The days of multiple venture rounds based on the performance/execution capability of the company have been replaced by much simpler three main rounds. The first round of $ 300k to $ 500k happens at MVP (minimal viable product) stage, which is followed by a seed round of $2 mn to $ 4 mn and is done for validation of hypothesis and building some traction. However post validation of hypothesis/execution capabilities, the third round is happening in the range of $  $ 20mn+ and going up to  $ 100 mn.

This round of $ 20 to 100 mn range is also called as  ‘Scare Round’ as it scares the competition, chokes the further supply of money to competitors and aims at land grab in validated market opportunity. As one can easily see, this scare round of capital/ valuation has hardly any correlation with the revenue of company and thus gives a crazy sense of valuation to usual public which does not understand that this large round or scare round is not related to the performance of the company but rather related to the size of opportunity and ambition of an investor in owning the particular market opportunity.

So if it is early stage investors who are creating this false sense of bubble through their scare round commitments and by giving valuations with little correlation to present revenue nos, the late stage investors are creating a sense of bubble by taking very large risky bets at crazy valuations. These monster rounds are creating a sense of euphoria as well as a bubble where it seems to the army of commentators that investors are a bunch of morons who are again driven by greed and ignorance and are being Icarus. However, unfortunately, our commentaries don’t know that all these investors are deriving their happiness and courage for investing at such crazy valuation from a quite standard legal clause hidden in voluminous shareholder agreement (SHA) knows as LP or “Liquidation preference right”.

Liquidation preference clause (LP), a standard VC industry legal clause, is used to protect investors from premature exits as well as downsides gave the risky nature of the business. However, hedge funds have discovered a totally new use of LP clause. LP clause gives investors a huge downs protection while guaranteeing a return in upside thus converting an equity instrument into more like a superior debt paper which has strong downside protection but unlimited upside. This unique scenario where very large companies are staying private and needs loads of capital has attracted hoards of hedge funds who are using LP clause to ensure health return even in the case of a downside e.g. if a company raised $ 300 mn at a valuation of $5 billion with 2x participative LP clause, the investors will make $ 600 mn (2x return) even if the company is sold at $ 600 mn ( a steep 88% drop in value), a rare probability for large companies . Hence the large amount investing is becoming like capital protection betting where one can gamble as much as one can with capita guaranteed.

This clause along with the fact that a large number of companies are choosing to stay private while consuming loads of capital has created an ideal playground for hoards of hedge funds, which are anyway flush with liquidity and looking for new areas for investments.

No wonder this kind of utopian scenario is getting capital by drove and every week we are witnessing announcements which are much bigger and audacious with Unicorns becoming the new normals in the startup’s hinterland.

However if the general public is missing the argument due to lack of understanding of basic dynamics of VC industry, the VC community is not far behind in miscalculating the fail-safe nature of their investments by overestimating the capability of capital, underestimating the human spirit and assuming deterministic solutions to a problem.

Overestimation of the capability of capital is creating a scenario where investors are led to believe that capital will breed innovation as well as help in scale and build a wall of defense. However, as it happens in the law of nature, the best-laid plans go haywire and work counter-intuitive as it’s not the capital but generally lack capital which breeds innovation and creates focus. Housing.com is a perfect example of capital going nowhere in building a powerful business and hence wall created by capital will only force the sharper downfall of the business due to the very weight of the wall.

Further by underestimating human element there is a false sense of belief in first mover advantage in low innovation fields. History has shown that first mover advantage is the worst advantage in low innovation fields as traditional players are able to catch up with the first mover by copying the low threshold innovations in the long term.  As venture investment is not a sprint race but a marathon of 7-8 years, a lead in the first two years is of no significance as founders of FashionandYou can attest. Hence the no-brainers sectors which are attracting capital by droves will also see maximum casualty in long run be it hotel room aggregators, food delivery marketplaces or asset leasing models as traditional corporates will play catch up or new solutions will emerge. The other problem with large ticket investment over a very short time period is folly of taking a deterministic approach to a problem as solutions are still in the evolution stage. Remember the mobile pager market or a taxi operator like Meru Cabs which is a perfect example of low innovation field challenges as well as changing business dynamics. At one spectrum, Meru faced constant challenges by new players due to low entry barrier where capital was the only wall of defense while at another spectrum it has been obliterated by new solutions like Uber which just made the classic business of leasing cars and renting them out totally unviable.

