Uni­corn fund­ing: Hype or sus­tain­able model?

Business Standard - - OPINION - ATUL PANDEY & HIRAK MUKHOPAD­HYAY Atul Pandey is Part­ner, Khai­tan & Co, and Hirak Mukhopad­hyay is As­so­ciate, Khai­tan & Co

Ever since Wal­mart’s much-awaited ac­qui­si­tion of a ma­jor­ity stake in Flip­kart for a whop­ping $16 bil­lion, the spot­light has been on the other In­dian “uni­corns” (pri­vately-held en­ti­ties val­ued at over $1 bil­lion). Con­sid­er­ing that a few years ago, Flip­kart was be­ing writ­ten off by most in­sti­tu­tional in­vestors, the mam­moth val­u­a­tion of the e-com­merce firm (though de­bat­able) is be­ing high­lighted as a suc­cess story in­so­far as vi­a­bil­ity of In­dian uni­corns are con­cerned and, in the process, has re­newed the in­ter­est of for­eign in­vestors in in­vest­ing in In­dian start-ups.

Change in cor­po­rate cul­ture

Be­fore mov­ing on to whether such high lev­els of in­vest­ments are sus­tain­able or not, it is vi­tal to an­a­lyse the im­pli­ca­tions of the Flip­kart-Wal­mart deal on over­all cor­po­rate gov­er­nance in the start-up in­dus­try. Tra­di­tion­ally, In­dian start-ups and the ven­ture cap­i­tal­ists in­vest­ing in them have ma­jorly fo­cused on im­me­di­ate short-term ex­pan­sion plans fu­elled by dis­counts, thus re­sult­ing in most In­dian start-ups go­ing bust af­ter two or three rounds of fund­ing. Wal­mart on the other hand is a strate­gic player look­ing to ex­pand its in­ter­ests in In­dia, af­ter sev­eral failed at­tempts to en­ter the In­dian mar­ket as a B2C player. Reach­ing mid­dle ground, as far as clash­ing cor­po­rate cul­tures is con­cerned, will be vi­tal if this syn­ergy is to con­tinue.

An­other ma­jor change that is ex­pected to come is greater ad­her­ence to cor­po­rate gov­er­nance norms. Start-ups have gen­er­ally fallen short as far as cor­po­rate gov­er­nance norms are con­cerned. Founders rou­tinely award them­selves greater wind­falls at the cost of the prof­itabil­ity of the com­pany. A di­rect con­se­quence of more in­sti­tu­tional in­vestors and in­vestors such as Wal­mart com­ing in is there­fore go­ing to be greater ad­her­ence to grow­ing cor­po­rate gov­er­nance norms.

Exit op­tions

So far, the big­gest bot­tle­neck to in­vestors is the lack of vi­able exit op­tions. Glob­ally, the ideal way of ex­it­ing a com­pany would be by way of an op­tions con­tract. Un­for­tu­nately, en­force­abil­ity of op­tions con­tracts in In­dia, es­pe­cially in cases where for­eign in­vestors are in­volved, has been shrouded in con­tro­versy since reg­u­la­tors such as the Se­cu­ri­ties and Exchange Board of In­dia (Sebi) per­mit op­tions con­tracts only sub­ject to com­pli­ance with var­i­ous con­di­tions. Fur­ther, for­eign exchange reg­u­la­tions ex­pressly bar any op­tions con­tracts that per­mit com­pa­nies to avail them­selves of for­eign in­vest­ment by pro­vid­ing as­sured re­turns.

De­spite such re­stric­tions, sev­eral share­hold­ers’ agree­ments still tend to con­tain such clauses and in most cases also con­tain ar­bi­tra­tion clauses that pro­vide for ar­bi­tra­tion out­side In­dia. To add to the com­pli­ca­tion, there has been a flurry of cases wherein ar­bi­tral tri­bunals have passed awards up­hold­ing en­force­abil­ity of such clauses and re­quir­ing the In­dian party to hon­our its obli­ga­tion un­der such clauses.

How­ever, In­dian par­ties ag­grieved by such awards tend to chal­lenge the en­force­ment of any award, claim­ing the award is con­trary to the pub­lic pol­icy of In­dia. This com­pli­ca­tion has abated to a cer­tain ex­tent by virtue of cer­tain de­ci­sions of high courts (for ex­am­ple, NTT Do­como Inc. vs Tata Sons Lim­ited), which have ruled in favour of en­force­ment of such clauses. How­ever, for­eign in­vestors are still wary of util­is­ing op­tions clauses to fa­cil­i­tate their exit.

An­other ma­jor bot­tle­neck in case of ex­its is the lack of sim­pli­fied IPO pro­ce­dures. While the gov­ern­ment is at­tempt­ing to take mul­ti­ple steps to as­sist start-ups, com­pli­cated exit routes such as IPOs prove to be a bot­tle­neck for in­vestors in In­dia. Sebi is con­tem­plat­ing sim­pli­fied IPO ex­its in cer­tain cases, in­clud­ing by way of di­rect list­ing — i.e., on a given date, with­out rais­ing any money from the pub­lic, the com­pany de­clares it­self to be pub­lic, and its shares pub­licly trad­able. Whether such ef­forts will as­sist in sim­pli­fied IPO ex­its for in­vestors will be­come clear only in fu­ture.

Most cur­rent fund­ing is of the later-stage va­ri­ety that only hap­pens when in­vestors are con­vinced that the fi­nan­cials of a start-up are suf­fi­cient to sus­tain long-term growth

Fu­ture trends

Sus­tained in­vest­ments from in­vestors are a pri­mary in­di­ca­tor of the fact that the In­dian start-up sec­tor has moved out of the bub­ble phase, wherein in­vest­ments are now driven by virtue of num­bers rather than by hype. The present trend of high-value in­vest­ments is fun­da­men­tally dif­fer­ent from the trend prior to 2015, to the ex­tent that most fund­ing presently is hap­pen­ing at the Se­ries C and Se­ries D level, which are later-stage in­vest­ments and can only hap­pen when in­vestors are con­vinced that the fun­da­men­tals, fi­nan­cials and busi­ness plans of the start-up are suf­fi­cient to sus­tain long-term growth, and that such a busi­ness model does not fo­cus merely on dis­count-led growth (which does noth­ing more than trans­fer the risk from one player to an­other). This surge in Se­ries C and D deals this year is en­cour­ag­ing and hints at in­creas­ing ma­tu­rity among in­vestors, in­so­far as their In­dia ap­proach is con­cerned.

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