Why the startup investing market is headed for a bustSuhas Baliga
The startup investing market is headed for a bust. I don’t like to say this; I’m a connoisseur of startups, so I really hope I am wrong. But we ARE riding a dangerous boom. As a corporate lawyer who has served as advisor in over 100 venture capital, angel and private equity transactions in my career, I must confess to being a part of setting up the (often faulty) structures that inform early-stage investing. In this rather longish read, I will explain why I think so and invite you to disagree.
The boom that began with the bust in the IPO market
The deep recession of 2008 caused a bust in the IPO market, which continues till date. This has been a boon for startups seeking investments. Investors who did not see much excitement in public markets invested in startups at fantastic valuations, in the hope that their returns would multiply manifold when the IPO markets opened up. This was the cause for the first round of startup investments during the recession.
The second wave of startup investments started more recently, in the shadow of the continuing bust in the IPO market. Seeing no hope of recovery, there continued to be an abundance of private capital chasing startups. This second wave was fueled not by the hope of an IPO, but by the excitement generated from exits seen in the secondary market as a result of the first wave of investments. Soon, investors bought into the idea that startup investments make money. While it is true that startups do make money for early shareholders, this can be driven by excitement from other investors. It’s not necessarily because of profitability of the business invested in.
This is also made possible because of the legal and regulatory flexibility that startups have for the purpose of raising money. “Private placement” rules allow companies to go on and raise as much money they like without making a single dime, as long as investors are interested in investing in them. But why would investors be interested in a business that does not make money?
The “traction” hypothesis
Any business that wishes to raise large amounts of capital from the public is required to be profitable for a sufficient period of time before being allowed to do so. This is not the case with businesses looking to raise private investments. A large number of gigantically valued companies in Silicon Valley and India have attained their valuations through a different measure of ‘success’ – “traction”, i.e. growth in usage and customers – with little to no weightage being given to their actual revenues or profits. The success of Facebook, Instagram and Google (among others) perpetuated the idea that the number of users a business garners is more important than all other factors in startup investments.
Investors who have gained from their investments in startups with sufficient “traction”, that attracted follow-on-funding and acquisitions, poured even more money into businesses with “traction”, thereby making “traction” a self-fulfilling prophecy. As a result, most entrepreneurs focused less on means to cut down costs and more on means to optimize spending of money on marketing and sales, to ensure that more users are accumulated and valuations are driven up.
So mesmerized has been the venture capital world with the idea of “traction” that all of India’s e-commerce businesses today spend more money than they make. They are likely to continue to do so for the foreseeable future. Money keeps flowing in, as long as the number of users and the revenue rates increase, irrespective of whether more fundamental aspects such as costs, processes, innovation, and customer preference have been established. We are seeing here the scene being set for a systemic bust in investor confidence - once the aura of “traction” recedes.
A dangerous inversion of corporate governance
There are other and more serious reasons why investors are slated to lose money. Given that startup investing is a high-risk game usually played by the super-wealthy, it is not the failure of investments that result in loss of investor confidence but the hows and whys of the failure - especially since we thought we’ve had this figured out for the last 200 years or so.
The traditional model of corporate governance, put very simply, is as follows: shareholders who invest in the company democratically (linked to their skin in the game) appoint a board of directors, who oversee the management of the company, which is done by a group of experienced, expert professionals. The percentage of shares held by an investor reflects her power to influence the appointment of directors, and to block or push through resolutions on matters that are material to the company. This results in a fair degree of alignment between the interests of the investors and the management of the company.
Public companies are subject to a high standard of disclosure requirements. These ensure that even a shareholder who holds one equity share in a company has access to the same information available to all shareholders. This is so that his continued investment in the company is undertaken on an informed basis. Further, directors appointed by the shareholders owe a “fiduciary duty” to the shareholders, in addition to being obligated and liable for the day-to-day management of the company. In a public company, there are also independent directors who are required to be disinterested, thus enabling them to act as “whistle-blowers”, and bring fresh perspectives to the board and its shareholders.
These checks and balances ensure that the management of a company is required to keep its shareholders, employees, and other stakeholders informed in matters of decision making and strategic direction. The startup investing world has, however, inverted these concepts, and along with entrepreneurs, sees these checks and balances as stifling of innovation and “nimbleness” in early and growing businesses.
Perverse incentives everywhere
The founders of Google were early trendsetters, and still continue to effectively control (their?) company despite their nominal collective shareholding. This is an anomaly of the US legal framework, and may not be possible in jurisdictions with well-regulated public securities markets.
