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Spreading cash like manure
Start-ups are on steroids due to the deluge of cheap capital. Is it too much, too soon?

Kripa Mahalingam

By the end of September, Ritesh Agarwal, founder and CEO of OYO Rooms, has zipped through six different cities in less than a week’s time. All of 21 years of age, Agarwal wants to build the world’s largest budget hotel room aggregator and some of the biggest names in the venture world are backing his audacious dream. In January 2014, Agarwal raised ₹4 crore — his first round of capital — from Lightspeed Venture Partners. He raised a second round of $25 million from Sequoia Capital, Greenoaks Capital and Lightspeed in April 2015.

A month later, Agarwal met Nikesh Arora of SoftBank at Silicon Valley and they got talking. Evidently, Arora liked what he saw because by August 2015, accompanied by existing investors, SoftBank led a $100-million investment round in OYO Rooms, making this one of the largest bets on an early-stage company in India. “When I was building the company, my focus was not on how much capital I will be able to raise. Having access to capital is just one of the problems solved when you are building a company,” says the 21-year-old, who realised that he liked to do things differently when he wrote his first piece of code in third grade. Agarwal decided formal education had little use for him and went on to get selected for the $100,000-strong Thiel fellowship. 

And it is not just OYO Rooms that is attracting big bucks. There has been a marked difference in the venture capital deal landscape compared with just three years ago. In 2013, investors were warming up to the e-commerce story and Flipkart and Snapdeal managed to raise about $400 million between themselves. In 2014, as investors saw increased traction, the bets got a whole lot larger, with Flipkart and Snapdeal drawing in more than 50% of the funding raised — according to data by Venture Intelligence, both companies raised about $3.5 billion among themselves.

Rolling in the green

This year has seen a huge spike in the number of venture capital deals

The first half of 2015 not just saw cheque sizes getting bigger but also funding cycles moving from seed to series B in quick time; companies started seeing $100-million cheques pretty early in their life cycle. This begs the question — why do these start-ups need so much money and where are they spending it? Start-ups such as OYO Rooms, Olacabs, Grofers and TinyOwl are aggregators that connect existing suppliers with demand using technology and work with vendors to streamline the process. 

Take OYO Rooms, for instance. The company works with 2,700 hotels across 123 cities that have posted a total of 30,000 rooms on its platform. It has collaborated with the hotels and vendors to standardise the rooms across properties by offering a uniform set of features such as Wi-Fi, breakfast, a flat-screen TV, spotless linen and branded toiletries.

According to Agarwal, nearly 400 million Indians travel every year but a majority stay with relatives because there is a lack of affordable and reliable accommodation. On the other hand, there are 2 million budget rooms in the country that have an occupancy rate of just 20-30%. Agarwal says that with the help of technology and by building an ecosystem of vendors that will standardise the company’s offerings, the gaps between demand and supply can be filled in.

“If we offer a reasonable and reliable alternate option for travellers, they would prefer staying at a hotel rather than with relatives and this would lead to better occupancy for hotels as well. There is an inventory of 2 million hotel rooms in the country and over the next three to five years, we are looking at adding them on our platform and improving their occupancy rates,” says OYO’s Agarwal. OYO Rooms’ offerings begin at ₹999 per night and go up to ₹6,999 per night. The recent fund infusion will go a long way in ensuring that the company manages to scale up operations.

Making it rain

So far, the surge in venture capital has helped companies scale quickly and well. Take the case of taxi service provider Olacabs, which raised around $910 million in the past six months. “The company was doing 1,000 rides a day when we first invested in 2012. Now, it is doing close to a million. The business has scaled beyond our expectations,” says Tarun Davda, director, Matrix Partners. “The capital has helped the company build the supply side rather quickly and create a network effect,” he adds.

Ritesh Agarwal, OYO RoomsMohan Kumar, Norwest Venture Partners IndiaTo get more consumers on board and thanks to fierce competition from Uber, Ola had to give discounts or free rides to new users and offer attractive rates as well. For instance, if Meru Cabs was charging ₹20 per km for its rides, Ola offered a more competitive rate of ₹12 per km.

The company also had to offer incentives to drivers in order to create supply. While the huge quantum of investments helped the company burn cash, what worked in Ola’s favour was that the company was able to scale quickly and capture half the market — more consumers meant more drivers getting on its platform.

