Where have all the startup hedgehogs gone?

Some comparisons can be eye-popping. Here’s one of them.

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 Rs 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 skeptical 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.
Summary

The article discusses the rise and fall of startup companies in India, particularly in the tech industry.
To set the context, the article compares the market capitalization of top IT services companies, which
have been around for 30-40 years, with that of unicorns. Despite the fact that these unicorns were
having a lot of cash-burn, their collective valuation in 2022 was roughly the same as that of the top 10
IT services companies.

The article also talks about the IPO euphoria of 2021, when several startups such as Zomato, Nykaa,
Paytm and BigBasket went public. Zomato and Nykaa had successful listings, but Paytm’s debut was
disappointing. This era of easy money was both good and bad for the startup ecosystem. On one
hand, it inspired young professionals to try their hand at entrepreneurship. On the other hand, many
ill-conceived ideas were funded and valuations were highly inflated.

The article argues that easy money induced two fatal errors in judgement: a mistaken belief that the
ubiquity and size of a problem was all it took to rapidly build large and profitable companies, and an
over-reliance on growth at all costs. It suggests that tech solutions to big problems in education,
healthcare, real-estate, and financial inclusion were hastily deployed without a careful assessment of
whether they were really innovative enough to get customers to pay. While customers may not be
completely satisfied with the current solution, dissatisfaction alone does not mean that an alternative
solution is worth pursuing

The article also discusses the importance of the ratio of the lifetime value (LTV) that any one customer
generates for the business to the cost of acquiring the customer (CAC). If this ratio remains low or
negative for extended periods of time, it is a big red flag that should not be ignored. It further
advocates that 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 may
need to take a haircut. Some of this has already begun to happen with unicorns that continue to have
high cash burn.

It suggests that the excessive euphoria around building large and valuable companies with VC money
is fading slowly. Instead, founders need to revisit the idea of scaling, and ‘small’ may after all be
attractive in certain contexts.

The article also discusses the challenges of building and delivering basic products and services
profitably for those in the middle with lower disposable income. It suggests that startups that aim to
be successful in the next phase need to nurture a deep understanding of the problems of the 400
million Indians who are just below the top of the pyramid. These companies also need some
imagination around creating low-cost products and solutions.

In summary, the article provides an insightful analysis of the rise and fall of startup companies in India,
particularly in the tech industry. It discusses the challenges faced by these companies and offers some
suggestions for how they can navigate the transition from private to public markets, as well as how
they can address the needs of a broader segment of the population for unlocking next level of
growth.