Hence, only the time will tell if this massive shift in asset price is going to be a type I error ( false positive) or type II error (case negative) and whether VCs will have the last laugh to the bank or will end up facing analysts with the smirk on face!!  Till then enjoy the irrational exuberance of these interesting times. Ah, the coupons!!

This article originally appeared at Inc42 at this link.

Part 2: Startup Bubble: Case of misplaced Schadenfreude – Part II

Part 3: Theory of Asset Bubbles: Its all about Colour of Money! – Part III

Liquidity Preference 101 : All you want to know about Liquidity preference in venture Capital world

Liquidity Preference is one of the few terms in a VC term sheet (other than drag along/vesting and management rights) that really evoke strong reactions from either side. While Majority (or rather 100% ) of VCs swear by it and won’t sign a term sheet without it, entrepreneurs see it as another “Shylock” term inserted by very, very bad VCs to suck blood from poor innocent entrepreneurs. We see numerous posts/blogs by entrepreneurs (funded/wannabes) denouncing “Liquidity preference” and terming it as a draconian term.

So what is “Liquidity Preference”? Liquidity preference is a macroeconomic term, that was first described by renowned economist John M Keynes in his book “The General Theory of Rate of Interest” where it was emphasized that Investors are entitled to a premium to invest risk capital for a long-term which is a function of demand and supply.

However, in Venture Capital / Private equity, liquidity preference refers to the division of proceeds once a company (investment) is liquidated and is one of the standard terms in the shareholder agreement between Investor and company founders.

First, let’s see what is liquidity in this context? Liquidity event does not necessarily mean when the company goes bankrupt, wound-down or insolvent. In this case, Liquidity also means when the company is sold or gets acquired, or there is a change in management control. However one must note that liquidity does not include when the company goes for IPO ( initial public offer) or get listed in a public stock exchange.

Liquidation preference provides downside protection to VC/PE investors from losing money by ensuring that in liquidity event they get a certain return on their money before any other equity claimant. If the company is sold at a profit, liquidation preference can also help them to be first in line to claim part of the profits. As VC/PE investors invest through preference shares (Cumulative convertible preference (CCPS) or optionally cumulative convertible preference shares (OCCPS) etc, they have preferred rights over general stockholders and are paid before holders of common stock.  It is important to note that company founders and employees etc. get common stock and do not have preference shares.

Liquidity preference is defined as: “Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference)”.

Let us see as how liquidity preference works:
Let us assume that a company “ABC private limited is being bought over by XYZ limited for Rs. 800 million in March 2011. ABC Private Limited shareholders include promoters holding 65% stake and the rest 35% is held by Private Equity fund by investing Rs. 100 million in April 2007. So at the time of investment, the company was valued at Rs.285 million

In the above example, the preference shareholders will be first paid out. So out of Rs.800 million, first Rs.100 million will be paid to Private equity fund.

If the company has declared a 10% dividend every year for the last 4 years, but unpaid, totaling to Rs. 20 million, then that amount has to be paid.

The remaining Rs. 680 million will be distributed in 13:7 ratio between promoters and private equity fund. The promoters will receive Rs. 442 million and private equity fund will receive Rs.238 million.

So in total, the private equity fund will get Rs. 358 million for a 35% stake and the promoters will receive Rs. 442 million for 65% stake.

Now, it’s clear that PE fund got almost 44.75% returns despite having 35% stake and promoters made “only 55.25%” on 65% stake and this creates heartburn among entrepreneurs. However, like all scenario, there are more shades of grey (of course not 50 shades) than we can see. Likewise, in this case, VC made 3.58x on multiple and 258 million while entrepreneur made 442 million. It is important to remember that investor provides all capital and hence all risk on capital loss is taken by investor and one must not forget that these kinds of liquidity events are very rare. So rare, that Economic Times will run a screaming headline, CNBC and every business channel worth its name will conduct innumerable interviews and rest of world mentally calculates the money VCs and founders made and plan their next venture!!!

So what happens when these rare events don’t take place, in a day to day scenario. Liquidation preference helps investors to protect their capital when the company is either average or unable to scale up, which is the case in at least 8 out of 10 times Now let us see how investors use liquidity preference to protect their capital and try to get fair value out of it.

2 Ivy league graduates who just returned to India are building kwitter.com a clone aiming to target Kannada speaking population from North Karnataka. Their USP is to focus on regional language and to create real differentiating factor they are focussing only on north Kannada dialect so as to create real deep penetration in the first trial market ( a fact harped by every VC in all last 15 conferences they attended over a lot of red wine and chicken tikka masala).

