How the Markov process can help in the times of markdowns

19 September, 2016

Startups in India seem to be going through a rough patch these days. Not a day passes by without a few reports of companies shutting down, downsizing or struggling to raise funding.

The same media that put founders on a pedestal not too long ago now seem all too eager to pull them down in the quest for readership. But such is the nature of the game, and if it wasn’t clear by now, it bears repeating – entrepreneurship is definitely a double-edged sword!

In the midst of all this, oddly enough, I’m reminded of a particular mathematical construct I learnt in college called Markov processes. The concept fascinated me because it represented almost the exact opposite of how human beings behave. So what is a Markov process? It is essentially a “memoryless” event, one in which predictions and decisions about the future can be made based on ONLY the current state, and is completely independent of history.

People are quite the opposite – most decisions tend to be burdened with history and the baggage of how the decision point was reached, and thus our thinking tends to be a victim of several fallacies (read about loss aversion and the sunk cost fallacy – the most common fallacies of this type). History is important, but it is equally important to discard history when it is irrelevant to the problem at hand.

This brings me to valuation markdowns. Granted there has been an unusual euphoria surrounding the Indian tech ecosystem over the past two years – this has most obviously manifested itself in valuations that have now become easy fodder for endless questions and debate. I will not even get into the debate of whether these numbers were rational, but I will say this – valuations are nothing but an opinion of the future, and opinions, like many things in life, are subject to change, and even more so in the face of changing facts. The only question that remains, to my mind, is how to move forward as an ecosystem, while maximising value for everyone, and the Markov Process gives us a good hint.

Forget about valuations of previous rounds. Be memoryless!

OK, maybe don’t forget! But definitely don’t let that be your sole guiding light going into your next investor discussion. By the way, the message applies equally to investors. I have seen far too many situations where founders have not been able to convince their early investors that a down round is the only pragmatic choice at this point. Don’t be that investor, who lives so much in fear of a markdown on paper that he/she is willing to stall a critical fund-raise for a company that might create a ton of value in the long term.

The mantra to follow when things are not so rosy is ‘live to fight another day’. It is also a sign of a mature startup ecosystem when investors are willing to take such trade-offs (see this list of 70+ down rounds, mostly in Silicon Valley). I don’t think we are there yet in terms of maturity, but I do think this cycle is teaching us all a lot on a daily basis, and we will all emerge much stronger.

To entrepreneurs, all I can say is – don’t tie too much of your self-esteem to a number. Numbers are not as important compared to your dream of creating a valuable business. I’m in no way suggesting you run out and raise funds at any valuation; I’m merely hinting that you shouldn’t be fixated on a certain perception of valuation.

It would be apt here to mention the needless fixation on a $1 billion, or ‘unicorn’, valuation has led to a generation of companies with bloated obligations (via preferred returns/liquidation preferences) sitting in their returns waterfall. A clean term sheet, with a reasonable valuation, is far more valuable to you today in my opinion.

Don’t ignore M&A

The environment today favours consolidation. Investors will tend to crowd around “safer” assets (see here). So there is a real chance a suitor might come knocking at your door with an offer that will be very tempting to say no to at first glance.

I understand and empathise – the scale of an entrepreneur’s ambitions is rarely matched by an acquirer’s offer. My only request, don’t say no immediately. Sometimes the cost of survival might be just too high, and getting acquired is a realistic outcome for everyone.

In case your business model requires a large amount of capital/getting to mega-scale before it achieves a semblance of profitability, re-think it – it may be better to merge/get acquired with someone who has those resources, or pivot whole-scale to a less capital-intensive model – don’t blindly shut the door on option 1. If you have a different view, that’s okay too, just be clear about the ‘why’, and, even more importantly, the ‘how’. Have a cold beer, think over it cold-heartedly. Don’t react, respond.

The overall message is clear – be realistic, be pragmatic, develop conviction on the way forward, and then throw your entire weight behind it, and convince everyone that matters, including your investors and your team, of the new plan. Uncertainty in a startup, more often than not, means slow death, so it is important that you do this quickly.

Norbert Fernandes is co-founder and principal at IvyCap Ventures.

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How the Markov process can help in the times of markdowns

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