“With more than 250,000 drivers on the Ola platform, it doesn’t need to offer driver incentives anymore,” says Davda. 

But it is not always the start-up that spends big on habit-forming which emerges as the winner. “It is the company with the best product that walks away with all the customers. Google is a classic example. While Yahoo, Lycos and AltaVista got us used to search, it was Google that captured the market thanks to the better customer experience it offered and a sound business model,” explains Sandeep Singhal, co-founder, Nexus Venture Partners. In Ola’s case, it was a bit of both that gave the company its advantage. But that is not the case with most companies, and those that don’t have the best product offering will soon find themselves without consumers and investors to back them. 

Right now it is the season of plenty and there are other factors at play. Currently, there are two new types of investors in the market — those that missed the e-commerce boom and are looking to bet on the next Flipkart or Snapdeal and those that are flush with funds from their bets in China. Mohan Kumar, executive director, Norwest Venture Partners India, calls it the Alibaba effect.

“The Alibaba IPO was definitely a game changer for investors, since they saw once-in-a-lifetime kind of return. Now, they are looking for a repeat performance or something along those lines by betting on start-ups in India,” he says. For instance, SoftBank, which made a $20-million investment in Alibaba in 2000, saw the value of its stake go up to $75 billion on the day of listing. Silver Lake made $5.1 billion on the $500-million investment it made in Alibaba in 2011 and 2012.

A mix of the old and new

The top deals of 2013 saw old-economy companies get a chunk of investor money 

But Kumar is not buying into the India-China comparison. “While both countries have a large consumer population, the dynamics are very different. India is a $2-trillion GDP country, while China’s GDP is $10 trillion. Alibaba has a gross merchandise volume (GMV) of over $394 billion whereas India’s largest e-commerce play has a GMV of around $4 billion-5 billion. There is a long way to go before these start-ups can catch up and that is certainly not going to happen anytime soon.”

China, which has 667 million internet users, accounts for 35% of the world’s e-commerce market. According to a Morgan Stanley report, the internet user count in India doubled from 50 million in 2007 to 100 million in 2010, then tripled to more than 300 million by 2014, making the country the second-largest internet market after China. Morgan Stanley expects the Indian e-commerce market to grow from $11 billion in 2013 to $137 billion by 2020.

While the number of Indian internet users may be larger, only about 15-20 million have the requisite purchasing power, so the jury is still out on whether India will have the same dynamics as China. But investors are willing to take their chances. “If a particular model has worked in the US and China, investors are willing to bet on a similar model in India. While that doesn’t guarantee the model will work in India, these investors are sitting on large corpuses and don’t mind making million-dollar bets,” says Subrata Mitra, partner,
Accel Partners. 

Bubble, bubble, toil and trouble 

Unfortunately, this little betting pool is becoming larger by the day and the game isn’t confined to venture funds anymore — hedge funds have made their entry as well. Avnish Bajaj, managing director, Matrix Partners, has an interesting perspective on why some of the larger hedge funds are starting to get in early into the game.

Avnish Bajaj, managing director, Matrix PartnersSubrata Mitra, partner, Accel PartnersEarlier, a lot of companies would go public when they touched billion-dollar valuations and hedge funds and public market investors would invest in their IPOs. Now, you have companies staying private till they reach a valuation of around $30 billion-40 billion and then going public for $100 billion. So, as companies stay private longer, the funds want to ride the growth and are hence getting in early,” Bajaj explains. “While hedge funds are often accompanied by negative connotations, they are some of the smartest investors I know and have been able to identify trends better than the local guys,” he adds.

Peer pressure also works just as well among venture capitalists. Funds that missed out on backing unicorns (start-ups with a billion dollar valuation) were later willing to overpay for a number of different companies, setting up the entrepreneurs for unrealistic expectations. Until the meltdown in China last month, there was frenzy among investors to get in on deals. 

“There were a couple of deals that went from seed to series B in two months. Valuations were getting frothy, but the China meltdown has thankfully put an end to the frenzy. In the coming months, I foresee a considerable slowdown in series A deals and a freeze on series B and C deals. Companies that have raised enough money for the next 18-24 months would do just fine, but my advice to companies that haven’t raised money to last this period would be to cut costs and make sure they have a runway for that long,” says Bajaj. 

