Why Narayana Murthy’s wisdom on VCs is flawed

As a result, Murthy said, early investors in a startup (Series A investors) sell their stakes at a profit to investors in the second round (Series B), and investors in the second round sell stakes in the third round and so on, until losses are made. The last group of investors holds stake in the company going on in

Clearly, Infosys’ founders know that VCs aren’t playing the Ponzi game—in which a fraudster offers high returns to lure unsuspecting people into a pyramid scheme and pays off early investors using cash put in by later investors. until the entire structure collapses.

He may be exaggerating things to make his point. Too many VC investments fail, often because VCs focus too much on scale. Murthy knows from personal experience that market valuations can be very bad.

Infosys itself, already a solid profit-making entity, struggled to raise funds when it went public in 1993. 110 a share. Lead managers had to buy shares at a discount 95 (which means he ultimately made huge returns, assuming he held onto the stock).

The VC industry (and its sibling, the private equity industry) focuses heavily on growing the top line. Whatever the other factors, VCs won’t touch a business unless they think it can scale massively — that is, there’s a huge potential market for what it offers.

There are obvious reasons for this. A local bookstore can earn a living for a family, but you need Amazon’s scale to tap every reader in the world. VCs also focus on growing revenue because it is much easier to judge the size of the potential market than the ultimate profitability of a particular business model.

Take the case of Amazon (and its many rivals such as Flipkart and Alibaba), or a cab-hailing service such as Uber (and Ola, Didi, etc.). It is clear that there is a huge market for online sales of consumer goods and ride-hailing. But it is much more difficult to figure out how to make a profit by providing such services.

Any business offering consumer goods online must invest heavily in IT infrastructure, warehouses, people to sort and deliver goods, negotiate rates with vendors, etc. Similarly, a ride-hailing service either has to invest in buying cars and hiring drivers (such as BlueSmart), or negotiate rates with car owners and drivers to offer such services. It will also have to invest in building an IT backbone and apps to connect drivers with passengers and find rates that work for both parties. Furthermore, such businesses need to continue investing if they want to capture a larger market share. It took more than a decade for Amazon to become stable and profitable. Launched in 2005, Flipkart is still running at a loss. Launched in 2010, Uber was running at a loss in 2021 as well.

Given the relative visibility of potential markets (easy to judge) versus future profitability (difficult to judge), VCs look for the variable they can track most easily. Yes, it is a hit and miss way of investing. It’s a bit like playing poker, a game where even the best players lose money most of the time and occasionally make big profits.

VCs invest in, let’s say, 10 businesses they think have the potential to scale. They expect to lose money on six or seven of these, and break even or make a small profit on two or three. They hope and pray that one of those businesses becomes Amazon or Google.

Another factor is that VCs tend to be more optimistic when money is cheap – ie when interest rates are low and there is surplus liquidity. Every central bank reduced interest rates in 2020 due to Kovid. This boomed, as VCs chased every business plan with some promise of growth.

The situation has now changed, liquidity is drying up and rates are being hiked due to inflation. In February, India’s startup economy, which is the third largest in the world, saw 91 deals worth $1.32 billion, down 77% from 308 deals worth $4.77 billion in the previous February. If this trend of high rates and low liquidity continues, soon VCs will be accused of being too cautious rather than looking like Ponzi scheme operators.