The unicorn boom: Shareholder issues

Not a day seems to pass without a unicorn being created. Every day we see reports of a startup with a valuation exceeding a billion dollars getting funding. Neelkanth Mishra of Credit Suisse has written a very interesting report on the startup ecosystem, outlining the case for why India actually has over 100 unicorns, and why the ecosystem is coming of age today. He lays out the conditions facilitating funding and new company creation and why this is a huge positive.

What is now clear is that the vast majority of the tech-enabled, disruptive unicorns are targeting an IPO over the coming 12-18 months. Zomato will be the first of them. It is planning to raise $1 billion, list in India, and target a valuation of $6-7 billion. The roadshows for its public offering are about to begin.

One decision point for most of these unicorns is where should they list. In the US or in India? International banks will push for a global listing as their fees will be higher and they can avoid Indian competition. Local bankers will push for an Indian listing as it plays to their strengths. What makes sense?

I think every company has to look at its own business model and target investor base. What is clear is that by listing in the US, you cut out domestic Indian investors entirely. I am a bull on the financialisation of savings, and believe over the coming years, domestic investors in India, not global players, will drive the market. They will eventually be bigger than global investors in terms of the capital managed. Blocking domestic investors will be a big loss for any company, for they are the natural long-term buyers of Indian assets. If your targeted investor base is global EM (emerging market) investors, then you do not really gain anything listing overseas because these investors all have the ability to invest in Indian listed securities. It only makes sense to list globally if you think your natural investor base is global tech investors, those who will not buy or cannot buy an Indian listed security.

The targeted investor base depends on your business model. If you have a technology-enabled, disruptive business model focused on the domestic market, local and EM investors are your best bet. If understanding the business and its prospects requires a deep understanding of India, then domestic/EM investors are your natural base. You should list in India. If this type of company tries to list globally, it runs the risk of being orphaned, with no following or research coverage. Global investors with no India exposure are not going to try and understand India just to figure out this one company. Trading volumes languish, market capitalisation will be small by global standards, and the company tends to get ignored. This is what has happened to previous Indian internet listings.

However, if you have a global business that happens to be Indian only because it was founded in Bangalore and product development continues in the country or the founders are Indian, then global technology investors are your natural target. An obvious example of this is a SAAS (software as a service) business or a deep-technology business. There is no real India connect as far as the economics and scalability of the business go. These businesses do not require any prior knowledge of India and local conditions to analyse. They can easily be compared to global peers. The same factors will drive their success and scalability as they drive similar businesses listed in the US. These companies should list in the US. They will be easily understood and covered by global analysts.

Illustration: Binay Sinha

Another fear among many entrepreneurs is whether they can get a higher valuation by listing overseas. I would argue the opposite. The Indian markets are willing to pay very high multiples for well-governed, scalable companies with high returns on capital. Across sectors, be it financials, FMCG, paints, chemicals, automobiles, and classifieds, etc. the most expensive company in the world in the sector is listed in India. Also given their rarity, new business models will get a scarcity premium if listed in India. Unlike the Nasdaq, we do not have hundreds of technology-enabled disruptive business models already listed.

Of course the investor base in India will have to learn how to value these types of businesses. Historically the markets in India have not been efficient in valuing loss-making companies. However, the markets have been good in valuing long-term growth. Just look at the multiples we have on our consumer-facing businesses — 60-75 times earnings is obviously looking at long-term growth potential. There is no other explanation. The institutional investor base in India will learn to handle unit economic positive but currently loss-making business models. The local investor base is very adaptable and focused on global learnings.

Another point that entrepreneurs will have to keep in mind is the need to attract the right shareholder base, whether in India or globally. One of the biggest competitive advantages that an Amazon or a Netflix had was a shareholder base that gave the management the flexibility to build out their business and not worry about short-term profitability. As long as they could show positive unit economics and cash flows, the shareholder base was willing to let them invest all profits and cash flows to scale the business and not worry about showing immediate profits. Contrast that with, for example, an ATT in the US which has just been forced to spin out Warner Media to compete with Netflix and Disney because its shareholders are focused on immediate profits and dividends. How do you compete with Netflix in streaming when you are not allowed by your shareholders and therefore the board to cut dividends or margin/profit guidance? Your shareholders are not willing to back you to invest and pivot to a new business model of streaming, away from the cable bundle, if it means sacrificing profitability. That is not their mandate. These investors will only value current profits, not potential profits.

When pricing their issues, entrepreneurs must resist the temptation of only focusing on maximising price. Focus on getting the right shareholder base, which will support your growth ambitions and understands the unit economics of the business. They must have a similar time horizon as the entrepreneurs. Your investors must understand and back the tradeoff you as an entrepreneur are making between current profitability and scaling revenues. As you scale, what percentage of incremental margins drops to profits and how much is re-invested is a business decision your investors must be aligned with.

In most cases the selling shareholders are VC/PE investors who will only focus on getting the highest price at any cost. The entrepreneurs are normally not selling, and are the ones staying to run the company after listing. They should focus not just on price but the quality of the shareholder base and the alignment with their own ambitions.

The startup scene is one of the few bright spots in India at the moment. There will be a lot of capital issuance in the space. Entrepreneurs must think through their choices on their listing venue, shareholder base, and valuations carefully.

The writer is with Amansa Capital