Indian Unicorns: Venture Capitalists aim to breed dragons among herd of unicorns to extract more value
In continuation to this thought, I recently dwelled into a discussion with a senior wealth manager who manages several billion dollars of wealth on behalf of clients in Singapore.
After reviewing the pitch deck of a VC fund, he calls me and inquired, “Tell me, how is it that the VC fund is invested in a few Unicorns (a startup that has achieved a billion-dollar valuation) but is yet to have great returns?”
He was of course not expecting an answer from me, since he already knew the answer. However, it led to a discussion between ‘Valuation’ Vs ‘Value Creation’. The conversation further led to the discovery of another mythical creature in the investment world – ‘Dragon’, which is a portfolio company of a fund that returns the entire corpus for the fund.
Brief research online throws some facts that until the middle of last decade only about 1/4 th of the unicorns in the US went on to become a dragon for their funds. I am quite certain that this number has fallen over time.
As of last year, quick research on nearly 70 unicorns in India revealed that over half of them had a valuation/amount of equity raised multiple of less than 4 and a third of them had the same ratio of less than 3 and about 15% had a ratio of less than 2. In a business where a lot of companies are written off, it is obvious that most of these unicorns did not become dragons for the average investors.
Funds and wealth managers get measured by their clients on IRR (internal rate of return) and DPI (distribution to paid-in capital) and TVPI (total value to paid-in-capital). While the first is a return metric, the latter indicates how much is the fund worth for every dollar invested.
In recent times, investors made a beeline for investing in unicorns and FOMO is a dominant emotion amongst fund managers. But how do we explain it to our Limited Partners i.e. investors in the fund. To the layman, following the business press, it may be a mystery as to why investments in a few unicorns do not lead to high returns for a fund.
Let me first clarify that there is nothing wrong with achieving a billion-dollar valuation milestone. India is home to over a hundred unicorns. From groceries to e-commerce platforms, travel, food delivery apps, payment, lending, mobility, SaaS, logistics, beauty, fashion, daily essentials etc., many of them have reached a remarkably dominant and valuable position in their respective industries. It is indeed a huge achievement. I do wish there are hundreds more in the coming decade.
I am not delving into criticism of some unicorns on the grounds of ‘high burn’ or ‘poor business model, inflated multiples, a line of argument that has become part of the course in any discussion about unicorns. That is for the market and investors who are investing in them to judge and if someone is voting by infusing/divesting money, it counts for a lot. The more important question stems from the observation made by the wealth manager and the topic of ‘Valuation’ vs ‘Value creation’ and the importance of ‘Dragons’ over ‘Unicorns’.
Why is there sometimes an incongruity between the two?
The answer lies in the investment choices and strategies that venture funds deploy. Here are a few choices that are embedded in the decision-making of investors and the consequences of these choices.
Narrative vs. Fact
In a world full of tweets, it is easier to capture attention and imagination by talking about valuation (unicorns) than talking about the rate of returns and dragons which require a more detailed engagement and discussion. A pitch deck with unicorns does look impressive to start with, but perhaps cannot make it through a discerning eye of the manager like my friend.
Diversification vs. Concentration
There is a belief amongst a lot of investors in the VC space that if you invest in a lot of portfolio companies you are more diversified and hence your chances of success are likely to be more. In contrast, some funds run more concentrated portfolios and may be considered less diversified. A portfolio of say 40 companies at the seed stage, may yield a few unicorns. But, it is less likely to result in a dragon because the percentage of the fund invested is small. It is also true that beyond a certain size of the fund, it becomes hard to deliver dragons. How many dragons can Softbank $100 billion Vision fund create? That is a very tall ask.
Membership vs. Ownership
The common practice of VC funds, driven by FOMO, is to seek membership in winners and hence take small stakes in each of their companies by putting a small percentage of their corpus. This is a risk diversification strategy and not a value maximization one. So, the likelihood that “membership” results in a dragon are low unless your fund is small and you are running a concentrated portfolio. As an illustration, if you have taken a 5% stake in companies and after dilution your stake is just 2.5%, then even if your portfolio company hits a unicorn status, you can’t make it a dragon unless your fund size is just $25 million (which is what a micro fund today maybe).
In contrast, larger bets (“ownership”) in a more concentrated portfolio, if successful, are more likely to yield a dragon. Take for example, in a $100 million fund, if you put in $10 million for a 30% stake, which after dilution ends up at 20%, then even if the portfolio company hits $500 million, it becomes a dragon for the fund.
An ownership mindset also comes with keeping adequate reserves for follow on investing in winners of the portfolio and avoiding dilution in your big winners. Clearly, this is a strategy that increases chances of creating a dragon. The narrative-building bias combined with FOMO has also resulted in a ‘membership approach’ for several funds, who somehow want to be on the cap table of a “soonicorn” that is about to become an unicorn.
Valuation is thrown to the wind in such situations. If one can somehow invest say 2% of my $100 million fund in a $500 million valuation company, it may give me no stake, but it increases the prospects of acquiring logos of a unicorn in a portfolio, something that can be flaunted in the pitch deck.
Raise more vs. Capital Efficiency
Making unicorns a primary barometer of success for founders incentivizes raising more and more capital and higher and higher spending. As a consequence, initial investors and founders are diluted significantly. This undoubtedly crashes the time to becoming a unicorn, but in the process, capital efficiency is sacrificed. Almost all other asset classes penalise the excessive deployment of capital.
A capital efficient approach on the other hand means better margins, better returns on marketing spend and a pragmatic overheads- G&A expenses. Over a while, dilution levels can make a lot of difference to the multiple, what fund makes on its investment and hence the chance of making a unicorn.
Just as valuation is often said to be in the “eyes of the beholder”, capital efficiency is a mindset that requires discipline and a lot of conviction and thought.
Entry price and Liquidation preference
Competition amongst funds and FOMO often result in funds accepting any entry price. In particular, funds that don’t lead a deal, basically participate in a round at any price. The justification often is that the valuations are protected by liquidation preference. While this is true and once again reduces risk, such an approach reduces the chance of creating dragons. On the other hand, obviously an attractive entry valuation lets you hold a larger stake and gives one a greater chance of creating a dragon.
At the end of the day, Venture Funds are answerable to LPs, and LPs are driven by returns. Unicorns are great to have in the portfolio but Dragons are even better. A unicorn which is a dragon is the real deal.
(The writer is a managing partner at IvyCap Ventures)
Credit: Source link
Comments are closed.