(Saturday Deep Dive) - VC’s Role in Over-Inflating Indian Startups

In today’s deep-dive, we will explore the phenomenon of venture capital (VC) firms over-inflating startup valuations, a practice that has both propelled innovation and raised serious questions about sustainability. From the rush to create unicorns to the high-stakes competition among investors, the strategies behind these inflated valuations reveal a complex web of motivations.

While high valuations can signal market leadership and attract further funding, they often come at the cost of long-term business viability and governance. Using examples from leading Indian startups like OYO Rooms, Paytm, Zomato, and Byju’s, this report examines the stages where over-inflation occurs, the tactics used by VCs, and the consequences for the startups and the broader ecosystem.

India’s startup ecosystem has grown exponentially over the last decade, producing a record number of unicorns and emerging as a global hub for innovation and entrepreneurship. While venture capital (VC) firms have played a pivotal role in this growth by providing much-needed funding and strategic guidance, but their practice of over-inflating valuations has become a contentious topic in the entrepreneurial ecosystem.

At its core, over-inflation is driven by a combination of strategic motives and market dynamics. High valuations can attract follow-on investors, signal market dominance, and enhance the perceived success of the VC’s portfolio, which is crucial for raising future funds. Moreover, in competitive markets, aggressive valuations can serve as a defensive strategy to outbid rival investors and secure stakes in high-potential startups. However, these inflated valuations are often based on projections of future growth rather than present-day fundamentals, fueled by the pressure to deliver outsized returns. While such strategies can create short-term gains, they also risk undermining the long-term sustainability of both the startups and the broader ecosystem.

How do VCs over-inflate valuations?

VCs use various mechanisms to overinflate startup valuations, often driven by the need to show high returns, justify their investments, or dominate market dynamics. Here’s how this happens:

1. Massive Capital Infusions

VCs inject large amounts of capital into startups during funding rounds, sometimes exceeding what the business needs at its stage. This capital infusion not only escalates valuations but also creates an impression of robustness, attracting further investments. For instance, the excessive funding of food delivery platforms like Zomato and Swiggy led to unsustainable valuation wars in their early growth phases.

For example, SoftBank has been a key player in over-inflating valuations through excessive capital deployment. OYO Rooms, once valued at $10 billion, received billions in funding from SoftBank. This aggressive capital infusion allowed OYO to expand rapidly, often onboarding properties without adequate quality checks or operational oversight. While this growth initially created the perception of a thriving business, it eventually led to operational inefficiencies, layoffs, and a valuation cut to $2.7 billion.

2. Rapid Scaling at the Expense of Sustainability

VCs often push startups to prioritize scaling over building sustainable business models. The emphasis on “growth at all costs” can lead to short-term metrics like user acquisition or geographic expansion being overvalued, while ignoring profitability or operational efficiency.

For example, Tiger Global is known for pushing startups to scale quickly. Infra.Market, a B2B construction materials marketplace, saw its valuation skyrocket to $2.5 billion after a Tiger-led $125 million funding round in 2021. However, critics argue that such rapid scaling often masks underlying inefficiencies and raises questions about whether these valuations are supported by fundamental business performance.

Another example is Sequoia-backed GoMechanic, which also fell into the trap of rapid scaling. Encouraged by investors to capture market share, the automotive services startup expanded aggressively but eventually admitted to financial misreporting and scaling challenges. This resulted in operational downsizing and layoffs, revealing the risks of prioritizing growth over sustainability.

3. Valuation Markups in Successive Rounds

Another tactic used by VCs to inflate valuations is leading multiple funding rounds for the same company, each at a significantly higher valuation than the previous one. This creates a perception of consistent growth and investor confidence, even if the underlying business fundamentals haven’t changed substantially.

For example, CRED, a credit card rewards platform, saw its valuation leap from $2 million to over $60 million within a year, thanks to successive funding rounds led by Sequoia Capital. By 2021, its valuation exceeded $2 billion, despite limited revenue generation. The reliance on valuation markups rather than core business performance has sparked concerns about whether these startups can justify their high valuations in the long run.

Another example is about OfBusiness, a B2B commerce platform, which doubled its valuation to $3 billion within two months, driven by successive Tiger Global-led funding rounds. This rapid escalation has raised eyebrows, with critics questioning whether the business fundamentals justify such valuation growth.

4. Hype-Driven Investments

VCs often focus on trendy sectors, such as fintech, health tech, and crypto, where valuations can rise quickly due to market enthusiasm. While this can create short-term value for investors, it can also lead to unsustainable bubbles when market excitement subsides.

For example, BharatPe, a fintech startup backed by Sequoia, achieved rapid growth and a high valuation, but internal governance issues - including allegations of financial misconduct against its co-founder - later cast a shadow over its success. The hype surrounding the fintech sector contributed to BharatPe’s high valuation, but the lack of strong governance structures exposed the vulnerabilities of such hype-driven investments.

Another example is about Tiger Global’s investment in Apna, a professional networking app, which became unicorn within a short period. The rapid valuation increase was driven more by market excitement around professional networking platforms than by tangible financial performance, raising concerns about the sustainability of such valuations.

5. Limited Due Diligence

In their rush to secure deals, some VCs conduct limited due diligence, particularly for early-stage investments. While speed can be an advantage in a competitive market, it also increases the risk of funding startups with flawed business models or poor governance.

For example, SoftBank invested $170 million in IRL, a social networking app, based on inflated user metrics. Later investigations revealed that 95% of the app’s users were fake. This lack of due diligence not only led to financial losses but also damaged SoftBank’s reputation.

Do they succeed every time, or does it backfire?

