The decade that was: The story of VC investing in India

For those familiar with the excesses of a previous era, some of the mistakes of this era seemed familiar. But as they say, every generation is entitled to learning its own lessons. Why learn from others’ mistakes! The early success of IT outsourcing created a stampede towards it. Very soon, every American company was rushing into India, some to find outsourcing vendors and others to set up their own captive centres. Their hope, and belief, was that every engineer in India would be like those from the IITs they had seen in their own companies abroad.

Very soon, the harsh realisation dawned that less than one-fourth of the engineers in India were even employable, let alone capable of doing cutting-edge work at companies like Google. While this realisation forced these companies to recalibrate at several levels, it did not distract from the basic thesis that a lot of work could be performed in India at much lower costs.

In this latest wave of VC investing, the scenario hasn’t been very different. After the initial blind rush, VCs soon figured out several things. First of all, India was no China. The depth of the market was not comparable. India was a heterogeneous market and more an aggregation of diverse and mutually exclusive micro-markets. The multitude of languages added to the difficulties in creating market participation and penetration. The infrastructure was creaky. In a throwback to an earlier era when investors and companies outsourcing services were appalled by the infrastructure and frequent power outages, newly arrived VCs too realised soon enough that the building blocks that could accelerate the scaling of new ideas were absent.

However, like the MNCs before them, VCs too recalibrated but this did not distract from the basic thesis that India was the next big opportunity - one they could not afford to miss. They learned that patience, customisation to Indian tastes, and consumers’ ability to pay was critical. Indians still liked Western brands, and it would take time, and building social confidence, to change this preference.

When it came to a user base, the Indian online consumer market was grossly over-estimated and migration from offline to online was a slow process. The size of the population and the internet penetration turned out to be a poor surrogate for online commerce. As per analyst estimates, both Amazon and Flipkart had roughly 15-20 million monthly active users in 2017, which is not a great number.

Another study published by Omidyar showed there is a large variation in the propensity to transact online across different socio-economic groups. The number of individuals who transact online in the upper crust of the “New Consumer Classification System” (or upper crust of the socio-economic groups) are just 40 million! This again points to the relatively nascent state of the Indian consumer when it comes to transacting online.

One investor we spoke to said the reason could well be that Indians have been highly value-conscious. While most M&A numbers in the startup space remain undisclosed, it is widely acknowledged that most deals have been acqui-hires and distress sales. Given the option of spending Rs 25,000 on a luxury item, most people we know would forego a Rs 25,000 designer handbag, spend Rs 2,000 on a fake, and keep the remaining Rs 23,000 inside it! That's us. The truth is that India is a heterogeneous country across several dimensions – approach to consumerism and visible display of wealth being one of them. Therefore, unlike other countries that are relatively wealthier or more homogeneous, it is difficult to extrapolate blindly or paint the whole nation with a single broad brush.

Achieving scale would, therefore, be a long, drawn-out journey. Soon enough, discounting as a way of accelerating growth began to face the wrath of regulators. For instance, as per the definition of a marketplace model, a marketplace was not allowed to influence pricing.

The fear of missing out!

Somewhere around 2014, VCs began demonstrating an appetite for much bigger ticket sizes, and were willing to cut short the due diligence process. Hedge funds like Tiger Global changed the investing game with quick, bold bets on audacious ideas. India’s macroeconomic potential had caught the imagination of investors from across the world. Those that had tasted success in China as well as those that were too late to the party there rushed into India. The associated frenzy gave new meaning to the phrase “fear of missing out (FOMO)”.

At its peak, the FOMO manifested itself in two bad habits that VCs continued to demonstrate for some time. The first was a ‘herd mentality’. It was not surprising to find waves of similar ideas where one VC would back a particular startup, and a different VC would back a competitor with a similar idea.

Ideas were in favour, or out of favour, and not good or bad! At one time it was horizontal ecommerce startups, at a different point it was Foodtech and at yet another point, it was Fintech. The second was to back copycat ideas – ideas that had succeeded in the West. Not enough thought was given to the context and the need for making relevant tweaks.

One example was Rocket Internet – it’s entire premise was built around such copycat ideas from different geographies, eventually resulting in it shutting shop and exiting India in 2016. The frenzy to race ahead saw VCs making two fundamental compromises. Firstly, there were alleged ethics issues in many of the companies they backed. Ethics is always too fundamental to be compromised. Secondly, while imitation is a good form of flattery, it can’t be the basis for building great companies.

Two years down the line, things are changing rapidly, almost as if an invisible tipping point had been breached. The payments infrastructure, and a unique citizen identity, is now the envy of the world. Reliance Jio is proving to India, and the rest of the world, that innovation and disruption are not the prerogative of 25-year-olds. Large corporations led by leaders with imagination can disrupt at scale, and quickly redefine how the world looks. India Stack, for instance, is demonstrating how a loose network of passionate professionals in India is replicating what Open Source, triggered 20 years ago in Palo Alto, achieved for software applications.

There is also the matter of a (perceived) bias. One debate that refuses to die down is the ‘bias’ that investors tend to have for entrepreneurs from IIT, IIM, or a similar background. We don’t have an opinion on this because everyone has a different story to tell. All we would say is that as human beings, we are inherently drawn to people like ourselves – people with similar backgrounds and sensibilities. And so, while it is true that a large chunk of early investments in India went to such entrepreneurs, we would attribute this to the fact that the investing community drew heavily from people with these backgrounds. So, in some ways it was an old boys’ network at play.

