Why Flipkart-Walmart and Tata-Bhusan deal will put India on the path of 10%+ GDP growth

There have been numerous presentations, articles, columns since the late 90s about India’s potential and how India can be a super economy in time to come. With the rise and rise of neighbor China in the last 10 odd years to unimaginable levels, this dream has not only bigger but also look so close and achievable. Unfortunately, despite getting billions of Dollars as FDI in the Indian economy, we are yet to see a China level growth. In the world of a friendly Institutional investor – “the Indian story has remained a story so far”.

However, while all experts/economies have been debating about the growth rate of India in next 2/5/10 years and why this is not possible based on rearview mirror data. Two mega events which happened quite silently and without much hoopla, are now going to change the path of India forever and will finally put India in autobahn of economic growth.  These two events proved that finally after a lot of errors/mistakes,  India seems to be finally getting its act together. For the first time, a GDP growth of 9% or 10% does not seem such an impossible dream.

The first mega event which grabbed everybody’s attention was the acquisition of Flipkart by Walmart for $17 billion. This deal was the biggest deal in the world and gave not only 400x plus returns to earlier investors, but also made founders richer by $1 billion. While it was a fantabulous deal for investors and founders, it was even better for the Indian ecosystem.

From the time Indian VC/PE story started, there has been one single complaint by investors of all shapes and size and that is lack of exits. Money just comes into India and never goes back. Of late, the momentum of exits have started ( it started by RedBus when Seedfund made an exit, as Naspers acquired Redbus) but Flipkart had remained worrisome as it had absorbed almost $7 bn and almost anyone with even a tiny India interest, had some exposure to Flipkart either through direct investment or through being investor in the funds which had invested in Flipkart. This liquidity event of $17 billion is going to erase a lot of doubts and will pave another wave of capital hitting Indian shores.

The other bigger question which this event answered was if India’s Amazon would be either Amazon or Flipkart. This question has been adequately answered now by Flipkart, Ola, Paytm and host of others. Despite no barriers or walls, Indian startups have fought and fought well. Two of my investors asked me last year as to why Indians don’t buy from Flipkart and what will Flipkart do? I have told them that India is country of surprises so please wait and don’t be so fast in your judgment! So the bottom line is – cheer up! India will have its share of Indian startups as well as global model startups and some will win in both categories. So keep calm and keep investing.

The other bigger or rather far bigger megadevelopment which happened last week. Surprisingly this mega event didn’t create the same level of excitement as Flipkart deal but will have for sure a 100 times bigger impact than Flipkart-Walmart deal. Tata Steel bought bank defaulter Bhusan Steel for agreeing to pay some 37,000 Cr ($5.5 bn) to bankers. One may say, what’s the big deal if a loan defaulting company has been acquired by lenders and sold to a bidder. It might be routine in any civilized and democratic society but is almost a miracle in India. In Indian banks there is a popular proverb – In India, companies go bankrupt not the promoters. They continue to live a lavish lifestyle and loot the public forever. As per last available data, Indian banks have a gross NPA of INR 8.41 lakh crore ( $125 billion approx) which amounts to around INR 16,000 per person if one account working population of India. This NPA is not because of the bad business environment but is more a function of fraud, questionable business practices, and questionable lending practices. Govt banks with no accountability and no skin in the game have squandered public money with abundance. India real estate survived mayhem of 2008 financial crisis and there was no correction in housing because of govt banks who kept on rescheduling loans and waving NPAs and kept builders happy.

This liberal loan policy didn’t mean that every business was getting loans liberally.  It just meant that people with connections and huge liability were getting loans while ordinary businessmen were still making rounds and rounds of govt bank officers to get even a 10 lakh loan. This insider networks where everything moved on connections not only looted the banks but also crowded out genuine businesses. Due to massive NPAs and with no hope of its recovery, banks build this loss in their business models. No wonder we have deposit rates of 6% but prime lending rates for SMEs hovers 12.5% (nonbanking – this rates jump to 18% plus) as SMEs and saving account holders were jointly subsiding corrupt defaulters.

This naked dance of the last 70 years was put to stop by NCLT/ bankrupts law and resulted in a first big win when Bhusan Steel was finally acquired by Tata Steel. There are some 28 other companies with big loan defaults and a lot of pressure on promoters who otherwise used to run the system on their own whims and fancies. Already some ¾ NPA accounts have been regularised and even unsecured trade creditors have started getting their long pending dues.

This cleaning and disposal of default assets are doing following things on the ground. First, a huge amount of capital which was already written off by Banks is going back in the system thus boosting profitability and stability of system and might even reduce the lending rates as risk spread will come down. Second, it has created a sense of law among promoters who are now aware of consequences as it is no longer an empty rhetoric that law of the land will take its own course, and so this large drawdown of fraudulent loan no longer happen as consequences are severe. This will lead to opening this capital to the unconnected, honest and hardworking businesses in India who remain uncompetitive in the world market due to lack of capital as well as high cost of capital. Hence suddenly all the capital which used to find its way to big businesses and to the connected ones will go to normal businesses.