One misty eyed VC who has just returned to India, so as not to miss the growing economy and all heat (in weather and economy) decided to invest USD 5 million for 40% stake in the company thus valuing the company at USD 12.5 million. Since both investor and entrepreneur speak the same highly accented American English, there is a huge degree of trust among them and so VC ignores his legal counsel’s advice and invests without any liquidity preference. The following scenarios emerge after a year

Scenario A: The dreamy-eyed entrepreneurs are not sure of kwitter, anymore as they realized that all north Kannada guys use English as their first language and are not keen to continue due to lack of sufficient market. They wish to close down the company. The company still has $ 8 million cash left. The promoters with a 60% stake in the company, are entitled to get $ 4.8 million as part of their share.

Scenario B: While promoters believe that kwitter doesn’t have much future, they have a solid team and have built a good translation tool for which a leading search giant is willing to acquire for $ 12 million, provided promoters continue for another two years and 50% payment will come after 2 years.

In the second scenario, promoters will make a total of $ 7.2 million,$ 3•6 Million immediately and the balance after two years.
So, in the second scenario, the company can’t be called a total failure and can be seen as a moderate success as there is some suitor for the product.

But wait a minute – what about investor – he invested $ 10 million and in the first case is getting $ 3.2 million (a loss of $ 6.8 mn) and in second scenario$4.8 million ( a loss of 5.2 million). While in a losing venture, founders will make $ 4.8 million despite closing the company and $7.2 million in case the deal goes through.

It is obvious here that such deals are very unfair to investor and in fact, by structure encourage the entrepreneur to quit early or set a very low sight. Hence liquidation preference is designed to protect capital and depending on the type of liquidity preference, Investor would have received all of $ 8 million in the first case and either all $ 12 million or $ 10.8 million depending on type of liquidity preference (we will learn about types of liquidity preference in our next edition of the article).  Hence one can see that despite all bad press, Liquidity preference remains quite favorite terms of VCs and they don’t like to do a term sheet without it!! Hence Liquidity Preference creates a perfect alignment of interest between VC and entrepreneur where both aim to create a high-value company rather than creating incentives for selling too early.

Now, what happened to Kwitter guys? Well being smart entrepreneurs, they chose to take $$ 4.8 million upfront by shutting the company and moved to Valley while our foreign returned VC friend, last heard, was working as an accent-trainer in local BPO in Bangalore after failing to raise next fund.

E-Commerce Bubble vs Modern Retail ~ The perspective fallacy

1/6 Future Retail raised close to 6000 Cr ($1.5 bn) to build a business with a top line of $2.5 bn with marginal profit/loss #StartupBubble

2/6 @Flipkart has raised $3.5 bn to build a business with a top line of $ 3bn in its 6th-year #StartupBubble

3/6 In the time of crisis, between Flipkart and Future Retail, who will be able to cut their costs drastically? #StartupBubble

4/6 Which brand is touching more consumers and reaching remote parts of India? #StartupBubble

5/6 So despite all gyan by Bizz Gurus and all maths, e-commerce is for real and nowhere near bubble #StartupBubble

6/6 In any bizz, there r winners & losers, Some bizz will die & some flourish, that’s not a bubble but usual Darwinian world #StartupBubble

Startup Bubble / Debt Crisis

1. If 2001 dot-com bubble was Type I (false positive) error for analysts/columnists etc, 2015 is going to be type II error (false negative) to all wise women/men.

2. About impending Startup bubble burst, there is unanimous certainty among newspapers, ex-CEOs, Missed the bus-VCs/ entrepreneurs !!!

3. However, as it always happens, Crisis won’t hit the Startup bubble but might come from a totally unexpected quarter.

4.  Debt overhang at Indian corporate is going to bite and bite it big time. Amtek Auto and Now Jindal Steel, debt rating crisis are here!

5. Debt contagion will spread and may start from debt mutual funds who
don’t have the luxury of public money to ensure perpetual liquidity.

6. Debt at top 10 stressed Cos is 10x> all startup funding!! and all startups are not stressed!! So worry about debt MFs / Indian Banks.

7. Brace up for debt crisis at Indian banks. So yes winter is coming but to a lot of other sectors than startups!!

Union Budget 2015: Ordinary Ahoy!

First, let me give a disclaimer before I get into the nitty-gritty of budget analysis. Overall, this has been quite a good budget, and in normal routine times, it might have got 8.5/10 or so. But then these are extraordinary times with extraordinary ambitions, and so, we all need an extraordinary budget and not routine, as routine brilliance is nothing but mediocre in such times!!!