Like investors who resort to me-too investing, the deluge of cheap capital also spawns me-too entrepreneurs. While the passionate ones are focused on building long-term businesses, there are entrepreneurs who go after businesses that are easy to start and which will be a quick sell with investors. For instance, the hyperlocal space has spawned over 30-40 companies across the food delivery, grocery and home services verticals over the past 18 months, and about 10-15 of these companies have managed to get funding.

Cheques get bigger

2015 has seen a glut of $100-million deals in comparison with preceding years 

Clearly, this is a space where there is a lot of consolidation waiting to happen, and most of these companies will burn out, with some merging to survive. “Apart from some key players such as Grofers, PepperTap, TinyOwl, Swiggy, RoadRunner and Shadowfax, a lot of the players will be very vulnerable over the next one year. The hyperlocal business is a tough one to execute,” says Norwest’s Kumar.

This space has caught investor attention as the latter can make small bets and see if any one of these segments — food, grocery and home services — can scale up quickly like the e-commerce players. For entrepreneurs, the entry barriers are low in this space and it is an area that has investor attention. But getting a big cheque is hardly any assurance of success, more so if you are early on in the life cycle.

“The biggest misconception in the start-up world is that raising $100 million is a guarantee of success. Raising money does not assure you of success. If you are building the wrong product and going after the wrong customers, you will fail when you stop buying market share,” says Accel’s Mitra. In a bid to get more people to use their services and get them into a habit-forming mode, most consumer internet businesses offer steep discounts or coupons.

“Capital is being misspent and companies are treating couponing and discounting as ways to build a business. The companies are not spending enough time to see if they have built the best product or have a sustainable business model for the long term,” says Nexus’ Singhal. “You can sustain a business by buying market share for only so long. Ideally, you test your hypothesis with a smaller set of customers, make changes to suit consumer needs and then amplify it with market spend. But when growth expectations are so high, you tend to miss a few steps in the rush to achieve the growth
committed,” he adds.

Unhealthy competition 

Of course, it doesn’t help that some of the entrepreneurs involved are able to raise money ahead of time, even though they might not need it. “Some of these companies are able to receive funding ahead of market growth, which signals to competitors that they have no chance of making a mark because the cash will keep them at bay,” says Mitra.

Sandeep Singhal, Nexus Venture PartnersPranay Chulet, QuikrMoney is becoming a means to compete. So, companies are raising money not because they need it but because if they don’t, the competition will raise money and buy market share. Sometimes, even money isn’t able to solve the problem, as the market may not be ready. In such cases, only time can solve the problem,” says Singhal. While it is tempting to take the money that is being offered on a platter by investors, the money comes with an expectation of hyper growth. “When you raise a lot of money, you tend to do many things at once, and that takes away focus from the core business. Merely throwing bodies at the business will not help you scale up, and companies need to be mindful of that,” says Davda. 

For instance, start-ups now have marketing budgets that run into hundreds of crores and often hire celebrities to endorse their brands. Online grocery company BigBasket just hired Bollywood actor Shahrukh Khan to be its brand ambassador and has a marketing budget of ₹100 crore, of which 20% will be spent on digital campaigns, while the rest will be spent offline. Hiring the actor alone cost the company ₹12 crore.

Similarly, Housing is said to have spent ₹80 crore-100 crore on its ‘Look Up’ campaign, which was an invitation for users to try its web portal. Mobile commerce platform provider Paytm has a more ambitious ₹500 crore marketing spend budget for FY16, of which ₹50 crore is earmarked for IPL sponsorship. This is higher than the ad spend of even e-commerce majors such as Amazon, Flipkart and Snapdeal, which have budgets running into ₹200 crore-300 crore. Norwest’s Kumar cautions that increased ad spend may not always get start-ups the customers they seek.

Drawing eyeballs

The ad spend of some start-ups rival that of more established e-commerce players

“Branding is about an assurance of consistent quality of service or product. No sustainable brand has been built by throwing money at ads or celebrity endorsements. In fact, if you are not sure of offering a consistent quality of product or service for the larger audience that you will get as a result of increased marketing spend, you are just wasting your money,” he says.

