Environment, Valuations and Starting Up in 2023
“The West or the US specifically has always been built on a 222 kind of model, it’s 2 percent growth, 2 percent inflation, 2 percent interest rates, and India has always been more 777, 7 percent growth, 7 percent interest rate, 7 percent inflation, give or take in India maybe a little bit more but it’s not a shock to the Indian economy and you can see it around you because people are spending, businesses are investing.” said Rajinder Balaraman, MD, Matrix Partners India in our latest episode of Matrix Moments on “Environment, Valuation and Starting up in 2023” with Avnish Bajaj, Founder & MD, Matrix Partners India.
Rajinder:
Hi, and welcome to Matrix Moments. Happy New Year to everyone and, Avi, we’ve done many episodes on valuation including marginal value add, valuations versus dilution amongst others. But it seems like this is one of those topics where every time the macro environment is evolving it’s an evergreen topic one needs to do it again. So we’ve titled it Environment Valuations and Starting Up in 2023. And let’s talk through some of this environment now it’s changing.
I guess recapping to begin with 2020 was Covid, big year in terms of how founders needed to react. 2021 was very quickly a boom cycle and that changed many things and then 2022 is the exact opposite, it was almost like a bust cycle where nothing could go right, many things did but still. So it’s actually very hard for founders to navigate and any early thoughts rather on what 2023 will likely look like and what do you think how will valuations likely trend this year.
Avnish:
So glad to be back, happy New Year to everybody. So what advice did we give in 2020 and how did that play out.
Rajinder:
2020 we said conserve because there was basically – you're saying in the start of 2020?
Avnish:
Well, no, in Covid time. Us and everybody gave the advice that the world is ending, and it ended up being the biggest boom for a year and a half. So therefore caveat, it ended up being really crazy times. But I think if you step back it is very human and natural to react to boom and bust cycles but if you do that I think it’s a very hard. The thrill and the excitement and the enjoyment of the startup journey and a venture capitalist journey actually becomes the opposite. One needs to recognize that this is how disruptive innovation happens.
And by the way I have read some stuff around it goes all the way back to the railroads and to gold mining. These are all driven by manic depressive behaviors and that's when things get over capitalized. So net point booms and busts are a feature not a bug. And they do create a long term – generally it is they create a new industry, happened with the internet, they create new infrastructure, so don’t overreact to it.
We’ve also discussed in the past and you and I guess will continue it’s also one of the funner things to do to kind of recap where things stand. So we’ve discussed what defines a bubble every time I guess we’re in a bubble. We’ve also done these during bust times earlier, I remember. So we’ll keep doing it every time there’s a big macro shift.
So typically we’ve said there are three Vs to a bubble. It depends on and we’ll talk about how this one played out differently. Volume, value, velocity. Lots of deals are happening at high prices generally and very fast. I would say whenever we have discussed this before we would see this in the later stage and we would see it volume clearly and value and in later stage. In early stage we would see velocity and volume. This time it was all three Vs even early stage valuations went whack and sadly this is a 18 month period, maybe a one year period which is why I'm very keen and why we’re doing this.
That can really mess with the founder’s mindset of what is normal and what their expectation are. A 12-month period, over the last 10-12 years of Indian venture capital. So we really need to make sure people are not anchored to this because it was a very random time, our peers did -- most of them did 30-40 investments. We did less than 10 which today looks smart but if this environment had lasted even three more months, I think our own FOMO would have taken over. So this time was different, have seen this play out multiple times in mid to later stages, first time we saw this spill over into early stages and with a vengeance.
Rajinder:
I think definitely agree but at the same time what’s the new normal then like is it back to 2016-2018 kind of timeframe because the market has deepened so how should one --?
Avnish:
See the market has deepened but we have to keep in perspective that the free money kind of so and this is going to be very hard for us as investors especially the ones who have not seen pre 2008 as well as founders to adjust to that this is not 2020-2021 issue. This actually started at a macro level post GFC and we’ll talk a little bit about how big a deal that is. Free money, money printing which is money supply as well as almost zero interest rate. The flight to venture capital when rates really started going closer to zero people start becoming more risk seeking and I think when the big fund announcement happened with the Vision Fund I think the craziness kind of started then.
So I think this is a 5-6 year period of craziness, the normal time which will also have cycles by the way but the more normal time when you look at macro conditions that are likely to repeat is actually 2010-2016 and maybe 2003-2007. Now both of them had cycles, I'm not taking 2000-2002 because that was a clear bust. But if you want to talk about normal conditions those are the normal conditions. In venture capital what we saw I would say ’16, ’17, parts of ’18 were normal.
