Home / Opinion / Columns /  US Fed’s policy reversal stirs trouble in startup paradise

Greed, among its many attributes, also generates amnesia, forcing people to ignore past lessons in their uncompromising pursuit of wealth. Greed also invests the aphorism “history repeats itself" with renewed relevance every time a bust follows a boom. Greed also repeatedly demolishes, somewhat vicariously, the concept of humans as rational beings.

The world of startups is providing us renewed conviction. The US Federal Reserve Bank’s monetary policy normalization programme which, apart from increases in interest rates, has also resulted in withdrawal of excess liquidity from the market. Apart from injecting volatility into asset markets, the Fed’s actions seem to have also upset the startup universe, imperilling the survival of many entities.

The first ones to bite the dust have been crypto companies and fintech firms with business models built on regulatory arbitrage. But the impact radius is far wider and encompasses many more ordinary startups. For example, many leading edtech companies have laid off employees and taken the axe to employee benefits. Delivery companies, e-commerce-focused startups and all other manner of startup organizations have in recent weeks been paring costs down to the bone and trying to focus on revenues.

The fate of companies listed on the Indian stock market point to trouble in startup paradise. PayTM is quoting at 699, way down from its listing price of 2,150. Zomato is around 55, compared with its listing price of 76. Stocks of many startups aspiring to list on the market’s big board have been languishing in the unlisted grey market: the stock of a pharmaceutical products delivery startup has lost close to 80% of its value even before it can officially list on Indian stock exchanges.

This points to an uncomfortable fact: most startups were being nourished on the easy availability of funds, with venture capital (VC) and private equity (PE) funds leveraging the easy liquidity market to invest in promising startup companies, and then cashing out after 24-36 months. The 2008 financial crisis in the West forced central banks in advanced nations to pump in excess liquidity, an approach accelerated after the covid disruptions. Interest rates also hovered close to the zero bound, making borrowing costs historically cheap. This 13-14-year phenomenon lulled many into thinking that easy liquidity would continue infinitely. Many VC-PE funds leveraged their capital multiple times to participate in this round-robin game: invest in a startup, force it to spend as if it’s going out of fashion, exit 2-3 years later by selling the stake to a similar fund. Each time, the valuation spiralled up giddily, creating illusions about the company’s intrinsic worth.

Till the music stopped, that is, and valuations tanked. What makes this meltdown astounding is that the musical chairs game kept going without any sense of impending tightening despite alarm bells ringing for more than 12 months. VC funds pumped about $10 billion into Indian startups between October and December 2021, at a time when Russia was amassing troops on the Ukraine border and the Fed had started darkly hinting at an economic slowdown and consecutive interest rate hikes.

In reality, the funding model used for creating Indian unicorns should have raised red flags long ago. Most of the startups that became unicorns, defined as startups valued over $1 billion, used each round of funding to meet their working capital needs. Capital infusion is usually utilized for creating additional capacity, strengthening the company for future growth (which could even include acquisitions). Yet, each new round of funding went for meeting employee salaries, aggressive advertising and marketing budgets, providing an exit route to existing VC-PE funds, and letting promoters cash out a little bit.

It can be argued that VC-PE capital became the only source of funding for startups since bank doors were closed to them. Commercial lenders are reluctant to finance companies without assets or predictable cash flows, and startups have neither. What was originally used to overcome a deficiency in the formal financial system—VC funds have traditionally financed Silicon Valley garage entrepreneurs—was converted into an instrument of avarice post 2008 and the liquidity deluge.

In many ways, the current implosion is somewhat similar to the dotcom bust when Nasdaq, the stock exchange of choice for tech companies, dropped 70% between March and October of 2000. The exchange once again seems to be signalling imminent value destruction, with the Nasdaq Composite Index having lost over 30% during the current year so far.

There are, of course, many startups that have a robust business model and a clear pathway to profitability. Many of these happen to be in the business-to-business space, focused on providing critical software services to larger technology companies or other clients. Many of these startups will survive this trial-by-fire.

As a matter of fact, the dotcom bust provides another credible analogy: out of the ashes of many startups will emerge some sustainable business models with a clear line of sight to the bottom line. Much like Amazon emerged from the detritus of the dotcom collapse, some interesting businesses are also likely to emerge this time. This new generation of startups will also need to have iron-clad business models, designed to survive the tough economic times ahead.

Rajrishi Singhal is a policy consultant and journalist. His Twitter handle is @rajrishisinghal.


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