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 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. 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

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!!

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