There is a sense of belief that India is capital scare country and without foreign capital, we will remain starved. While we all believe in this, we forget that same capital starved Indians also buy gold worth $35 billion every year. So India is not capital scare country but capital does not go to right areas due to the issue of lack of legal system, crony capitalism, and corruption which are built in the last 70 years. These walls of corruption, crony capitalism etc have started to fall now.

India in the last 70 years has seen a culture of crony capitalism in its finest form where to succeed all one needed, was connections. These two events in the summer of 2018 have demolished this theory forever and connections do not matter anymore. The honest and hardworking get billions and defaulters’ business get sold.

Gentleman, the age of India has arrived.

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 10 million for 40% stake in the company thus valuing the company at USD 25 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.

Startup Pitch: An Insider’s Guide on What Do VCs Want?

As a VC, we suffer death by PPT (on a cue from Alexei Kapterev) almost every day. Every month, we see 100s of PPTs and attend many events where again one is drowned by pitches and more pitches… all vying for a time which is equally captured by e-mails / social chatter and other noises.

However, the majority of those (almost 99%) become dead on arrival or rather lose the plot in next 60 seconds. A lot of them are great business ideas or have better teams but all is lost in enthusiasm/eagerness to impress or in storytelling. Given the constant bombardment of pitches, a lot of startups don’t get a second chance to pitch again and lose a great momentum as a result.

This presentation is just an attempt to guide entrepreneurs to weed out unnecessary details and focus on the core belief of the startup. You might be having the next best idea, but if you are not able to put things forward succinctly, chances are that you might miss the bus, and we as investors might end up doing Type I / Type II error, as the case may be.

Remember – your first pitch is not about getting a cheque but is all about getting a second meeting, so work on the pitch to get attention / second meeting rather than drowning in details and losing the plot. Hope this pitch gets your attention or at least tries to achieve what I am preaching (or maybe I also lost the plot!!! ;))

Startup Pitch: An Insider’s Guide on What do VCs Want?

So You Want USD 5 Mn Series A Valuation for Your Startup: Some Key Metrics?

Venture Capital: What metrics does a VC look for in a consumer internet startup, e.g., a social networking site to fund a typical Series A valuation ($4m – $5m)?
I would like to know about the metrics such as:

A) How much revenue?
B) How many users?
C) What is the rate of growth?
D) How viral?

Also, please mention if there are any other metrics that VCs look for.

This question was posted on Quora with a request for an answer. This is a question which keeps on appearing at regular intervals in meetings / informal sessions/conferences or in secret whispers where people try to unlock the secret code of VCs on valuation related to a company.

Every entrepreneur wishes to know about those handles / lever-points, which will catapult their startup to get some particular valuation at Angel / Seed or Series A.

So what are the metrics which make us quite dizzy early in the morning and shows us dollar signs all around?

For any company (startup/growth/pre-IPO/listed-stock), any investment round is not the end but part of a journey where whatever enters at one point exists at another, and hence, let me rephrase this question and ask, “What metrics will get a startup USD 50 Mn valuation after 4/5 years?

USD 1 Mn revenue or 5 Mn?

EBITDA multiples 8 / 12 / 40 / 60?

Will you benchmark with Amazon (USD 54 Billion sales / USD 107 Bn EV) or Overstock (USD 1 Bn sales / USD 303 Mn EV) or Facebook / XING / LinkedIn or Groupon or LivingSocial?

Frankly, there is no clear answer as it all depends on the path the team takes it on since one can see from above-mentioned names that valuations differ greatly despite visible success in same vertical.

Web business is winners’ game and it’s 1 or 0 where winners take all, so factor that, and also-ran or 2nd / 3rd companies are valued at a fraction of what winners make.

On a broad basis, valuation is a function of earning and growth. Hence, earning and growth remains the fundamental case as far as financial metrics related to valuation works and all investment opportunities with financial objectives since the key parameters are bound to be valued on the basis of earning and growth only. Hence, there is no reason why a startup as it matures won’t be measured against these two metrics.

However, for Series A, valuation is more a function of many other factors, and in many cases, is also not very dependent on the startup itself and has more to do with market dynamics, investor internal road-maps / goals as well as peer group actions.

Hence, rather than worrying about Series A 5 Mn valuation, think of what it will take to make it a 50 Mn or 100 Mn or 1 Bn company (whatever the numbers are), since Series A valuation is a small stop-over and is not going to change or impact you for few % basis points here and there.

If you get a real bad valuation in Series A and do exceedingly well, Series B will take away all pains of Series A, and if you get very good valuation in Series A and don’t do well, there won’t even be a Series B, and you would end up having good paper stocks which can’t be used even as paper-roll!!!