I think in India you can expect that that's where we’ll end up so Fred Wilson’s actually sent Union Square Venture someone I look up to he actually has written this in his last newsletter. 2010-’16 is the period. Seed rounds in the US by the way are back to 6 million post, our seed investments in fund 3 are exactly in that range. I mean you were involved with this and a bunch of them. A’s are 10-20 million post corrections have started happening in India. The same deals that would happen at 20-40 are now happening at 8-15 post.
Now which is why I'm saying it would be tragic if people are indexed on 12 months because those were infinity and there was a logic to the infinity because... And you had a point and maybe we should talk about it why in zero interest rate environments any valuation can be justified, what’s the logic.
Rajinder:
I mean, simple, right, like ultimately private markets somewhere correlate to public markets and in public markets people are doing some version of a DCF model where 80-90 percent of the valuation of any company sits in the terminal value and if you have 1 percent interest rates let’s not take 0 let’s take 1 as a simple example you're basically discounting those cash flows at very, very different rate versus the same interest rate was 5 percent. For argument sake if like 80-90 percent of your value sits in terminal value and that discount rate changes then basically automatically your overall valuation drops by like 30 percent like just basis the shift in interest rates.
Avnish:
And by the way just as a corollary which is also why near term profits become more important than long term profits because terminal value becomes --
Rajinder:
There were some companies which were actually projecting in 10-15 years forward their cash flows and then that's never been the case in the past.
Avnish:
No, so the reality is it’s not that this time is different it is that 2021 was different and therein lies the nuance. And valuations in my view are back, 8-15 post depending on the stage at a very early stage and single digit valuations are again I mean they’re happening in the US which is a much deeper market.
Rajinder:
Now that is true and agreed and accepted like especially the global context and public market context but at the same time India now has over a 100 unicorns and that's also real, it’s fantastic. It’s great to see many of these companies having got into where they’re at, it’s also a bit worrying to hear some of the news that’s coming out of some of these companies around org design changes, layoffs, how is this going to play out like closer to home in India?
Avnish:
So I'm going to actually borrow from maybe what we were going to speak about a little bit later but I think given we’re speaking of valuation we should again keep reminding what we’ve said in the valuations episode. Valuations are notional, dilution is real. And we’ll talk about in the context of our advice to founders how that is relevant. Coming to your point I think we first need to go back to the macro and we’ve discussed this, we’ve chatted about this in other episodes.
Current GDP 3.5 trillion, next 5-7 years most forecast we’re breaking away should add 3.5 trillion. You should just pause and take a deep breath, we will add in 5-7 years the same amount of GDP that we have ever had in the history of the country cumulatively in 75 years. That's a big deal, really big deal. And it is happening digital first. You have done some Math, I’ve done some Math that it is 1.5-2 trillion the point being that we believe that somewhere in the trillions of digital market cap is getting created so you want to walk through your Math.
Rajinder:
Yeah, so I think it’s actually for founders this is something that should give everyone a lot of inspiration but just do the top down Math like market cap to GDP in listed markets generally tends to be in the 1:1 range like sometimes it overshoots, sometimes it under corrects all of that. But India is a 3.5 trillion economy, coincidentally our market cap is also somewhere in that range 3.5 trillion. If that 3.5 trillion GDP gets to 7 trillion over the next 5-7 years likely that market cap will also get there.
Now if you look at what is private plus public on the digital side what’s the cumulative market cap and add all the companies, right, Flipkart, and everyone, that number today is not more than 100-150 billion.
Avnish:
Even if you were to take the implied value of the globals here probably no more than 200, yeah.
Rajinder:
So we’re talking sub 5 percent penetration of digital market cap into total market cap of 3.5 trillion. That same 5 percent number by the way in China is closer to 35, at peak it was almost 50 percent now it’s closer to 35.
Avnish:
US is 42 percent, 40-42 – was at peak. Yeah, it’s probably come down to 30.
Rajinder:
Now again it’s probably in the 30 percent. And over the next 5-7 years even a conservative guess for India it has to get to somewhere in the 15-20 percent zone.
Avnish:
I actually think even more.
Rajinder:
Yeah, I mean of course, I also believe that it can be even more but --
Avnish:
No, but I’ll give you a logic but finish your --
Rajinder:
Listen, 20 percent of 7 trillion is 1.5 trillion. We’re at 100-150 so we’re talking actually a whole 1.4 whatever 1.3-1.4 trillion of market cap that's waiting to get created. And a lot of it is going to come to incumbents but a very large portion is going to come to innovators and so that's obviously what excites us.
