Active Stocks
Thu Mar 28 2024 15:59:33
  1. Tata Steel share price
  2. 155.90 2.00%
  1. ICICI Bank share price
  2. 1,095.75 1.08%
  1. HDFC Bank share price
  2. 1,448.20 0.52%
  1. ITC share price
  2. 428.55 0.13%
  1. Power Grid Corporation Of India share price
  2. 277.05 2.21%
Business News/ Opinion / Columns/  Opinion | It's time for startups to shift focus to internal validation
BackBack

Opinion | It's time for startups to shift focus to internal validation

Firms must pass test for internal validation before dealing with leveraged buyback

Startups need to go through internal validation to test if they are ready for public markets. (Bloomberg)Premium
Startups need to go through internal validation to test if they are ready for public markets. (Bloomberg)

Beneath the surface of our daily life, in the personal history of many of us, there runs a continuous controversy between an ego that affirms and an ego that denies. On the course of this controversy depends the attainment of inner harmony and consistent conduct in private and public affairs. These words of Beatrice Webb perhaps best explain the conflict between the outer world and one’s inner world, now being seen almost on a daily basis in the fast-paced world of startups.

Increasingly, for every event in this space, there are two kinds of reactions that are seen, one a validation which appeals to the affirming ego and one of huge criticism, which obviously appeals to the denying one. While external validation is hugely appealing, it is good to take a harder look at how viable certain actions or events are, especially at a time when the talk of a slowdown gets louder, and perhaps shift the focus to internal validation. Consider this:

A. Ready for a debt trap? Just a few weeks ago, the Competition Commission of India (CCI) gave the clearance for Ritesh Agarwal, group chief executive of hospitality chain Oyo Hotels & Homes, to undertake a $1.5 billion stock buyback, setting a new valuation benchmark of $10 billion. While a buyback of shares is not a novel idea, the size of the deal has made it one of the most talked-about transactions, with positive sound bytes such as “take a bow" or “a bold move that other promoters can replicate", which compliment the founder and his risk-taking abilities. On the other side, there are critics who are drawing parallels to WeWork because of a semblance in their core business model, terming it a private “REIT" (real estate investment trust) with too much SoftBank Capital. Leaving aside the incestuous nature of this transaction, startups attempting to consolidate control via borrowings need to internally validate if they are ready for such a “debt trap."

In such private transactions, lenders would need a minimum cover of 1.5x (usually the industry standard), implying that for a loan of $2 billion, the founder would have to pledge $3 billion worth of shares. While such loans come with a non-cash interest feature (interest gets accrued to the loan balance) and bullet repayment, it seems unlikely that a cash burning machine such as Oyo will build enough cash reserves to repay its debt. This will lead to more fundraising to repay the debt, leading to a “debt trap".

Validation of the buyback action, from various quarters and the enticement to be able to raise debt and increase control in their companies, can force startup founders to walk down the ‘Oyo’ path, maybe even too soon in their journey.

Most tech startups today, unlike traditional core sector companies, do not have enough consistent cash flows to cater to the cost of operations and investment needs. However, deals such as Oyo, where founders borrow not for business requirements but rather control needs, pushes the company and its founder to assume unnecessary leverage often relying on valuations that are not based on free cash flows but rather on assumptions of growth. Amid uncertainty of free cash flows that could be repatriated to the founder, founders will be banking on future rounds of fundraise (debt or equity) at increased valuations to meet their financial liabilities, turning this into a zero-sum game for them. In event of a downslide of valuations or liquidity crunch in the financial markets, startup founders also stand a chance of losing control of the company. There are numerous examples in the traditional industries, in recent times, wherein over-leverage and economic downside resulted in promoters losing control of ‘good’ companies.

Hence, companies should pass the test of internal validation, which include profitable growth, cash flows to repatriate to founders, overall lower leverage and stable operations, before experimenting with leveraged buyback.

B. Ready for initial public offerings (IPOs)? There is a growing chatter urging startups to do IPOs. The perks of going public are known. It improves visibility and credibility, can lead to better exits for investors and more liquidity for shareholders.

In India, IndiaMART, online marketplace for B2B commerce, made a strong public market debut – oversubscribed 36x and currently trades at 48% premium over the listing price. Similarly, in the past, Info Edge India, made stellar debut in public markets. Overseas too, there have been some very encouraging response in few startups, such as Cloudflare, Health Catalyst, Livongo, Medallia and Chewy, to name a few.

While there are a few IPOs that have been well received, many others haven’t fared so well. Startups need to establish their readiness for IPOs.

Not many startup founders have a clear guidance to profitability, or the ability to deliver consistent, routine results, which can be considered too risky for markets. Boards have to be strong too. Several high-profile IPOs in the biotech space such as Vascular Biogenics tanked while ride-hailing behemoths, Uber and Lyft, experienced a slowdown in growth and increase in losses. Startups need to go through internal validation to test if they are ready for public markets, the preparedness for which has to begin much in advance.

In an entrepreneurial journey, there will be enough temptations to fall prey to external validation, but it will be imperative for entrepreneurs to focus on the inner scorecard than the outer scorecard.

Shrija Agrawal is Mint’s associate editor. Due Diligence will cover issues in India’s venture capital, private equity, deals and startups space.

Unlock a world of Benefits! From insightful newsletters to real-time stock tracking, breaking news and a personalized newsfeed – it's all here, just a click away! Login Now!

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
More Less
Published: 20 Oct 2019, 11:38 PM IST
Next Story footLogo
Recommended For You
Switch to the Mint app for fast and personalized news - Get App