Catching Dragons

An LP who had read AVF’s monthly newsletter inquired why we had rejected one of the deals based on the fact that the founders were raising 12 crores. He asked why we didn’t co-invest or take a small chunk of a larger round if the deal was good. This is a common and frequently asked question not only by our LPs but also by founders, their advisors, our advisors, our investment committee and almost every employee. Despite the overwhelming number of times we reject deals based on their valuation or the size of their raise, I continue to stick my neck out on the line for our investment strategy. It has been devised with an important mathematical, strategic and logical reason.

While later stage funds invest at a time when the business has achieved a product market fit, positive unit economics, solid revenue streams, etc. we, as an early stage fund invest when the founder is still contemplating the answers to these questions. Therefore, I stay grounded to reality in expecting that 90% of the early investments we make will fail and return nothing, and the remaining 10% should:

  • Return the total corpus of the fund
  • Deliver a return to the fund’s investors

This is difficult unless there is a clear strategy and discipline while investing.

A fund makes money for its investors by selling its ownership stake in what is called a ‘liquidity event’. This liquidity event can take place in many ways; by selling our ownership to buyout funds, to an acquirer or to the public during an IPO. But how much we make from a liquidity event is decided by two numbers

how much stake we own * how much the company is valued at = size of exit

Considering the small percentage of successes I expect, it is important for each successful investment to have the capacity to return the whole corpus of the fund or be what Kanwal Rekhi calls a “dragon” exit. To figure out at what valuation an investment becomes a dragon for the fund, you can use the same formula

20% X 1000 crore valuation = 200 crores

10% X 2000 crore valuation = 200 crores

5% X 4000 crore valuation = 200 crores

2.5% X 8000 crore valuation = 200 crores

The chances of an early stage fund getting an 8,000-crore exit are slim but if the fund team has picked and worked on such a winner, they should ensure that the exit will have a significant return i.e. multiple times the fund’s corpus and not just the corpus. Therefore, holding a 2.5% stake in such a winner will only return the corpus and I would need 4 such investments to return 4X of my fund – the odds of which are far and wide.

I have modelled our portfolio on an exit ownership between 15-20% with exit scenarios of 1,000 to 2,000 crores over 4-6 years. One such exit will return the fund’s corpus and the rest is just the icing on the cake.

Such a portfolio construct is good for the founders as well. Chasing $1 billion exits promotes behaviour like excessive marketing spends, massive hiring, multiple (and massive) fundraises, lots of founder dilution and an overall impatience to deliver results which cause long term issues. It is simply not sustainable.

Therefore, while I regularly review our investment strategy and thesis, changing the portfolio construct to have lower average ownership just doesn’t make mathematical sense to me. And while numbers can tell a story, they cannot lie.


Fluff Metrics

An interesting phenomenon has been noticed in startup presentations over the past few weeks. Founders have come up with innovative ways of showing large numbers that have nothing to do with what counts as revenues to the startup.
Let me share a few examples with the explanations as provided.

  1. Gross Transactional Value: this the value of the transaction that is taking place because of the service provided by delivering the service. Therefore, a simple example would be that if a truck delivers 5 MT of steel the GTV is the value of the 5 MT of steel which has no correlation to the revenues of the trucking company since that is dependent on the route or no of kms
  2. AUM (Assets Under Management): the value of the videos that have been uploaded to sell to customers. This has no correlation to the revenues as they are made on a pay per click model. How the videos are being valued and by whom – I have honestly no idea
  3. MRP Sold: the sticker prices of the items that were sold. These were very different from actual revenues as there were coupons and discounts that were given. So, if I stick the price tag of a Mercedes on a Maruti the MRP sold would be ginormous but the actual number would be a fraction. These MRP’s are set by me so MRP sold is also in my hands. Do you feel fooled just yet?

Do founders really want to attract investors that are awed by such numbers? Of what use will those investors be who themselves don’t understand that these numbers are useless?
My sincere request to founders is to have the courage to tell me the real numbers. They may not be as awesome as the fluff metrics, but I’ll respect you for your honesty and I’ll work with you until your actual metrics look like the fluff metrics that your peers are showing me.
Just remember this immortal quote attributed to Abraham Lincoln:

Keep Calm and Don't Generalize

Imagine if this elevator pitch was given to you  

“There is a lack of reliable sources for procurement of farm fresh produce & it’s impossible to buy directly from farmers without traveling to farms. High consumer demand of farm fresh produce is hugely under-served.” 

For those of us that have been brought up on a steady stream of Bollywood movies that show farmers as poor, uneducated simpletons, this statement could ring true. However, when I made the effort to dig beneath the surface, the generalizations made in this statement are very misleading.  For example, a simple online google search to buy farm produce in Mumbai provided 4-5 websites that supply farm fresh vegetables. I went ahead and placed orders on a couple of them to test the quality of produce… so that debunks the “impossible to buy” assumption!  
So now…..what do you think are the chances of me calling this founder back? 
When a founder generalises an issue that a few people face and claims that it plagues the entire population that they are addressing, they treading on dangerous waters. Here’s how:  

  1. The target market is actually much smaller than they are estimating  
  2. Sales targets promised to the investor (and the team) are unrealistic  
  3. The product/service requires several customizations to address the customers that fall outside their calculated target market  
  4. Sales growth stagnates as the target market shrinks 
  5. Budgeted spends are overshot thereby reducing the runway to pivot  
  6. The customers, team, investors and eventually the founders lose confidence  

This is a common plot of many companies that I have witnessed shutting their doors (as an investor, employee or even an observer)  
I understand that as a founder with a limited budget, it is difficult to conduct a survey that includes every person in the actual target market, but it is unwarranted to survey a small sample of people in this market and assume that it exemplifies the overall population. Founders bear the brunt of this error when they try to scale their businesses beyond the reach of the market that they have surveyed (geographically or demographically).  
My advice to all the founders out there is to: 

  1. Test your business model in a small geographic area, preferably a home city or an area that can represent what you would call your “target market”  
  2. Build an MVP  
  3. Test the MVP with all the different people (that come under your TAM) in that one area  
  4. Identify the customization that your product requires to serve each member of the audience 
  5. Decide which audience makes most sense to pursue as the primary target (usually the one that is willing to pay the most to solve this problem) 
  6. As you solve the problems of this primary audience start testing out customizations that will solve them for the remaining part of the TAM   
  7. Once you have achieved a level of comfort in understanding your target audience you can take your model beyond the initial area that you started off in 
  8. Finalize your business & revenue model based on the actual knowledge you have received from your testing your product 
  9. Build and roll out a plan for a new geographical area – keeping in mind that you will need to make customizations for regional preferences  

When founders use funky excel formulas to magnify a problem, the people that it affects, the funding needed to address that problem, the sales numbers and so on… all in the hope of getting a higher valuation and a larger round of financing… they become the problem instead of solving one.