In today’s article on AI Post, we will cover the evolution of startup industry in India and its impact on the economy. We will start our discuss from the origins of the startup culture in India and which way it is likely headed. For simple illustrations which everyone can understand, we will be taking examples of Uber, Ola and Flipkart. Same trend is getting replicated in other startups as well. A good Sunday read, which may take approximately 8-10 minutes to finish.
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Startup is a new culture in India which really picked up pace after 2009. As you are aware, a startup needs money for which it approaches angel investors or venture capitalists (VC). There is no dearth of bright ideas in India considering so many inefficiencies which still exists. With large population having smartphones in hand, it is an ideal breeding ground for entrepreneurs and venture capitalist (VCs).
Startup culture may be new to India but it has been very popular in US, particularly in San Francisco (silicon valley) since mid 90s. By a decade, many VCs had made tons of money by selling their stakes in startups to another VC. Flushed with hot money, many VC companies itself grew and started to behave like corporations. They crossed US boundaries in search of foreign opportunities. Here comes India. Particularly Bangalore, India’s very own silicon valley.
Another interesting development coincided. The economic recession of 2008. Economy plunged and central bankers in US thought they can hard-boot the economy by pumping money at extremely low interest rates (almost free). The idea was that cheaper loan rates will encourage people to buy and also help corporations to manufacture more using cheap credits. US central bank (Federal Reserve) slashed interest rates from 5% in 2007 to 0.1% in 2009. Such a drastic monetary measure taken by world’s biggest economy was unprecedented. This resulted in a tsunami of US dollars available at almost zero cost. What made matters worse was that other countries also followed the same path. Japan, Europe, Britain, China, South Korea all of them slashed interest rates. Suddenly, world was awash with easy money.
The number of VCs mushroomed all across the globe while existing VCs were already bloated with money. Within India, a whole new brand of VCs emerged. Not just traditional investors who turned into VCs but even famous personalities like Ratan Tata, Yuvraj Singh etc had their own VC arms ready. The result was five folds increase in VC investment between 2009 to 2012. This is the time when Flipkart, Uber, Ola, Snapdeal startups were incubated and flourished.
Excess of anything is..
This party went on till 2015-16 and thousands of startups found their angel investors (VCs). Excess of anything is bad. The euphoria created around startup was surely going to hurt later and it happened. By 2015, a large number of startups failed which is the very nature of this business. We keep on hearing success stories of only big startups who are continue to get new funding. As per estimates between 2014 to 2016, 40% of startups closed their shop within first year itself. Many more were shut in subsequent years. It is said that if a startup can survive for first three years, chances of surviving for long-term is very high.
Few reasons of failures were attributed towards lack of vision or innovation or business expansion. However, lack of funding also played a key role. VCs who started their business out of easy money were stretched too thin and unable to fund again. If the startup was promising, they sold their shares to bigger VCs and hence some consolidation happened among VCs.
Interest Rate Reversal
Another reason for the pause on startup funding is because cheap money era stared to fold back. In Dec 2015, when US central bank hiked interest rate for the first time, it signaled an end to 9 years long dollar printing spree. Since then, interest rate have continued to climb and liquidity in the market is being slowly squeezed out. It was felt as many startups suddenly found it hard to fund themselves in next round. Data shows that startup funding activity has considerably slowed down between 2015 to 2018. VCs have become selective and only a few startups are being funded. Overall funding numbers in dollar terms may look higher because of ever increasing valuations of famous startups but the number of startups receiving funding is dwindling. This situation is likely to continue as monetary policies are still tight globally. Having said that, VC culture has evolved beyond a threshold and futuristic startups will continue to get funding albeit the numbers will be normal as sanity has returned.
Profit? Does it matter?
Usually a startup may take initial few years to report first profit. This is understandable for any new venture. However, what will you say if a startup do not report any profit for 5, 6 or 10 years? Unfortunately, this is exactly what is happening with a lot of startups like Uber, Ola, Flipkart, etc. They seem to have ignored profitability logic at all. Ignoring profitability is affordable to them because they are funded by deep pocket VCs like Japan’s Soft Bank. These startups have a very different approach. They rely on predatory pricing to capture large volume of market share in the hope of making a profit in future. Such predatory prices demolishes the incumbents. Existing players find it unsustainable to match the offers made by the new startups. Soon, market dynamics gets changed as customers quickly migrate.
The strange thing is that despite not making any profit, almost everyone associated with a startup is making money. Be it founders, VCs, employees, or customers. In such a case, a logical question arises: From where is this getting funded. The culprit here is same old greed which has taken a form of something called VALUATION. Since there is no profit to show, startup investors invented new metrics to show company’s progress. For Flipkart, it is gross merchandise value which is a proxy of overall sales. For Uber, it is number of ridership (again a proxy of sales). Based on these invented metrics, they increase valuations with each rounds of funding. Typically in funding, either promoters will dilute their ownership or some existing investor will be willing to sell their shares to a new investor at elevated prices (courtesy revised valuation). This is a game of musical chair and the one sitting on the chair when music stops, may find it difficult to find new buyer. Later, we will tell you who is most likely to be seated on the chair when music stops.
