Going Public Early Is Advised Instead Of Valuation Tags As Metric For Startups

In H1 of 2023, there was no new unicorn in India as startup funding plunged more than 70 per cent in the January-June period from a year ago, signalling that the funding winter is here to stay as several top unicorns continue to face an economic downturn.

The first six months witnessed Indian startups raise just USD 5.48 billion, from the USD 19.5 billion they raised during the same period last year, according to data by market intelligence firm Tracxn. 

Whereas after a lull in the IPO market in 2022, the recovery is in line with a bull run in the broader Indian equity market. Industry leaders and market experts expect the environment to stabilise within the next 12-24 months for startups.  

On similar lines, Rohit Nuwal, Partner, Telus Ventures shares his candid take on the current dynamics of investing in startups as well as where are the Indian startups headed.

According to you, what are the three major factors that impacted the growth of unicorns in India?

One can simply go back to Econ 101 framework of Supply and Demand of Venture capital to explain the boom and bust of this complex growth of unicorns.

In the venture market, demand is the number of companies seeking venture funding, while Supply is the capital investors are willing to invest based on their desired rate of return (inverse of price at which they will invest). Supply was elastic historically due to easy capital flow in a low-interest rate environment, whereas demand has been relatively inelastic due to the power law of venture outcomes (debatable in Indian context), leading to a chart that looks like the one below where Supply of VC before (SB) and Demand for unicorn (DU) intersects to result in a number of unicorns (QB).

Due to the aftermath of COVID and the increased adoption of online/tech companies, the low-interest rate environment and higher return expectations sparked a venture capital supply shift. Investors rushed to meet the demand, leading to more capital available. As a result, even companies that would not typically meet investment criteria secured funding at higher valuations, causing a surge in the number of unicorns globally, including India. Despite lower return expectations, it was still considered attractive compared to other asset returns at the time (interest rate being low).

As interest rates soared, the venture market became unstable. Public tech suffered, creating uncertainty. Investors reacted by slowing down investments, resulting in a supply shock as it is called in economics.

During a supply shock, the supply of capital shifts dramatically far left (SS*) as investors suddenly raise their required return rate threshold (R*), leading to funding only the top-tier companies. The number of new unicorns decreases significantly, and other companies receive ‘coaching’ on burn rates, unit economics, and structured term sheets/ratchets instead of unicorn valuations!

From a regulatory and compliance point of view, corporate governance lapses at startups prompt LPs to opt for direct investments and VCs lose out.

If becoming a unicorn is no more a significant 'benchmark', what would be the ideal mark of achievement for startups going forward? Any disruptive term/word/tag you would like to state in place of 'Unicorn'?

Historically, the term 'unicorn' emerged to describe companies with rare high valuations in private markets. While there is nothing inherently wrong in tagging high valuations since the ultimate aim in a capitalist society is to maximise shareholder value and will continue to be.

However, private market valuations can go beyond rational demand-supply dynamics and future cash flow rationale. Emotional and social factors come into play due to signaling value, resulting in "dirty" or structured term sheets which maintains headline valuation numbers (and by extension tags such as unicorn). But these terms hide economic gains for new investors through complex arrangements like guaranteed IPO returns, ratchets, dividends, M&A vetoes and more. The reason why these structured term sheets are a massive problem is that their complexity will render future financings all but impossible and the most likely way out is IPO.

Instead of changing tags of valuation or changing valuation as a metric altogether, going public early is advised, as it helps founders maintain ownership and liberate common shares from preferred shares' control and senior preference. It aligns founders and VC on boards to focus on growing profitably and creating defensibility for their businesses.

IPOs benefit the long-term value of a company and its employees' shares. Public markets offer more rational valuation discovery compared to private markets, where mark downs are more acceptable. Overall, IPOs are better for the company's growth, and their economics are openly determined by the market.

The nation has the ability to scale to one lakh unicorns and almost 10-20 lakh startups in future, according to Union Minister Rajeev Chandrasekhar. Would Soonicorns overtake the hype? What is your prediction for the next 6-12 months?

The current supply shock equilibrium makes it unlikely to reach a scale of one lakh unicorns in the near future, if we look at this from the above framework of supply and demand of venture capital any movement from the current supply shock equilibrium we are in today is highly unlikely. Even if we assume significant change in demand drivers which causes demand curve (DU) to shift to the right such as rapid innovation, new technologies or externality akin to Jio introduction/ COVID moment which led to mass digital adoption etc. Even if the demand curve shifts to the right (dotted orange line below), the quantity of unicorns (Q*) remains unchanged.

We are stuck in this equilibrium for the short to medium term, resulting in slow or negative growth of unicorns unless the supply curve becomes more elastic. This could happen with lower return expectations, facilitated by factors like low-interest rates, favorable tax sops, or regulatory interventions.