Where have all the startup hedgehogs gone?

IT services companies in India have been around for 30-40 years, and the collective market cap of the top 10 companies, which generate a profit after tax of nearly $12 billion, is roughly $320 billion. The average growth rate of these companies is about 15%. This translates to a price-earnings ratio of 27 and a price-earnings to growth ratio of 23.

And IT services companies have been operating with a near perfect product-market fit, or the extent to which a product or service is addressing a real market need. They also operate in a space that has a relatively low degree of difficulty in comparison to startups that followed Flipkart—startups have tried to solve some of India’s most wicked and intractable problems with varying degrees of product-market fit.

Yet, in 2022, the collective valuation of the unicorns, or private companies with a valuation of over a billion dollars, was roughly the same as that of the top 10 IT services companies even though these unicorns were burning a whole lot of money.

Take the case of edtech company Byju’s, one of India’s most valuable startups. In 2020-21, the company’s loss, at ₹4,588 crore, was twice its revenue. Yet, its valuation in 2022 was an incredible $22.6 billion.

Things didn’t quite add up, but an era of easy money was probably not the right time to unpack the nuances.

The funding winter that followed on the heels of startup India’s tentative entry into the public markets arena in the second half of 2021 offered some rich insights, and created conditions conducive to reflect from these insights.

IPO euphoria of 2021

The founding of Flipkart in 2008 triggered a new wave of first-generation entrepreneurship in India. In the following decade, startups that were inspired by the success of Flipkart—Zomato, Nykaa, Paytm and BigBasket among others—made themselves both loved and indispensable in the lives of Indian consumers. Some of them were set to unlock value for their investors through initial public offerings (IPOs).

Zomato kicked off this IPO fest, listing at a premium of 53% on its issue price. The verdict was unanimous: ‘India’s new age tech companies had come of age’. And when Nykaa went public less than four months later, and listed at a premium of nearly 80% on its issue price, this narrative solidified. Those sceptical about unprofitable companies going public had to lie low.

In the meantime, Paytm was preparing for the country’s biggest IPO. The IPO was subscribed nearly two times and the demand from institutional buyers was nearly three times the number of shares reserved for them. Just 10 days after Nykaa’s stellar debut, when Paytm went public, it opened at a 10% discount to its issue price. It closed day one 27% below the issue price. This was probably the worst debut on the stock markets in a very long time.

Though many analysts and observers had questioned Paytm’s business model and its utter lack of focus, very few had anticipated this collapse on day one. So, what happened in just 10 days?

Two fatal errors

The era of easy money was both good and bad. Good because by putting the startup ecosystem on steroids, it inspired thousands of young professionals to try their hand at entrepreneurship. And bad because many ill-conceived ideas were funded, valuations across the board were highly inflated, and fundamentals of what constitutes good product-market fit were ignored. And the heady concoction of venture capital (VC) money, media spotlight, and instant fame created the wrong role models. It also proved to be the undoing of many founders and startups.

Easy money induced two fatal errors in judgement. One was a mistaken belief that the ubiquity and size of a problem was all it took to rapidly build large and profitable companies. When viewed with a macro lens, many of India’s problems are big and waiting to be solved more efficiently. And in all fairness, some tech startups have come up with innovative solutions. In the process, they created insurmountable entry barriers that allowed them to grow unhindered. For example, technology combined with network effects worked like magic when it came to cab aggregation and there was no way anyone could disintermediate the platform.

The platform was both a game changer and a necessity. Many e-commerce startups, too, would pass this test. However, not all big problems are amenable to tech solutions. The devil, therefore, lies in the details. Tech solutions to the big problems in education, healthcare, skills/employability, property/real-estate, and financial inclusion were hastily deployed without a careful assessment to determine whether they were really game changing enough to get customers to pay.

The collapse in the edtech and proptech sectors in the recent past is symptomatic of this gap.

In the property transaction space, broker networks were already doing a reasonably good job of addressing an infrequent and high-value need of the customer. Quite obviously, if one would have asked customers if they were totally happy with the current state of affairs in this space, their answer would be ‘no’. However, mere dissatisfaction with the current solution, as Rob Fitzpatrick tells us in his book The Mom Test, does not automatically mean that this is a problem worth solving. Dissatisfaction with the current state of affairs is the default state of customers. What needs to be validated early on in the game is whether the alternative solution is a game changer that customers would be willing to pay for.

Easy money also lulled everyone into believing that customer delight and high repeat rates meant great product-market fit. Customer love and repeat rates are merely indicators that you are probably doing something right. The truth, however, is that there is no real product-market fit until customer love and repeat purchases come at a price point that makes the business profitable.