Startups have picked up on this, and so have their investors. Promoters in startups are not required to, and neither are they expected to, take anyone along. Given the hunger for startup investments and the flexibility of private shareholder arrangements, it is increasingly common for founders to control their companies through the board of directors, even after their shareholding is far below the 50% mark. The usual quid pro quo demanded by investors is – (a) lock in of shares; (b) indemnities; (c) vesting provisions that reduce a promoter’s equity shareholding if she exits earlier than a specified period, and (d) the first right to gain from any upside in the business.
While some of these can be reasonable ((a), (c) and (d) for instance), in several instances where a startup is “hot”, investors have compromised on even these aspects, in ways such as offering opportunities to promoters to sell and capitalize on a part of their shareholding (housing.com).
Further, given the general prevailing disdain for transparency and the “might is right” attitude of investors in the unregulated market of private investing, it is often the case that smaller (in most case the first or earliest) shareholders’ rights are compromised. In many instances, promoters and later investors are reluctant to provide such shareholders even basic information rights that are typically offered to any shareholder in a public company. It is especially atrocious since the said shareholders may be holding in the range of the higher single digits of shareholding in a company, by any standard a substantial portion of ownership.
This results in fewer voices on the board to guide and instruct the promoters, and also much frustration and disdain among earlier investors. It has incentivized early investors to book early profits and leave companies because (a) they have no voice or visibility in terms of where they stand; and (b) they are able to do so because of the frenzy of new capital chasing the company.
All of this has fostered a culture of closed-door decision-making, with a lack of accountability to a larger set of stakeholders. The processes adopted by companies are often limited to including the latest and biggest (hence relatively powerful) investors who are sometimes least knowledgeable about the promoters or the business. This leads them to often take the business to places that even the promoters may not be able to contemplate or manage effectively.
Compromises in compliance and public engagement
A widely held and profitable company is required to extensively engage with a wide array of stakeholders on a day to day basis: regulators, stock exchanges, institutional and retail investors, independent directors and independent legal and auditing firms. This results in such companies investing a substantial amount of time and resources in ensuring that the spirit and letter of law and policy is given effect to (at least to a larger extent than companies driven by private capital).
Given that a large number of startups do not aim to enter the public markets, the average levels of legal, regulatory and tax compliance have plummeted. It is increasingly fashionable to invest and do business first, and worry about law and compliance later.
The argument offered in favour of this method is that legal and regulatory matters are stifling of innovation as well, and consume unnecessary bandwidth and attention early on, in privately held businesses. If it were true that public companies are excessively regulated to innovate, it does not explain why most of the innovation in recent history has been driven by large public companies. It is also interesting to note that a large number of privately-held venture-funded companies are larger and more heavily capitalized than smaller public companies that play by the book. Hence, the argument around “lean and mean” may not suffice to justify disdain for compliance and regulation.
Private investors, who have invested billions of dollars in technology startups in the past few years fueled by the “traction” of mobile and web applications, are on shaky ground. Given the systemic lack of controls fostered by a certain definition of “innovation” and “freedom of enterprise”, all it takes is one wayward founder on whom billions are riding, and in whose business not a single dollar, dime or rupee has been generated by way of profits. Basically, - a “hot” company with no fundamentals except the so-called “immensely talented team of founders”.
Not only this, the system is also producing a large number of Founder-CEO-Managing Directors who have no experience in taking people along, fostering good corporate governance, complying with regulations, or engaging with policy makers. This is not an unfortunate coincidence, but a deliberate approach fostered to a large extent by the investing community. This is reflected in their approach to participating as financial investors in their portfolio companies, and evidenced in deal documentation in successive investment rounds.
Unlike in conventional brick-and-mortar businesses, where investments may be used to create assets with long term and residuary value which can be liquidated, most venture-funded businesses spend on “traction”, something intangible and temporary, i.e., here today, gone tomorrow. The residuary value of a business, if any, is limited to the experience gained by a failed entrepreneur. This may add value to the startup ecosystem, but may erode investor confidence in general.
For all these reasons and more, the startup world needs to fix itself soon; or else the money is going to dry up faster than we can say “invest”. The problems are systemic and may not find easy resolution until investments tumble from their already shaky foundations. This may open a window of opportunity for reinventing how founders and investors look at startups, and how lawyers, bankers and other professionals advise them. That will be an interesting time, if there is anyone left on the scene. After all, IPOs may well be on their way back.
(The views expressed here are solely those of the author in his private capacity and do not in any way represent the views of YourStory)