Unicorn funding: Hype or sustainable model?

Ever since Walmart’s much-awaited acquisition of a majority stake in Flipkart for a whopping $16 billion, the spotlight has been on the other Indian “unicorns” (privately-held entities valued at over $1 billion). Considering that a few years ago, Flipkart was being written off by most institutional investors, the mammoth valuation of the e-commerce firm (though debatable) is being highlighted as a success story insofar as viability of Indian unicorns are concerned and, in the process, has renewed the interest of foreign investors in investing in Indian start-ups.

Change in corporate culture

Before moving on to whether such high levels of investments are sustainable or not, it is vital to analyse the implications of the Flipkart-Walmart deal on overall corporate governance in the start-up industry. Traditionally, Indian start-ups and the venture capitalists investing in them have majorly focused on immediate short-term expansion plans fuelled by discounts, thus resulting in most Indian start-ups going bust after two or three rounds of funding. Walmart on the other hand is a strategic player looking to expand its interests in India, after several failed attempts to enter the Indian market as a B2C player. Reaching middle ground, as far as clashing corporate cultures is concerned, will be vital if this synergy is to continue. 

Another major change that is expected to come is greater adherence to corporate governance norms. Start-ups have generally fallen short as far as corporate governance norms are concerned. Founders routinely award themselves greater windfalls at the cost of the profitability of the company. A direct consequence of more institutional investors and investors such as Walmart coming in is therefore going to be greater adherence to growing corporate governance norms. 

Exit options

So far, the biggest bottleneck to investors is the lack of viable exit options. Globally, the ideal way of exiting a company would be by way of an options contract. Unfortunately, enforceability of options contracts in India, especially in cases where foreign investors are involved, has been shrouded in controversy since regulators such as the Securities and Exchange Board of India (Sebi) permit options contracts only subject to compliance with various conditions. Further, foreign exchange regulations expressly bar any options contracts that permit companies to avail themselves of foreign investment by providing assured returns.

Despite such restrictions, several shareholders’ agreements still tend to contain such clauses and in most cases also contain arbitration clauses that provide for arbitration outside India. To add to the complication, there has been a flurry of cases wherein arbitral tribunals have passed awards upholding enforceability of such clauses and requiring the Indian party to honour its obligation under such clauses.

However, Indian parties aggrieved by such awards tend to challenge the enforcement of any award, claiming the award is contrary to the public policy of India. This complication has abated to a certain extent by virtue of certain decisions of high courts (for example, NTT Docomo Inc. vs Tata Sons Limited), which have ruled in favour of enforcement of such clauses. However, foreign investors are still wary of utilising options clauses to facilitate their exit.

Another major bottleneck in case of exits is the lack of simplified IPO procedures. While the government is attempting to take multiple steps to assist start-ups, complicated exit routes such as IPOs prove to be a bottleneck for investors in India. Sebi is contemplating simplified IPO exits in certain cases, including by way of direct listing — i.e., on a given date, without raising any money from the public, the company declares itself to be public, and its shares publicly tradable. Whether such efforts will assist in simplified IPO exits for investors will become clear only in future.

Future trends

Sustained investments from investors are a primary indicator of the fact that the Indian start-up sector has moved out of the bubble phase, wherein investments are now driven by virtue of numbers rather than by hype. The present trend of high-value investments is fundamentally different from the trend prior to 2015, to the extent that most funding presently is happening at the Series C and Series D level, which are later-stage investments and can only happen when investors are convinced that the fundamentals, financials and business plans of the start-up are sufficient to sustain long-term growth, and that such a business model does not focus merely on discount-led growth (which does nothing more than transfer the risk from one player to another). This surge in Series C and D deals this year is encouraging and hints at increasing maturity among investors, insofar as their India approach is concerned. 

Atul Pandey is Partner, Khaitan & Co, and Hirak Mukhopadhyay is Associate, Khaitan & Co