Avnish:
So I think I'm even more optimistic. One of the things we keep talking about is that we lag in physical infrastructure – so by the way 2028 we’re going to be the third largest economy hopefully, it may be even sooner. So when you benchmark to the US and China we have generally lagged behind in industrialization, manufacturing, bunch of these things, hard infrastructure but we’re number one in soft infrastructure. Our architecture, I mean, US can still not launch a goods and services tax, they just can't, there’s too much opposition.
So because I think digitization is leading our growth I think we could be 35-40 percent, so we’ll see, but large numbers. So now coming back to your question on 120 unicorns, so I think it’s going to be – and the fact that it’s going to be a year of reckoning and all of that everybody is saying when everybody is saying it, it doesn’t happen. I don’t think it’s going to be a year of reckoning unless the founders decide that it should be the year of reckoning. I actually believe it should be the year of reckoning.
But there is this confusion between runway and business model. Lot of these companies raised tonnes of capital and so they have what is called infinite runway in many cases. My personal view there are likely three buckets in these unicorns, there are ones that have no business models, they will add best gets to take exits and investors may lose money. I was listening to a US public market investor who said in the US the valuations of the companies in many cases if you would apply comparable multiples, if you were to apply comparable public market multiples the valuation of the private companies is less than the liquidation preference that they would have and that's the extent of the problem and that problem is here as well.
Because ultimately you have to realize who’s our investor, they can invest in these US public companies. A lot of the later stage investors they can invest in these, so we saw all these crossover fund suddenly went over to the US saying this is much cheaper, that is going to be an issue. So if the business model needs more money so that's one category.
Second category, need money, but some business model. Not profitable but need money with a business model. I think they will raise money; growth is going to save them. So India is a growth story and if their previous rounds are overvalued, if they’ve grown into it flat rounds, if it is it could be a down round, don’t worry about it. Just take it, this is all notional, it’s like in the stock market. All the industrialists here react, look at Elon Musk, his net worth has gone down by 200 billion. Is he doing anything different than he would do otherwise, no. You do what you can control.
Third I think is the most exciting category which is scaling with profits or a path to it and I think you will see a flight to quality. We’re lucky to be in a few of those including Ofbusiness so I think there is going to be a flight to quality and these companies will actually break away and you will see hopefully in the first half itself that – so my prediction first half will show you. So 20, 50, 30 is how I would say. 20 percent in the first category, these are deductional numbers. 50 percent in the second category, 30 percent in the third category.
Third category will blossom sooner in my view, first category will require the most work because I don’t think founders see it that way nor do sometimes investors. Investors also are very guilty of resting on their marks not having to confront 2–3-year ka runway hai, why do anything. I think these companies will and maybe some of the second category they will decrease in value with the passing of time. The intervention should be now whether its austerity, because beyond a point you can't cost cut your way to a business model. But at least focus on finding one, don’t just rest on the comfort of runway.
I think if there’s one advice I would give is don’t confuse runway and business model and everybody in this market has runway but very few have business models, focus on business models.
Rajinder:
Can't agree more and I think it’s a very challenging statement to make which is runway is not equal to business model because most founders will challenge that thinking.
Avnish:
No, why? You know, we had this discussion in the other episode on infinity founders. We actually learnt that thinking from them, we’ve spoken about a bunch of them and I’ll tell you there are so many of them when the market turned in 2022 before we could have a conversation they changed how they’re running their businesses and they took full control of their destiny until they felt that business model is now working and I’ll tell you they will be in that first category. Some of them are unicorns, some of them are not and will become. They will be in that third category where you’ll see up rounds even in this environment.
Rajinder:
So the conventional thinking which I don’t agree with is that the business model emerges with scale.
Avnish:
Yeah, in some cases. But passage of time doesn’t change anything. A business model emerges with scale, maybe in some cases. Profits can emerge with – okay, so let’s put it this way, margins can change with scale. Maybe profits can emerge a little bit with scale, I don’t think business model at the unit level emerges with scale. It has to work on a LTV to CAC level which was broken a lot for many companies.
Rajinder:
So is it fair to say then that the founders just waited too long?
Avnish:
Because we talk about macro a lot I want to have a chat just to – we started off saying that 2008 onwards the world has been different. How has it been different, so there’s something called and the US is the largest economy in the world, China was much smaller at that time. So what the US federal reserve does has a lot of influence on what happens in the world. They buy bonds, when they buy bonds, they release cash into the market and -- these numbers are directional not necessarily exact.