There are enough instances of start-ups being caught on the wrong foot. Case in point: the hoopla around Flipkart’s Big Billion Day sale. The company clearly did not anticipate the eventual demand and was unable to fulfil a lot of orders, leaving thousands of customers unhappy. There were several instances of people ordering phones and getting soaps instead and, in one case, a customer received two stones instead of the iPod she ordered. And this experience was with an established e-commerce major that has been in the business for nearly six to seven years.

Even in the case of hyperlocal services, where groceries are promised within 90 minutes, and food delivery, where the time constraint is a punishing 30 minutes, there are bound to be glitches. Both hyperlocal online grocery start-ups and food delivery start-ups are investing heavily in technology that will help their vendors streamline the process. 

Take the case of on-demand grocery delivery start-up Grofers, which has managed to raise around $50 million from Sequoia and Tiger Global Management. It currently deliver groceries and fresh produce in 27 cities and is building products that will help its vendors manage their inventory. “Technology will form the backbone of our business and a significant portion of the money raised will go towards developing products to help our vendors manage inventory and give them a lot of insights about what they should be stocking. We are developing dashboards that help our customer care centre monitor deliveries,” says Saurabh Kumar, co-founder, Grofers.

When the belt tightens and investor funds start to tackle unnecessary expenditure, the scant attention paid by start-ups to unit economics will hurt them more. In the world of venture financing, the funding tap is not always open — the same set of investors that pumps in money at an early stage could be the one to pull the plug. Already in the US the funding deluge is slowing down and there is renewed focus on metrics.

“The whole funding craze based on GMV has stopped in the US. In the past, start-ups would walk in and say that they were going to start operations in 20 cities and they would still be able to raise funding. But now, investors demand proof as to how the start-up plans to breakeven in one or two cities, before committing to 20 cities. You will soon start to see that happening in India as well,” says Norwest’s Kumar.

In fact, some of the investors who write large cheques make sure that their downsides are protected with liquidation preferences that decree that they have to be paid much before the founders and the employees of the investee, which is also possibly the reason why they agree to insane valuations. In such cases, the entrepreneurs end up with almost nothing and probably end up wishing that they had raised a lower quantum of capital. 

Saurabh KumarShashank ND, co-founder, PractoInvestors are willing to back entrepreneurs who are ambitious and are in a hurry to scale. Pranay Chulet, CEO, Quikr, explains, “I think of myself as someone operating a fighter jet and not a commercial aircraft. That means that I need to move at high speed all the time. Good investors understand that.” Quikr is an online classifieds platform with 30 million consumers that has managed to raise $360 million from Tiger Global, Matrix, Norwest and Warburg Pincus, among others in the past two years.

On the other hand, seven-year-old doctor discovery platform Practo wasn’t really looking to raise the kind of money it eventually did ($90 million). Shashank ND, the co-founder, could not really say no to the growing list of investors who wanted to put money on his company — notable applicants were Google Capital, Tencent Holdings, Altimeter Capital and Yuri Milner in his personal capacity. “It was one of the largest fund-raises in the digital health space, but we were lucky that a marquee set of investors wanted to invest,” he says, adding, “More than the money, we wanted to leverage our investors’ experience of building successful international businesses.”

Apart from being the market leader in India, Practo is present in four other countries and is looking to increase its presence across 10 more countries in southeast Asia, west Asia and Africa. It has expanded to 35 cities with approximately 200,000 doctors available on its platform and gets about 10 million searches a month. “There are a lot of things that are broken in the healthcare space that we plan to fix with our products. Luckily for us, the world is becoming flatter and we are able to provide a universal solution out of India with minor changes to suit the respective markets,” adds Shashank.

While capital remains a critical component in building a business, getting too much of it early on can clearly put a lot of pressure on the entrepreneur to grow quickly. “It creates a lot of instability in the ecosystem and when the growth numbers don’t come in as expected, it becomes difficult to raise money in the next round,” says Singhal. Already, due to the meltdown in the Chinese market, some investors have begun pulling back but a lot many continue to support their investees. The coming winter could soon separate the ants from the grasshoppers.

Additional reporting by Krishna Gopalan

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