One indicator of the structural attractiveness of a business is the ratio of the lifetime value (LTV) that any one customer generates for the business to cost of acquiring the customer (CAC). This ratio could be low or even negative for a short while in the initial phase. But if it continues to remain low or negative for extended periods of time, it is a big red flag that you could ignore at your own peril.

Startups that ignored this wisdom eventually went down. Quick commerce is stuck in this quagmire and is desperately hoping to find a way out of this trap.

The endgame

Startups that have listed or plan to list are at a sharp kink in their journey as they graduate from a private to a public company and learn the new rules of the game. Public companies are managed to a quarterly rhythm, with a high degree of predictability, governance, and disclosures. By the time startups come close to an IPO, there is also far more clarity on the valuation drivers.

Earnings and growth, as opposed to revenue multiples and scarcity value, have a disproportionate influence in valuations as embodied in the idea of price-earnings to growth. Any mismatch between prior valuations and valuations as determined by the more acceptable methods relevant for mature and public companies are expected to be corrected in favour of the latter.

The correction could happen with a sharp decline of the share price (as in the case of Paytm) or the share price remaining flat over an extended period even when the company keeps growing (as is likely with Zomato or Nykaa).

There is probably no VC funded unicorn in the current lot that is likely to stand the test of its private valuation in a public market. Even those that are profitable, or near to profitability, will have to take a non-trivial haircut.

In anticipation, some of this has already begun to happen with unicorns that continue to have high cash burn. US-based investor Baron Capital marked down the valuation of Swiggy by 40%; Blackrock and Prosus did the same with Byju’s, by nearly 70%; and SoftBank cut the valuation of Oyo by more than 70%.

Going by the benchmarks of 2022, even a grossly undervalued company like BigBasket would struggle to justify its valuation when measured by the yardstick of price-earnings to growth. Therefore, the majority of unicorns that could have realistically aimed for an IPO in 2023 will have to take haircuts, in varying degrees, on their valuation, or postpone the IPO. They will need to sharply reorient the business towards profitability.

Another category of startups includes those that continue to be unprofitable because of blindly using high customer experience scores and large funding rounds as surrogates for great product-market fit. They will have to question their offerings and seek to make sensible pivots. But there may not be enough room for a meaningful pivot. Some of them are likely to shut. All quick commerce startups and many in the edtech and proptech sectors would fall into this category.

Probably, the only two edtech startups that will continue to thrive in the new environment are Simplilearn and Entri. Both have deeply understood that the only time most Indians pay for any kind of offering in education is when it results in a job, a promotion, or a salary increase.

And finally, there is a category of unicorns that lost their way by diversifying into unrelated areas, opting for hasty mergers and acquisitions to keep the growth story alive. They also indulged in massive mis-selling, or deliberately ignored governance.

Some of them have just withered away and others have been in the headlines with bad news trickling in every other day. These unicorns, and their investors, will have to do some soul searching.

In the ultimate analysis, when all the noise dies down and the dust settles, the winners would be what author Jim Collins calls the ‘hedgehogs’—those that stayed incredibly focused on the one or two things they did well and remained grounded.

The next 400 mn

The excessive euphoria around building large and valuable companies with VC money is probably fading slowly. India will continue to offer large and interesting problems that would excite entrepreneurs, and many of these problems can be solved only by applying the basic principles of business building.

But not all problems and markets are conducive to being addressed by a few well-funded hyper-scaleable startups. Founders need to revisit the idea of scaling, and ‘small’ may after all be beautiful in certain contexts.

There is also the realization that it is far easier for first generation entrepreneurs in India to build tech companies that deliver products and services for well-off consumers at the top of the pyramid than to build and deliver basic products and services profitably for those in the middle with lower disposable income.

The ultimate example of pandering to the top 100 million consumers has been the irrational obsession for quick commerce and the rush to launch 10-minute grocery delivery. The top of the pyramid consumers had already been spoilt for choice and a 60-minute delivery by multiple platforms was already available. Cutting this down to 10 minutes was stretching the idea of convenience to a new level.

While it is certainly an acceptable market segment and a meaningful target for some, it pales in comparison to the massive existential problems that limit availability of affordable, effective and essential services to the next 400 million Indians—just below the top of the pyramid.

Startups that aim to be successful in the next phase need to nurture a deep understanding of the problems of this 400 million Indians. They also need some imagination around creating low-cost products and solutions .

India’s destiny cannot be equated to the destiny of the upper crust that comprises less than 10% of the population. It is the destiny of those at the middle and the bottom of the pyramid—which comprises more than 90% of the population. And entrepreneurship must enable their tryst with destiny.

T.N. Hari is an author and co-founder of Artha School of Entrepreneurship.