Between GFC and pre Covid that number went from like a 1-1.5 trillion on their balance sheet to like a 2-2.5 trillion. Between start of Covid to now that has doubled to 4 trillion, so this has just been awash in liquidity. Then a lot of this stuff happened so interest rates were also brought down. Now let’s do some Math, so now you know interest rates in the US have gone up by 5 percentage points. What’s the world’s GDP?
Rajinder:
World’s GDP, probably somewhere in the 80-100 trillion range.
Avnish:
100 trillion, 96-97 trillion. What’s the world’s debt?
Rajinder:
This will be – it’s actually greater than 100 trillion.
Avnish:
250. By the way what is India’s debt to GDP which is why I'm a big India bull.
Rajinder:
India’s debt the GDP is much lower.
Avnish:
.7, 70-75 percent. US debt to GDP 200 percent, China debt to GDP like that, Japan debt to – which is why the number because we’re still smaller. So if interest rates go up by 5 percentage points on 250 trillion dollars of debt how much does interest outflow go up by?
Rajinder:
It’s like crazy, it’s like whatever.
Avnish:
12 trillion. What percentage of the world GDP is that?
Rajinder:
Like 12-15 percent.
Avnish:
12 percent. What is the world supposed to grow at, where will this money come from, how was this money coming from before, they used to print money. Now what has changed? What does printing money do?
Rajinder:
Inflation. Can't do it.
Avnish:
So there is a version of the world where by the way so what the US Fed is doing is they’re taking out 100 billion dollars a month now from their balance sheet. Which is a good idea because slowly over 2-3 years you bring that 4-5 trillion balance sheet down back to whatever that number should be. I'm not an economist to know what the right number is but 5 is wrong. So I think this could be a multi-year, that's why I say don’t go by the last few years. This could be a slow soft landing, but it will be 2-3 years and if you start thinking like that then you start wondering, hey, all this current environment, valuations have changed, whatever. Let’s keep the bigger picture and do what you have to do.
In that we have discussed about market cap India. I just think many things you want to talk about this 777, 222 concept. My idea is different.
Rajinder:
No, it’s the simple logic is the West or the US specifically has always been built on a 222 kind of model, it’s 2 percent growth, 2 percent inflation, 2 percent interest rates and India has always been more 777, 7 percent growth, 7 percent interest rate, 7 percent inflation and so in the current environment when inflation is at 7 percent give or take in India maybe a little bit more but it’s not a shock to the Indian economy and you can see it around you like people are spending, businesses are investing.
Avnish:
No, let’s make it real. My own home loan EMI has gone up 15 percent in the last one and a half years, maybe 20 percent. What is that number in the US?
Rajinder:
In the US the mortgage rates were actually less than the long-term average.
Avnish:
2-2.5.
Rajinder:
It used to be 1 percent and then it’s now gone to 6-7 percent.
Avnish:
So people’s monthly EMI has gone up 2, 3, 4 x. It’s going to destroy the consumer spending; it’s going the destroy the consumer spending. So that is the – when we say 777 and 222 what people have to think is, is it transmission through the economy. We’re always used to this and this is one of those times like we’re like this only helps us versus there it’s a big shock to the system.
Rajinder:
And you can see it, right, like the data from the US is actually not the clear like.
Avnish:
Yeah, it’s really confusing.
Rajinder:
At one level there’s like the jobs data is very positive, inflation is very strong, at the same time you're hearing of tech companies laying off large numbers of people. So it’s actually very mixed so I concur with you, I think the US is definitely going to not provide that clarity to us sooner versus later.
Avnish:
And what happens is when these companies they’re public companies, they can't give out their results on a daily basis or tell the market. The leading indicator is the layoffs, what can they control. If their revenue is not showing up what can they control immediately.
Rajinder:
Cost.
Avnish:
Cost. And I was just looking at – and you know the cost do add up and I believe sometimes people don’t think of that even in the Indian context because you have to look at INR revenue, INR cost. The cost of a fully loaded employee in the US what do you think it is. Like Twitter fired they basically went to half, right, so maybe 4000 people. What do you think is the cost, fully loaded cost of that employee?
Rajinder:
250,000-300,000.
Avnish:
I think it’s lower than that, I mean that would make it a – if you do the Math that would generate $7.5 billion of profit a year now for Twitter. I think it’s closer to 100-250 because there will be junior employees and all that in which case it’s still going to be $4-5 billion a year of increment. I think people need to think like that but where I think – and this is not a discussion on Musk and his style but I think incrementality doesn’t work in these things, non-incrementality does.
