The PE/VC trap: do they push growth over profitability?

“Venture Capital (VC) funds identify an enormous opportunity. Why wait around? Just go after it full throttle," these words of Harminder Sahni, founder and managing director at Wazir Advisors, bring to mind a goose being force-fed to get it ready for market. Everything is inflated. “Valuations seem inflated; the whole ecosystem seems inflated. Nothing changes fundamentally—just the belief of those people writing the cheques changes, and they are willing to bet on that belief. It's private money. If it was public money, then people would wonder why are we paying double for building a flyover, for instance? Rightly so.”

Alok Goyal, who is a partner at a seed-stage VC, Stellaris Venture Partners, said that if he were to guess why the big cheques were becoming ubiquitous was possible because the market opportunities had become so outsized.

Goyal believes that VCs are overcapitalising firms is not untrue but a “gross generalisation."

Valuations have indeed gone up, but the reason is threefold. “Firstly, opportunity and exit size have gone up, and therefore deals can be underwritten at higher valuations today; secondly, scalability of companies is much higher, given that a lot of the underlying infrastructure exists, e.g. payments, logistics, market access, and thirdly many second and third-time founders are starting new companies and they have been through a learning curve in the past,” he added.

Renuka Ramnath, the founder of Multiples Asset Management Ltd, laughed when she heard it being suggested that VCs pushed for growth. “VCs are not forcing growth. The entrepreneurs are. VCs only back entrepreneurs. There are cement, steel and pharma companies that build capacity ahead of the market, too. Sometimes you can misread a market. I will maybe tell someone don’t grow at such a speed that you might crash. But you can't hang them for wanting to grow fast. Sometimes you allow your aspirations to run ahead of data which is okay. It is all part and parcel of entrepreneurship.”

The notion is that with enough money a start-up can outgrow its competitors and rapidly claim a significant share of the market. But that is not exactly true. “Money only ensures that you have the marketing dollars to reach out to prospective customers. What it does not ensure is whether or not they will adopt your product, and if you can retain them. So a good product and strong customer orientation is important and not just money,” said Goyal.

Often, all that money does is make the market disappear. “It’s an effective way to drive out competition. That is they may shut down or pivot to doing something else,” said Ashvin Chadha of Anicut Capital. Notwithstanding, there is nothing new about big guys chasing away the small guys.

For instance, Snapdeal was a VC favourite, but when the merger with Flipkart never panned out, the VCs lost interest and sold back their stakes to the founder for cents on the dollar. Now, the company is making a comeback and planning an IPO. This turnaround happened because of them serving Bharat—the pincodes in small towns and rural areas that Amazon and Flipkart did not serve.

"VCs raise their first fund and invest in 10 companies. Two or three will do well. The only way to raise further funds is for them to show an uptick very quickly on the ones that are doing well. That is why they are in the rat race of growth at all costs," said Ashvin Chadha of Anicut Capital.

Chadha elucidated that VCs would then raise the next round on these companies and put in more money, so they can keep pushing the evaluation. The same VC may then pool money with a new VC and they share the value pro-rata. That could be a large number and that helps VCs to raise a second fund, and so far it has only been up to three years. It is too early to judge a portfolio company's performance, but then you've already raised the next fund. It's an ability to deploy more capital quicker. "That helps us as VCs to raise larger funds. This is what is happening globally. People are being able to raise new funds quicker. It's a little bit of a selfish model," he added.

Sahni disagrees that VCs push founder. “VCs are funding those people who believe in growth and require that money. They are not looking for people they can push. They are looking for people who are already driven.”

That seems to be in the Indian DNA. “Indians are used to these kinds of rewards. They have the same kind of drive to get through competitive exams. Why are there not so many startups in France? Indians are so sure of competing even when they know their chances of success are very low, only one or two per cent. They are used to it,” said Sahni.