The cost of starting up

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With a startup, the conventional wisdom is that all resources should be poured into the core business. But most Indian entrepreneurs don't seem to think this way if a study done by Amarnath Bhide, Glaubinger Professor at Columbia Business School, is correct. Bhide examined small firms in the Bangalore area, excluding IT from his focus.

Bhide says that most Indian firms in his study required an average startup capital of about Rs 3.75 lakhs ($8,300), whereas the average (non-IT) US startup needs about $10,000. With purchasing power benchmarks, Indian firms shouldn't need more than about $1,500-$2,000 equivalent as startup capital.

Next, Bhide found that 80 per cent of Indian startup capital was sunk into buying real estate regardless of the "core" business. Indian firms will buy rather than rent even when, as now, rental yield is low and real estate prices are high. Net of real estate commitments, startup requirement drop close to expectancy. (I suspect that real estate commitments would be officially understated due to black:white pricing ratios and there would also be undisclosed leveraging on many land purchases.)

The number of firms that achieve high growth (Bhide's cut off was 15 per cent CARG for 5 years) is low, at about 1 per cent. In five years, the top 1 per cent of US small firms grew to turnovers that equaled 378 times the initial capital base. The top 1 per cent of Indian firms grew to turnovers of 20 times their initial capital base.

This seems weird, given Indian GDP growth rates and known returns from listed corporates. There are reasons for the distortion " namely, stultifying labour laws and tax structures. Above a certain threshold, it's better to split one firm into two or into three, four, or 10 firms.

That way, the entrepreneur avoids firing restrictions and makes lower indirect tax payouts through availing SSI excise exemptions. So, the total number of small Indian firms grows very quickly rather than individual firms exhibiting high growth.

This structure is frustrating for the passive equity investor. Few Indian firms ever reach a size where they need to access the capital markets. Even worse, as and when IPOs are launched, each entity seeking listing has several unlisted group companies trailing its coattails, and making valuations tricky.

Let's return to real estate. Empirical evidence suggests that Bangalore firms are not exceptional. If Bhide's study is replicated in the NCR and Greater Mumbai, we're likely to find small firms also sink most of their capital in real estate.

Hence, most small Indian businesses are actually real estate plays. If 80 per cent of the capital is sunk into self-occupied premises, you must expect a high capital appreciation on that land and that is actually your core business.

This has many scary implications. The real-estate bubble is of far larger dimensions and has far larger externalities than generally realised. If real estate ever goes into a genuine tail-spin, it will crucify entrepreneurs with no apparent connection to it. It's an open question what the creation of mega-SEZs will do to the market and to this mindset.

There are few listed plays and India doesn't have real estate investment trusts (REIT). On the other hand, construction/developer firms like Lok Housing and Parasvnath probably have larger customer bases than is generally realised. Bhide's study may provide a basis for upgrading return expectations from this sector.