By the way we had to do it in Baazee, we went from 193 to 70 one shot employees when we had to do it. So I think you have to take these big bold calls because only then does this Math. Otherwise you do a 10 percent layoff you kill the morale and you don’t get the cost merit.
Rajinder:
We are meeting many founders --
Avnish:
Before that, sorry, Rajinder, you had asked me if founders waited too long and we branched off into something else. I again keep the perspective -- so my answer is no, what are you building a business for if you were to start what are you building it for?
Rajinder:
For your customers, for your employees, for yourself what’s changed? Nothing?
Avnish:
So I actually believe fund raise is not success, you're not building it for fund raise. Has the fund raise environment turned, yes, but turned off something that will never come back in my view or will not come back for a period of time which was a 12-month period. Look at the normalized steady state period I actually believe this is a better time to build because when the funders environment is frothy not only are you raising money you may feel that you’ve gotten a great valuation but not only are you raising money others are also. What does that do to your expenses and burn rate and all that.
Rajinder:
Yeah.
Avnish:
So you may get a higher valuation but your burn is also higher. Are you burning cash?
Rajinder:
Yeah, for sure.
Avnish:
Where do you get the cash, equity, you’re burning your equity. You're setting your equity on fire. And so this is all notional and to me they’ve not waited too long, I genuinely believe this is the best time to start. We know there are layoffs everywhere within our human capital team we’re getting every week spreadsheets of people who are in the market and available. Here’s less competition for talent, less competition for customers. The CAC is going down so you have to look at the end state, think about what are you building for, what is the future that you’re building for and then these valuations get put in perspective that for the first principles right way to build these are the right way.
And you're probably better off now than you would have been otherwise. And I think we kind of answered your question on -- you want to just put it in --
Rajinder:
Yeah, so I think the point was really around in this environment people are still thinking valuation versus dilution, people are looking at some large companies and looking at the ownership of founders there and thinking what should my end state ownership look like, should it be single digit, like some of the other, should it be higher.
Avnish:
I think that’s the balance. That's a great point, if I were to start, I'm sure if you were to start and you were to look out when you have a successful business you've single digit ownership I think you’ll say it’s unacceptable, I think that's fair, I believe it’s fair. But the data is wrong, and the data is wrong because – and you're not going to name the most of the founders who have created these very large companies ended up in single digit ownerships. But why, because the market was not deep. Hyper competition was there, some of these hyper competition cycles were there.
The issue, the first round will always be 20-30 percent dilution, 25-35 percent dilution including so whether you call it seed or A including your ESOP. This is how it’s worked for 45 years, it’s not going to change. Second round, likely to be 15-20 percent dilution. What happened in these companies, is there C, D, all the way to Z rounds were happening at 25-40 percent dilution because of hyper competition, because I think founders were making the mistake of raising too much capital. We discussed in our episode think about single digit dilution and one of our founders has actually taught me, Anurag, that it’s like a public stock, when you don’t need the money and you're heading towards profit you're like a public stock. If you find the right price take a little bit more and you keep taking the price up.
So to me most and by the way we’ve done this analysis, they’re all in the 25-45 percent ownership range. So the data is wrong, and that data is resulting in wrong decisions now or not wrong decisions it’s harsh but just too much angst, ki yaar ye valuations change horai hai, It is actually ke phela round mein tou ye hona he ha. It’s actually how do you build your business and therefore in this environment it’s a better environment to build a business with capital efficiency. So, if you look at the outcome my bet, my conviction is you're better off in the this next 2-3 years than you would have been in the previous any other.
Rajinder:
I think good message. Putting it together like any closing advice just on environment 2023, more of a medium-term view?
Avnish:
I mean you know all this and it’s so exciting, digital nation building is underway, trillions of dollars of wealth creation is waiting to be taken. Ignore the short term fluctuations, valuation is notional, valuation is real, better environment to build businesses. So really think outcome backwards and I think personally I would have rather started in this environment than in the ’21 environment because the journey will be better. You said people who start the infinity entrepreneurs they take their time, you know, they’re thoughtful. Where did you have the time to do that, so don’t take a very abnormal period as normal because that period had a lot of negativity, a lot of issues so just super excited and hopefully –
And by the way on that note so just to put environment in context, April, May to about August, September company creation had fallen off, founders were scared, we were scared, everybody was, right. We were looking but we weren’t finding. Last 4-5 months founders are coming out of the woodworks, I love it. The only issue is this valuation reset hasn’t happened. Right, but excellent founders coming out and super excited to partner with them and highly encouraging of this phase.
Rajinder:
Thanks.
Avnish:
Okay, super.
