Just the other day, I had the somewhat unpleasant job of presiding over the shutdown of one of our investee companies. Not that it was a first – I’ve ‘lost’ a dozen or so companies in the last 15 years of investing, out of 50-odd companies that time and money has gone into, and I’m reliably informed it’s a good ratio.
At the same time, the returns from the ones that survived and made it big have made us, I’m told again, among the best-returning funds in the country. Which made me wonder whether we were good in any way – or just the one-eyed in the land of the blind. But more on that later.
As always, we’d documented the demises to our investors in our funds – the Limited Partners or LPs.
One common reason was “too early for the market”. And the next most common was “couldn’t raise the next round because the market turned”. Anecdotally, other causes were odd ones like “promoters didn’t get along” and we also had a couple we categorised as “governance issues” – officialspeak for “we caught them with their hands in the till”.
Nowhere among the reasons was that us VCs were to blame. While there certainly is much blame to go around our lot – one investor I know asked a friend’s company to morph into a copy of a US startup and then blamed the entrepreneur when it imploded - I'm sure I could write a long piece just on how misguidance by investors has killed many a startup – but the bigger issue is simply this:
That the VC fund structure simply isn’t good for startups – especially in emerging economies like India.
Most VC funds around the world follow the US model in their tenure – they’re 8+2 or less often, 10+2 – which means they have 8 or 10 years to identify companies, deploy funds, nurture teams, take them to exit and then return money to their LPs, with a potential extension of 2 years for the entire process.
Here's how the sausage factory works: if I raised money today – I'd have 3 or 4 years to find the couple of dozen startups to put the money in – and after that I'd have between 5 and 8 years to guide, help grow and exit all of those companies.
You can see the problem right away, can’t you? No Indian firm of any stature has had any real IPO exit within 5 to 8 years of starting up. Even our new economy giants MakeMyTrip and Naukri took more than 10 years, while JustDial took more than 16 years to exit on the market. Look at the big stocks on the BSE – and make a list of those that had a meaningful IPO within 8 years of starting up. Your list will be an empty one. All the giants – whether it’s a TCS or Infosys in India, or a Google in the US, took much longer than 8 years to exit.
The fact is – it simply takes longer than 5 or 8 years to grow a company to a meaningful size and big public exit in India – and in most other parts of the world too.
So if you’re a fund that comes in at the start of a business and does all the hard work of finding the opportunity and promoters, helping them build their team and business, guiding them through thick and thin, and then growing them past their rivals to profitability and leadership – then you simply can’t get the benefit of staying till the end. Because you have to return the money to your LPs before you've made any big money really. And you will almost certainly lose out on all the appreciation that should be rightfully yours.
So how do funds cope?
They do so with a few patently damaging behaviours – at least from the startup’s point of view.
One, as they get closer to the 5th year of investment in you, they start trying to morph you into something that they can sell to someone else. This might mean asking you to invest in things you don’t need – like a costly and meaningless TV campaign, or a complete change of focus, or even an ill-advised merger with another portfolio company.
The second option is the nudge out. At the 6 and 7 year mark they will put you on the block – and sell you to anyone who pays what they consider a decent price – regardless of the fact that you could reach escape velocity by yourself in a few more years and deliver a lot more in returns while retaining control – if only the investors had the ability to stay longer.
And the third, even more nefariously, is the circle jerk. A bunch of funds of roughly the same size all look at their portfolios around year 5 – see a bunch of unexitable businesses – and then proceed to give each others’ companies an up-round (A gives a 3x up-round to B’s investee, B gives a 3x to C’s company, and C in turn returns the favour to A’s investee.)
Net result? The LPs of A, B and C each think they’re doing very well indeed – but the startups and their founders are now left with new masters, a higher and even more indefensible valuation - and disaster is merely postponed and potentially amplified for the poor folks being led by investors in this dance.
The fourth choice is, of course that if none of these happen, the rug is pulled out from under the company and they say, sorry dude, this one didn’t make it, off to the dead pool you go.
VCs may follow a 8-year rhythm - but businesses certainly don't.
I’ve run businesses myself – and I know it takes more than 10 years to hit that critical size and stability. Sometimes 15. Sometimes even more. Ironically, if I’d taken VC funding for my own startup – I’d have been worse off today, with a huge artificial pressure to exit. I’m glad nobody was nudging me out at year 6. In return, I try not to do the same with my startups, but I confess I don't always succeed.
What’s the way out?
First, break the US model. Like most imported processes, it’s not right for the rest of the world. In fact, I’m not sure it’s right for the US either. Dump the 8 and 10 year fund structures. There are a few evergreen or 20-year plus fund structures around. Embrace that.
Some types of LPs, like pension funds, want quick returns every 8 years and hence will want to be in 8-year funds – perhaps they could be advised that early-stage, where the best returns are, shouldn’t be their cup of tea – or perhaps they could learn to be more patient if they want the super-huge returns.
Some other LPs – family offices, endowments, foundations and the like should gravitate more to the early stage - but their large bite sizes get in the way. They may have billions to invest and apparent logic may decide that each investment should be $100 million or more - but that's too large for early-stage funds.
It's unwieldy, yes – because they have more money to deploy than most early-stage funds can manage – but long-term early-stage funds are the right match for their tenure and temperament. They should figure that a teeny bit more work on their part - to write smaller cheques - will help them participate at the steepest part of the growth curve of new businesses.
Second, look to build real businesses that grow over the long term. Come with a Berkshire Hathaway mentality – not a Gordon Gecko built-to-flipkart mindset. Also, why exit just because the company does? In firm after firm, their values have risen much more after an IPO – so why not stay in and capture the gains for your LPs years after the company goes public? A longer tenure allows you to do that.
Third, even with all this, look to make the companies grow faster – not by putting unreachable milestones or unnecessary funding in front of them – but by helping them fill out their teams much earlier with good people.
No good CXO tends to join a startup till its third year and second round of funding. So most startups waste a few years dawdling and gather speed only after year 3. So why not get a bunch of these folks working for the fund as a SWAT team of CXOs, and you could deploy them across your startups from day 1? Wouldn’t that give you better-equipped companies at take-off?
I’ve been running funds and investing in India for 15 years now – and think we need to re-invent the way VC funding is done. The current way is broken. These are three key changes that I can think of. What can you add to this list?
There's one thing I'm certain about – that this isn’t the era of a few large giant family-owned businesses that have been around for many decades. This is an era when many smaller first-generation mini-giants can be created. Faster than before, yes. But not in 5 or 8 years.
All we need to do though, is not choke the windpipes of startups at year 5 or 6. A longer term can help ride out up and down markets, can make next round funding even more viable – and also gets rid of the “too early to the market” problem. While bringing higher returns that more than make up for the longer term of the investment.
Sure there will still be some startups with problems. Whether it's teams that can't get along or over-greedy promoters. And perhaps some of those do need to be put to rest early, before too much money is spent on them.
For all the rest, though, what we need is patient capital, not impatient capital.
(Mahesh Murthy is a founding partner at Seedfund.)