About a year ago, I authored an article in this very newsletter sharing my concerns on tech valuations worldwide and how entrepreneurs should approach the anticipated slowdown. I received mixed responses from various parties, some supporting my argument and some calling me a “pessimist”. I believe we are in an interesting phase of the current tech cycle. There has not been a wide-ranging catastrophic correction or a tech bubble 2.0, which I don’t expect in a primarily private market driven Unicorn world; however, there is a palpable slowdown in investment activity worldwide.
Negative outlook of the public markets is visible in 80% of the 90 tech IPOs that debuted in 2014-15, trading below their IPO price. Moreover, there were only 28 tech IPOs in 2015 as compared to 62 the year before. Public sentiment has now started spilling over into private markets as well. Mega rounds have fallen out of favour. There were only 38 $100M+ deals in Q4’15, a 47% decrease from the previous quarter. This has caused global tech financing to contract by 30% quarter-over-quarter. US deal activity has been at its lowest since Q4’11. Increase in interest rates and general souring of sentiments has led to a cut back in venture fundraising as well. The number of new funds raised during 2015 marks a 25% decrease in the number of first-time funds raised during 2014.
I can’t dismiss the possibility of this being a momentary blip. However, the fact that there are clear signs of slowdown across investor classes begs commentary. It’s tough to ignore the speed with which the phrase “the winter is coming” is gaining traction in our industry. The truth is that I see most start-ups in India struggling to raise their Series-B and higher rounds of financing, including our own portfolio companies. Q4’15 represented a more than 40% drop in funding dollars quarter-over-quarter. So, what has changed? Why the sudden pessimism from investors?
I see no change in fundamentals in the Indian economy or the new digital economy. In fact, there is more optimism for explosive growth. Morgan Stanley recently raised its forecast for the e-Commerce market size in 2020 from $100B to $119B owing to the momentum they’re witnessing in the sector. Smartphone shipments in India crossed the 100M mark in 2015, a 29% increase over 2014. Widespread 4G adoption is expected as Reliance gets ready to launch its service to the masses. This is visible in 4G shipments overtaking 3G in Q4’15. The Indian economy seems stable with agencies pegging 2016-17 GDP growth between 7.5-8%. Inflation is under control and the repo rate is at a six-year low of 6.5% after the recent 25 basis points reduction. We expect a massive credit expansion to be around the corner after RBI’s announcement of the new MCLR system.
To summarize, in my view there is no cause for concern on fundamentals; the slowdown is more a reflection of a change in investor sentiment. How does this happen? There is no logical explanation for this; we are human, we tend to make mental mistakes and the smartest of investors get carried away by market momentum. Unfortunately, momentum investing is a 2-way street. The most optimistic investors turn the most pessimistic in a slowdown and they can’t give you a logical explanation on “why” the overnight change in sentiment.
Investor euphoria over the last couple of years has led to what I call “random investing” by all of us; stage and sector focus went out the window, chase any opportunity at any cost, bid out your competitors for deals by offering exorbitant valuations, larger funds offering large checks to very young companies. I don’t blame the entrepreneurs raising large sums and demanding high valuations. I would too if someone is willing to pay. However, there is always a price to pay for such excess and all of us will have to weather this pessimistic phase together.
I worry about the large number of seed and series-A deals that have been done over the last couple of years that need Series-B/C funding and suddenly there are very few investors willing to write cheques. A correction always helps wash away froth from the market and forces all participants to focus on business fundamentals. The flipside to this is when fundamentally sound companies get washed out along with the froth.
Some clear leaders in promising sectors are still getting funded and I believe that will continue. The question arises when you are part of an emerging new sector and there are dozens of start-ups with no clear winner and no clarity on the market opportunity. The problem with business is that it doesn’t come with an operating manual. So, what do we do now? I encourage all my companies to raise cash, regardless of size, valuation and investor. Often, in a downturn, it’s tough to correctly price the value of an asset and your company valuation is no different. Pre-empt valuation conversations; that should be least of your concerns. Sell investors on fundamentals and your drive to build a solid company and your willingness to do whatever it takes. Flat rounds and down rounds will be common. So what? If you are the last man standing with cash in the bank, you are the winner! Believe me, it takes a lot more dilution in euphoric times to build winners, because a lot of cash is burnt fending off competition.
It is to be noted that much of the recent excitement has been around consumer businesses. There’s nothing wrong in that – the Digital India story is one of consumers. However, it is possible that innovation took a backseat in the pursuit of fulfilling consumer wants. Entrepreneurs need to be constantly testing their hypotheses around the market and the model. It’s very easy to get carried away by excitement and confirmation bias. A start-up demands a good chunk of one’s prime years, so make sure the idea is worth it before taking the plunge. Maybe Indian consumers don’t need another X for Y. Maybe what they need is a hitherto unimagined new way of performing Z. As the going gets tough, we expect the industry to return to what it does best – innovate.
Few things in the world are immune to alternating cycles of exuberance and panic. We face it in our daily lives, we see it at play in the wider economy. Interplay of rates, prices, expectations and policy causes the economy to go through inevitable ups and downs. Markets can’t help but respond and ape these cycles. So what can we do when the very odds offered by the house are stacked against us? Well, we still have two aces up our sleeves: technology and entrepreneurship – the two real factors of production. Factors that can weather any winter.