India’s recent startup valuation boom was simply too good to last

When it comes to companies listed on India’s stock market, their share price adjusts for current disappointments and weak future prospects very quickly. But the same cannot be said for firms funded by venture capitalists. Their valuations take time to adjust.

Over the years, the valuation of many Indian startups was built on the idea that the businesses of these startups will grow rapidly as people order more and more stuff online. Every bull market needs a theory. The bull market of startups was built around this theory.

Of course, anyone who understood how things worked knew that there was much more to these crazy valuations than just the prospect of India’s rapidly growing digital consumption market. Over the years, central banks of the rich world led by the US Federal Reserve have printed a lot of money, cheapening its value in the process and pushing down long-term interest rates. Further, these central banks have also cut short-term interest rates to nearly zero.

This zero interest rate policy (ZIRP) had forced investors to look for higher returns, explaining why stock markets and real estate markets had rallied almost all over the world. So did crypto tokens, digital art and a lot of luxury goods. ZIRP had also pushed venture capitalists to bet on startups with dodgy or almost no business models, with positive cash flows expected far into the future. Of course, venture capitalists (VCs) are no fools. The idea in many cases was to sell off the company or a bulk of it to newer investors, including retail investors.

This model started to run out of steam early last year once very high inflation became the order of the day through much of the rich world, forcing central banks including the Fed to start raising interest rates. Once interest rates started going up, money became dearer than it was in the past and in the process the cash-burn business models of almost all startups with very high valuations started to unravel.

When interest rates are low, the present value of the expected positive future cash flows of a business is on the higher side. When interest rates go up, the expected value falls, meaning that valuations should also fall. But when it came to unlisted startups, nothing of that sort happened in 2022, at least not immediately after the US Fed and other central banks started to raise rates.

But a year later, the valuations have started to fall. A recent news report in Mint pointed out that “startup valuations in the private market are beginning to crack". Another news report by Reuters pointed out that: “In recent weeks, BlackRock internally halved the valuation of Indian online education firm Byju’s it has invested in to $11.15 billion from $22 billion, while Invesco slashed food delivery firm Swiggy’s valuation by a quarter to $8 billion."

So, slowly the valuations of startups have started to adjust to this reality. The interesting thing is that the digital consumption story which was built up is also unravelling in the process. At its heart, like most saleable stories, this was also a simplistic one. India has a huge population (close to 1,430 million now) and so there will always be a huge market for whatever startups want to sell, especially as digital payment mechanisms like the Unified Payments Interface (UPI) become more popular. And given this huge potential, huge valuations are justified.

The trouble is that a large population and the ability of that population to buy things, or there being a viable market for what any startup is trying to sell, are two very different things. One of the most important points in the story of startups has been the success of UPI. But just because UPI transactions are growing, it doesn’t automatically imply that the overall number of economic transactions are also growing at the same pace. Before UPI, almost all of these transactions were in cash.

Also, when it comes to consumer transactions on which valuations of startups are built, a few people seem to be making a bulk of these. As the Indus Valley Report 2023 published recently pointed out, 1% of Indians take 45% of flights, 2.6% of Indians invest in mutual funds, 6.5% of users are responsible for 44% of UPI transactions, and 5% of users account for a third of the orders placed on Zomato. As Zomato recently reported: “Customers with annual order frequency >50 as a % of annual transacting customers have increased from 1.4% in 2018 to 4.7% in 2022." Basically, this means around 5% of Zomato’s customers order from it at least once a week.

So, as the Indus Valley Report points out: “Much of the consumption is driven by a tiny super-user set… [The] broad user base narrows sharply when it comes to paying users." Of course, the valuations of startups were based not just on small super-user sets, but the supposed consuming ability of India’s huge population of 1.4 billion plus. But as the super-user data points show, a large population and people’s ability to pay for stuff are very different things. And that reality has begun going into the valuations of startups.

Vivek Kaul is the author of Bad Money.