There seems to be quite a euphoria related to the formation of MUDRA Bank as well as the allocation of INR 1,000 Cr to start-ups. But before we all start celebrating, we need to pause and ask about what happened to the INR 10,000 Cr which was allocated last year to start-ups! Last year, the Railways Minister in Modi Government’s maiden railway budget said that every budget makes lots of promises but only a few get implemented and the rest remain on paper. Hence, it is high time the Govt provided implementation records and performance reviews of all the announcements made in previous years’ budgets.

In order to put the nation on a high growth trajectory and to create happiness all around, the Govt needs to foster an environment which enables entrepreneurship, the creation of jobs, a fair level playing field, and a sense of fairness & stability in the legal system. Unfortunately, the budget this year falls short in all parameters.

The Indian tax regime has remained as complicated as ever, and by postponing GAAR, the Finance Minister has just chosen to ignore the elephant in the room. Furthermore, a lot of provisions against black money have been brought in, but how the legal part of it will be solved remains unclear. Given the backlogs in nation’s courts and overall sad state of legal affairs, it’s high time the Govt takes another look at the budgets allocated to the judiciary and work on creating capacities in the system. Unfortunately, the Budget 2015 has chosen to remain silent in this area.

Besides the unstable legal environment, another major issue affecting entrepreneurship and creation of new business is red tape and the amount of paper-work involved, and in this budget, there is now a proposal to appoint an expert committee to oversee all that!!! So now yet another expert committee to view and analyze, which most probably means things will remain as they are. This budget has really fallen short on the expectations regarding making things simple, done no more than offer some words, and it seems words are all we have.

It’s high time we see some real action on cutting of the red tape rather than going back and forth on the same issues. In 2010, the then Govt made a bold move of bringing Direct Taxes Code (DTC) and to do away with all exemptions and thus plug all leakages as well as corruptions. DTC faced stiff resistance from existing power centers then also, and in this budget, got a quick burial.

The announcement related to MUDRA Bank is quite welcome, but again, rather than being a provider of capital, the Govt needs to create an environment where private capital shall flow in an efficient manner and create opportunities for all stakeholders. If Govt provides capital, it will lead to crony capitalism, and in long-term, will distort the system instead of reforming it, as we all have seen in the case of PSU banks in terms of high NPA/high real estate prices. Given the fact that SMEs in India suffer very high-interest costs (18% or above) and have continued to face challenges in terms of slowing demand and high-interest costs as well as real estate costs, it will be better if the interest rate for SMEs are lowered in the way it is done for the housing sector. Here again, this budget missed the chance to kick-start the economy in a major way and has chosen a rather timid option of creating another institution.

The Indian economy, notwithstanding the performance of SENSEX, is witnessing one of the toughest period post-2008/09 with falling corporate earnings as well as a reduction in overall capital formation. Large corporate, as well as small business, are facing serious challenges since overall consumption is falling due to drop in available discretionary income at the individual level on account of the very high cost of housing (EMI/Rentals), inflation and almost flat growth in income. Given the fact that 40% to 50% of individual income in young families, which are the basic blocks of the economy, goes towards housing in the form of rental/EMI, it is high time Govt increases affordability of the first house, and at the same time needs to discourage crowding out by investors. Unfortunately, this budget has remained totally silent on this aspect.

Overall, I agree that though the main aim of a national budget is to present checks & balances of annual revenue along with expenditure and provide an outlook of the overall economic health of the country, the annual budget for all practical purposes needs to go a little beyond that. It needs to shape-up the long-term behavior of the public at large by way of taxation, policies, etc., and therefore, by continuing to focus on exemptions, allocations, and tax limits, it seems that this year the Finance Minister has chosen to grant/allocate more medical leaves right when the economy needed lifestyle changes to jump-start to the next level.

However, it is still a great peace-time budget and would have done well for the economy. But as I said, we are in the middle of extraordinary times and this war-like situation, to which this budget fails to give direction, hope & vision and settles for ordinary. Hence, it shall be rated as 4/10. 

In the time of Euphoria

We are all at a wonderful ball where the champagne sparkles in every glass and soft laughter fall upon the summer air. We know, by the rules, that at some moment the Black Horsemen will come shattering through the great terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so that everyone keeps asking, “What time is it? What time is it?” but none of the clocks have hands.

                                                                               ~ Adam Smith, SuperMoney