Our personal experience has been that entrepreneurship is going down the same path as cricket – drawn from elite backgrounds to start with, but rapidly permeating to Tier 2/3 towns. India’s best cricketers today come from a modest background from smaller cities and towns. The best, and most grounded, entrepreneurs today come with a similar background and not necessarily with an Ivy League education. We have no doubt that we will see many more of these entrepreneurs in the years to come, and their ideas and execution will power India’s journey forward.

Flipkart, the turning point

From February 2018, the market was abuzz with rumours about Flipkart’s imminent acquisition by Walmart. There was also a rumour about a late wild card entry by Amazon. Knowing how fickle Amazon had been in the past when it came to M&A, nobody took this seriously, though several reliable sources reported that Amazon had officially put in a bid to purchase 60 percent of Flipkart around the time Walmart was reportedly in the final stages of acquiring a large stake. Apparently, the offer was at par with Walmart’s. In addition, Amazon was offering Flipkart a $2 billion breakup fee in case the Walmart deal fell apart as a result of Flipkart’s prenuptial flirtation with a rival contender. 

The sentiment at Flipkart, however, was pro-Walmart for several reasons, not least of which was the adverse view that the Competition Council of India (CCI) could potentially take of an Amazon-Flipkart combine. In a nutshell, Amazon had dragged its feet like it had done before on other deals in India. It was simply a matter of too little, too late.

On May 9, 2018, the suspense finally ended. Walmart and Flipkart entered into a definitive agreement where Walmart would buy 77 percent stake in Flipkart for $16 billion, valuing the company at a whopping $20.8 billion. Walmart was paying a hefty premium for a late entry. They could have potentially acquired a controlling stake much earlier, but had missed the bus. The management presentation to employees went viral on WhatsApp. The highlight of the deck wasn’t the value of the deal; it was that Co-founder Sachin Bansal did not have a role to play in the Flipkart’s new avatar.

Over the last couple years, there had been increasing doubts about the Indian startup market being able to provide its investors with successful exits. This single transaction provided everyone with some much-needed reassurance, at least for now.

When Sachin and Binny Bansal started Flipkart in October 2007, little did they realise that they had unknowingly triggered an avalanche. Their success ignited a new wave of entrepreneurship that set off a deluge of first-generation entrepreneurs. Suddenly, VC money was easily available for entrepreneurs with big ideas. At one point of time, the tables were turned, and VCs were literally pitching to entrepreneurs; or if that seems a bit of an exaggeration, then at least entrepreneurs could pick and choose from among multiple term-sheets.

Big bets and the valuation game

‘Disruption’, ‘network effect’, ‘winner takes all’ were the new buzzwords and phrases. Valuations were more about demand-supply dynamics and scarcity value than any fundamentals. It is helpful to see two different takes by two equally strong personalities on this topic.

Aswath Damodaran, who is arguably the most influential valuation expert in the world today, has written eloquently about the exaggerated valuations of companies like Uber, Facebook and WhatsApp. Obviously, VCs like Bill Gurley do not agree with his views and argue that (in the case of Uber), “In choosing to use the historical size of the taxi and limousine market, Damodaran is making an implicit assumption that the future will look quite like the past. In other words, the arrival of a product or service like Uber will have zero impact on the overall market size of the car-for-hire transportation market. There are multiple reasons why this is a flawed assumption.”

Damodaran retorted,

If you are old enough to remember market fevers from past booms, you are probably inclined to dismiss the claims and the valuations as fantasy. I do believe, however, that there is a kernel of truth to the disruption argument, though I think investors are being far too casual in accepting it at face value.

Wild swings in valuation became the norm as the game evolved within a sector. When Jabong was acquired by Flipkart-owned Myntra in July 2016 for a paltry $70 million, one could not help wonder how things could have gone downhill so quickly from the winter of 2014 when a potential deal with Amazon fell through because the asking price of $1.2 billion was a bit too steep. A new word in the startup lexicon was born: “Jabonged”.

The story was repeated with Snapdeal and a host of other consumer internet companies. This had happened before with Yahoo! in the US, but the number of Indian consumer internet companies that faced this predicament was simply far too many. These new businesses were all built around an unconventional business model. The elements of this brave new model were:

(a) burn money and change consumer behaviour

(b) race ahead of the competition by acquiring deep-pocketed investors

(c) stay ahead of the pack and use the network effect to take away market share from competition

(d) kill the competition by bleeding them to death by offering steep discounts

The last man standing would be the winner in this model. It was a risky game, and there were several uncertainties. One never knew how long, and how many million dollars, it would take to be the last man standing. What’s more, there was no guarantee that the market would be one where the winner takes it all. And, even if you were the last man standing, there was no guarantee of an exit via a strategic buyout or an IPO. This was another fear (that Indian startups could not attract large strategic buyouts) that the Flipkart-Walmart deal dispelled to some extent, besides proving the point that VCs that made big bold bets in India could see exits.

Read further: Part 3: New VCs and young founders come of page

Return to Part 1: The decade that was: How India’s startup landscape has evolved