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 second-round investors sell stakes to the third round and so on, until the last set of investors are left holding stakes in a loss-making company.

Obviously, the Infosys founder knows VCs are not playing the Ponzi game – in which a fraudster offers high returns to lure unwary people into a pyramid scheme and pays off early investors using cash pumped in by later investors until the whole structure collapses.

He may also have been exaggerating things to make a point. Plenty of VC investments fail, often because VCs focus too much on scale. Murthy knows from personal experience that market valuations can be horribly off the mark.

Infosys itself, which was already a solid profit-making entity, struggled to raise funding when it went public in 1993. The IPO devolved and did not find takers at the offer price of ₹110 a share. The lead managers had to pick up shares at a discounted ₹95 (which meant they eventually made huge returns, assuming they held onto the stock).

The VC Industry (and its sibling, the private equity industry) does focus heavily on growing the topline. Whatever the other factors, VCs will not touch a business unless they think it can scale massively – that is, there is a big potential market for what it offers.

There are obvious reasons for this. A local bookstore can generate a living for a family, but you need the scale of an Amazon to tap every reader in the world. VCs also focus on growing revenues because it is much easier to judge the size of a 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 like Uber (and Ola, Didi, etc.). It’s obvious there is a big market for the sale of consumer goods online, and for ride-hailing. But how to make a profit by delivering such services is much harder to judge.

Any business offering consumer goods online must invest heavily in IT infrastructure, warehouses, hiring people to sort and deliver goods, negotiating rates with sellers and so on. Likewise, a ride-hailing service has to either invest in buying cars and hiring drivers (like BluSmart), or negotiate rates with car owners and drivers to offer such services. It also has to invest in creating an IT backbone and apps to connect drivers with passengers, and figure out rates that work for both parties. Moreover, such businesses need to keep investing if they want to capture a bigger market share. Amazon took over a decade to become stable and profitable. Flipkart, which launched in 2005, is still making losses. Uber, which launched in 2010, was making losses even in 2021.

Given the relative visibility of potential markets (easy to judge) versus future profitability (hard to judge), VCs look for the variable they can track easily. Yes, this is a hit-and miss method of investing. It’s a bit like playing poker, a game where even the best players will lose money most of the time and make big returns once in a while.

VCs invest in, let’s say, 10 businesses they think likely to scale. They expect to lose money in 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 will become an Amazon or a Google.

Another factor is that VCs tend to become more optimistic when money is cheap – that is, when interest rates are low and there’s surplus liquidity. Thanks to covid, every central bank lowered interest rates in 2020. This led to a boom, as VCs chased every business plan with some promise of growth.

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