So, with every fresh round of funding, fresh money is generated in startups like fresh milk. It is the greed of the seller (selling at higher price) and hope of the buyer (hoping to sell it at even higher price in future) which is pushing valuations even higher. Flipkart is valued at $22 billions. To give you a context of this valuation, consider the fact that India’s largest company, Reliance Industries has a market capital of $166 billions, after spending decades in the business and with so much assets on the book. With such valuations, these startups will be easily categorized as large caps if listed. Quite contrary to the idea of startup which is perceived as a smaller company.
With more money, startups keep on generating money which is not coming through business operations. Media helps to add decibels to the music by covering catchy stories of the VCs or owners and how they are raking big money within few years. Ordinary investors sulk on reading such stories as they can’t invest in startups. These startups are not listed on stock exchanges. Obviously, one thing is surely working well for such startup is growing sales and overall presence in the market. Users embrace new technology and the benefits which comes with it (comfort, cheaper prices, etc). Only people sucking at it are existing players who are pushed out of the game by sheer amount of wealth that VCs posses. In a way, it is a capitalistic behavior which was originally fueled by cheaper money. In a way, the economic recession of 2008 has led to another mini bubble in startups. Strange but true.
Where does it stop?
There are two ways for it to stop.
One, startups push for business profitability by removing or reducing existing incentives given to the customer. This is risky for the business because the customer wants cheaper services. The main USP of using startup products or services is because it is cheap and easy to use. If startups do so, their competitive edge will be gone. Someone else can enter the market & start snatching their market share. Even good old existing players can launch a platform and challenge them. So clearly they can’t annoy their customers to much. Only suspect, who can be squeezed out to generate profit will be service providers like cab drivers for Uber since they are very dependent on Uber’s network reach.
Another quick way for promoters or VCs to exit this madness is by launching an IPO. Doing one final round of valuation for the IPO and offloading shares to ordinary investors who are already enticed by the media. Now you know who will be sitting on the chair when music stops. This is evident as so many technology IPOs in US market have fallen way below their listing price after listing. Latest IPO of Uber fell 17% within matter of days. Another IPO for Lyft fell 34% since IPO. Uber still reports loss and shares continue to tumble. In stock market, investors will not remain glued to a company it if does not show regular profit.
The startup culture is very good for any country as it promotes entrepreneurship which makes it possible for anyone with a brilliant idea to prosper. In a way, it is an enabler of the society. However, the recent culture of predatory pricing by startups is detrimental. This is our own view and some people may disagree with it.
For a country like India, predatory pricing is hitting the unorganized players who are usually poor and they are being forced to exit. This motion is slowly giving control to the hands of few corporate aka startups. Earlier if we hired a taxi, the money was going into the pockets of a taxi driver. Now with Uber, a fraction goes to the driver but majority will go back to the startups and eventually to VCs like Soft Bank etc. Hence the benefits of startup is skewed towards people with deep pockets at the cost of the poor. Also, it is not a level playing field as startups can afford to bear losses since they have access to cheaper foreign funds which individuals don’t have. In small towns like Jaipur & Lucknow, Uber promotes ₹49 flat fare for travel upto 10kms within the city. With diesel prices at ₹65 per liter and petrol prices even higher, these are unsustainable for normal taxi operators. Eventually, smaller players will have to join hands with startups by becoming their re-seller where their profit margin will be decided by the startup companies.
Recently, Uber drivers went on strike as Uber is curtailing their benefit in a bid to turn profitable. In Uber’s 286 page IPO document, it admits that with time, they have to reduce driver’s cut which irked many drivers across the world. However, with Uber controlling so much market share, drivers have lesser choice but to hard negotiate on their commissions. It will be ideal if there is some regulation put into place to stop predatory pricing from anyone across any industry. This will help many other industries like telecom, airlines, hotels, etc. One such step was taken by New York City administration as they cracked down on ride hailing companies by mandating a minimum pay rate for taxi drivers of these startups.
Lastly, economic progress of a nation depends on the income distribution patterns. Ultimately, goods and services are consumed by the residents. They drive up the demand & hence GDP. If income distribution patterns changes as these startups are doing, there will be lesser disposable money in the hands of ordinary people which will impact demand patterns and can slow down the economy. It is already evident as consumption patterns are declining and industrial capacities are lying idle. This will result in lower capex in future and slow growth for financial sector as well.
On the other hand, there is an argument that these startups are creating new job opportunities as anyone can join them and earn money. This is true to some extent but these people were anyway free to take up same occupation earlier as well. Infact earlier, their margins were in their own control. The only real benefit they are getting from startups is network reach where technology is an enabler to get more business in an easier way.
Don’t worry, as we said nothing lasts forever. Market conditions will force something to give way and economic order should get restored wherever it is getting disrupted by new innovations. Market participants (including policy makers) have a great ability to adopt and excel under new conditions and they will in the future.
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