Are venture capitalists value destroyers?

EQUITY investments into new enterprises are held aloft as a big economic multiplier. Investments lead to employment and output, both of which result in economic and social progress. That premise, going by several recent examples, is debatable.

Companies like Amazon, Reliance Jio (India), AirAsia, Flipkart (India), Uber (or Grab), Airbnb, Wework among others, have had a breath-taking few years of expansion, market reach, media ogle, investor lust and employment allure. These companies are called 'disruptors' and are the darlings of many. New startups wish to emulate them in terms of quick market reach and fame.

The financial numbers of these companies are quite another issue. Would you like to know how an airline can price a ticket (however short the distance may be) at US$9.99 per passenger? Or an e-commerce site that offers up to 97 per cent discount on many different items? Or a cab ride that costs a fraction of what it would have otherwise cost as per traditional taxi systems?

The answer is they are selling, by and large, at a marginal loss. In costing terminology, that means selling at a price that is lower than what it costs to produce an item. Why do they do it and how can they sustain it?

Three justifications are offered:

a) some of the products and services sold cost nothing as otherwise they would be 'unsold' items (also known as perishable capacity);

b) the purpose of selling these products and services (in the initial years) is not to make a profit; it is to make it widely known and enlist a customer base;

c) the products or services are 'new' or relatively less known and therefore the deep discounts are the price paid to encourage switches from other equivalents

Even if you are not an accountant, it doesn't take much ingenuity to conclude that there will be a loss when the sums are added up. And that may be for several years. So the question is who finances these losses? In one phrase - venture capitalists.

According to a report from KPMG Enterprise, global VC investment rose from US$46 billion in Q4 2017 to US$49.3 billion in Q1 2018. Many of the investee companies start with minimum capital which is then beefed up by angel and then venture capitalists based on establishing a product and ramping up a client base. These company valuations are not always based on revenue or profitability. In fact, the idea is valued more than any financial metric. Uber is reported to have burnt over US$10.7 billion in nine years till 2017 - and guess what? No profits yet!

INVESTMENT GAME

This is a very different investment game. Venture and angel investors stake their fortunes on the investee companies being able to multiply valuation over a three to seven-year period, again not through revenue or profit changes but by finding another late stage investor or the stock market (IPO route) to offload. So the game continues as long as you can find the next guy to put in his money. The next guy's goal is the same. Amazon struggled to raise US$1million in 1995 whereas that is now a pittance for most startups.

This story is not merely about the logic (or illogic, as some would consider) of venture investing. What do these companies (who become flush with enormous money pumped in based on promise than performance) do with the money? They disrupt the pricing structure of the industry segment. In plain language, they sell cheap. And for long periods of time. This is the good old strategy of your neighbourhood store three decades ago. But they didn't have the scale to upset the applecart.

As for the new price disruptors, their goal is to enlarge the customer base, and profits are incidental or a by-product, if at all. With steep falls in prices, consumers are of course very happy. But fellow industry players are not. Reliance Jio, a late-stage telecom operator in India (it entered nearly 20 years after other major players did) crashed the market so much that most companies are reeling. Not surprising when you can get one GB data every day for three cents. The Indian telecom industry may soon see only three deep-pocketed players standing.

Several leading clothing companies (Gap, for instance) are re-configuring their operations as the old model of high price for elite premium service and branding has been laid low by online players. Amazon recently reported that its international losses mounted to US$3 billion, largely on account of a bloody battle in India with Flipkart, a company that is yet to make profits. (It received large funding from Softbank, Japan). It's not just more competition, but virulent price fall that is resulting in value erosion in industries.

Is this the new order or is it only until venture capitalists burn out? That may not happen for quite a while, as the appetite of angels, investors, capital arrangers and intermediaries is still healthy.

MORE DEALS

There are also many more deals on the table. Just recently, Wework, a co-working space company operating in many countries, received US$3 billion in venture investment (The company provides a private office space for under US$1,000 a month in Manhattan!).

In the meantime, value destruction will continue in many industries. That could bring in its own pallet of griefs - company closures, job losses and economic brakes even as consumers make merry. Is it completely undesirable? No, but the devil is in the scale and magnitude.