This blog has been cautious about the startup sector of India (and developing countries in general) and global impact investing. I am inclined to believe that there is more froth than substance in both. In case of the former, the ultra-loose monetary policy and the global search for yields has seriously compromised the disciplining powers of finance (see this and this). In the latter, ESG investing have provided the convenient excuse for impact and green washing. In either case valuations are a misnomer for price.
The Indian startup scene has been set ablaze by the spectacular IPO of Zomato. In a largely conservative market this constitutes a huge collective leap of faith since the company has consistently made increasing losses and several questions hang on its profitability. With some more blockbuster IPOs lined up, the party is likely to go on for some time. Some high-profile boosters even think of it as a new dawn in risk capital raising. The problem is with those left standing when the party ends, as it must. And it's most likely to be not pretty.
The real Zomato IPO prospectus should have been something like this.
In fact, Aswath Damodaran has this typically rigorous take on Zomato's $14.2 bn post-money valuation,
With my upbeat story of growth and profitability, the value that I derive for equity is close to 394 billion INR (about $5.25 billion), translating into a value per share of 41 INR. That may seem like a lot to pay for a money-losing company with less than 20 billion INR in revenues in the most recent year, but promise and potential have value, especially when you have a leader in a market of immense size.
A good explanation for the divergence is that while $5.25 bn is Zomato's valuation, its market price at this moment is $14.2 bn.
On a global scale, Indian markets are just catching up with the western markets on startup IPOs. The Economist has a summary of the rise and rise of unicorns and gush of venture capital flowing into startup funding,
The number of such firms has grown from a dozen eight years ago to more than 750, worth a combined $2.4trn. In the first six months of 2021 technology startups raised nearly $300bn globally, almost as much as in the whole of 2020. That money helped add 136 new unicorns between April and June alone, a quarterly record, according to cb Insights, a data provider. Compared with the same period last year the number of funding rounds above $100m tripled, to 390. A lot of this helped fatten older members of the herd: all but four of the 34 that now boast valuations of $10bn or more have received new investments since the start of 2020.
Apart from entry of yields-seeking non-VC investors like pension funds, sovereign wealth funds, and family offices, and competition of fear of missing out (FOMO), the rush of startup focused risk capital has been triggered by divestments by startup's early VC backers,
These stakes command top dollar from investors desperate for exposure to the pandemic-era digitisation wave. Exits, via public listings and acquisitions, more than doubled globally year on year, to nearly 3,000. The proceeds are flowing back into new VC funds, which have so far this year raised $74bn in America alone, nearing the record $81bn in 2020 in half the time. The venture capitalists cannot spend the dough fast enough.
This is truly staggering,
In the three months to June Tiger Global, a particularly aggressive New York investment firm, made 1.3 deals on average every business day.
Howsoever brilliant the investment team at Tiger Global, it's hard not to believe that those were instinct-based investments. You just can't do due-diligence at anything close to such speed. This is pure impulse investing or throwing money at anything that looks attractive.
In addition to these global factors, the Indian startups have received an unexpected boost from the Chinese crackdown on its technology startups. It has made Indian startups the obvious favourites for western investors.
There are several compelling arguments against the frothy valuations of the startups. For a start, the business model of growth-focused aggregators like Flipkart, Oyo, Zomato, Swiggy etc is critically dependent on very large volumes to make up for the low margins possible from price-sensitive clients at both sides of the aggregator platform. Second, the large volumes are unlikely to materialise due to the surprisingly small size of the Indian middle-class (sample this talk of 500 million users!). Therefore once the initial flush of clients with the willingness to pay are captured and Covid recedes, the growth models is likely to struggle. In fact, the little meaningful commercial value for these startups are more likely to come in the form of "millennial lifestyle sponsorship" for a tiny sliver of the population.
Third, the developed market strategy of targeting capturing customers with deep discounts in the hope that clients are likely to be sticky even when prices are increased subsequently is unlikely to work in the Indian context. The small size of the middle-class means that the share of sticky customers will be small.
Fourth, another extenuating factor is the small average size of transactions on these platforms, far smaller compared to those in developed markets. This limits the realisable margins from transactions. This is a natural consequence of the country's low per capita incomes at all levels of the income ladder.
Fifth, even the existing margins are built on a combination of possible extortion of restaurants (allegedly 25-30% of order value) and regulatory arbitrage, both of which are unlikely to sustain for too long.
Finally, even at a global scale, despite bumper listings, the experience with post-IPO performance of aggregator startups has been uniformly disappointing. Despite being active for over a decade, all but one continue to make losses.
Equally important, it has the potential to change the investor culture in India and thereby expand both the envelope and, equally importantly, the share of risk capital (among all financing savings) available in the country. This is one of the most important requirements for the sustainability of high national economic growth rates.
However, this requires the party to go on for some more time. And that critically depends on what the US Fed does with its monetary policy actions. Indian startups should egg the Fed to keep the monetary gravy train going on. This, and not any real innovation in their activities, may well be the real creative destruction from the startup bubble.
Update 1
Good Livemint article on the IPO frenzy. In terms of revenue multiple,
At ₹1.04 trillion, Zomato is valued at 49 times its latest full-year revenues. At ₹75,000 crore, Paytm would be valued at 24 times revenues. By comparison, the median revenue multiple of the sample set of 73 companies is 5 times. DoorDash, the largest food-ordering company in the US, listed in December 2020 at a revenue multiple of 11 and is currently valued at 20 times. Zomato’s only direct competitor in India, Swiggy, is unlisted. Food franchise businesses like Jubilant Foodworks (Domino’s Pizza) and HardCastle Restaurants (McDonald’s) are valued at 13 times and 9 times revenues, respectively.
And this on the listing funnel, from 401 IPOs in US market listed over the last year
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