While VC-driven overinflation of valuations can sometimes yield success, it can backfire too, creating challenges for startups and their ecosystems. Overvaluation strategies rely on scaling quickly to capture market dominance and investor interest. However, when growth outpaces operational or financial sustainability, the consequences can be severe.

In India, startups like Byju’s and Paytm illustrate these pitfalls. Byju’s, once valued at $22 billion, faced significant downward corrections due to mounting losses, regulatory scrutiny, and delayed financial disclosures. Its valuation has been re-adjusted by investors prioritizing profitability over growth metrics. Similarly, Paytm's ambitious IPO led to a stark mismatch between its market capitalization and financial performance, with its valuation plummeting post-listing due to weak investor sentiment and profitability concerns.

Globally, companies like WeWork underscore the risks. Its exaggerated valuation, fueled by aggressive VC funding, collapsed when financial mismanagement and unsustainable business models came to light, causing a dramatic shift in investor confidence. Such instances highlight how inflated valuations, if not grounded in sound business fundamentals, can harm both startups and the broader market ecosystem.

However, some startups do leverage inflated valuations effectively, especially when they pivot successfully toward profitability. Examples like Flipkart demonstrate how strategic exits or acquisitions can validate high valuations, even amid substantial cash burn. Ultimately, while VCs aim for unicorn status to capture outsized returns, their approach doesn’t always succeed. Startups must now focus on profitability and sustainable growth to avoid being casualties of valuation bubbles. The shift in investor priorities towards sustainable models marks a critical evolution in India's startup landscape.

When VC Strategies Succeed

1. Market Leadership is Achieved

VCs often aim to establish their portfolio companies as dominant players in their markets. When this goal is achieved, even aggressive funding and valuation strategies can lead to massive payoffs.

• Example: Flipkart (Accel Partners)

  Flipkart’s rapid growth, fueled by successive funding rounds led by Accel and others, allowed it to dominate India’s e-commerce market. Walmart’s acquisition of Flipkart for $21 billion provided Accel and other investors with significant returns, validating their strategy.

• Example: Ola (Tiger Global)

  Tiger Global’s aggressive funding of Ola helped the ride-hailing platform secure a leading position in India, competing effectively against Uber. While Ola faces profitability challenges, its market dominance has kept its valuation relatively stable.

2. Strong Exit Opportunities

Successful exits through acquisitions or IPOs can validate high valuations, even if the companies have yet to achieve profitability.

• Example: Zomato (Elevation Capital)

  Elevation Capital’s early investment in Zomato paid off when the company successfully went public in 2021, providing investors with substantial returns. Despite post-IPO valuation fluctuations, the listing was a significant win for Elevation.

• Example: Paytm (SoftBank)

  SoftBank’s investment in Paytm led to one of India’s largest IPOs, providing a high-profile exit opportunity, even though Paytm’s post-IPO performance raised concerns about its valuation.

3. Sector Growth Outpaces Expectations

When VCs invest in sectors that experience unexpected surges in demand, their high-valuation strategies can pay off.

• Example: EdTech Boom (Unacademy and Byju’s) VCs like Blume Ventures (Unacademy) and Sequoia Capital (Byju’s) saw their investments benefit from the edtech boom during the COVID-19 pandemic. The surge in online learning adoption temporarily justified high valuations, though subsequent corrections have tempered this success.

When VC Strategies Backfire

1. Unsustainable Business Models

When companies fail to achieve profitability or build a sustainable business model, their inflated valuations can collapse, leading to significant losses for both the startup and the VCs.

• Example: WeWork (SoftBank)

  SoftBank’s heavy investment in WeWork pushed its valuation to $47 billion. However, unsustainable expansion strategies and governance failures led to a failed IPO and a drastic valuation cut to less than $10 billion, causing substantial losses.

• Example: GoMechanic (Sequoia Capital)

  Sequoia’s investment in GoMechanic backfired when the company admitted to financial misreporting and was forced to downsize operations. This highlighted the risks of prioritizing growth over governance and operational discipline.

2. Poor Market Timing

Investing in sectors or startups based on hype without accounting for market realities can lead to overvaluations that are hard to sustain.

• Example: IRL (SoftBank)

  SoftBank’s investment in IRL, a social networking app, failed when it was revealed that 95% of its user base was fake. The lack of real demand and inflated metrics led to significant financial losses and reputational damage.

• Example: FTX (Sequoia Capital)

  Sequoia’s high-profile investment in cryptocurrency exchange FTX unraveled when FTX collapsed due to financial misconduct. Sequoia wrote off its $150 million investment entirely, highlighting the dangers of investing in hyped sectors without thorough due diligence.

3. Governance and Transparency Issues

Governance lapses can derail even the most promising startups, undermining investor confidence and damaging valuations.

• Example: BharatPe (Sequoia Capital) BharatPe’s governance challenges, including allegations of financial misconduct against its co-founder, led to reputational damage for both the company and Sequoia. Despite its high valuation, the startup’s internal issues raised doubts about its long-term viability.

4. Overcrowded Markets

VCs often overestimate the ability of startups to outcompete rivals in saturated markets, leading to valuation corrections.

• Example: EdTech Saturation (Byju’s) Sequoia-backed Byju’s initially thrived in the edtech boom, but increased competition and post-pandemic market shifts have pressured its valuation. Layoffs and delayed financial disclosures have further dampened investor confidence.

5. Market Corrections

Macroeconomic factors like interest rate hikes or economic slowdowns can lead to valuation corrections across the VC ecosystem.

• Example: Tiger Global’s Write-Downs In 2022, Tiger Global significantly marked down the valuations of many portfolio companies in response to market conditions. This correction underscored the risks of aggressive valuation practices during economic booms.

Factors Determining Success or Failure

1. Sector Fundamentals:

   Success depends on whether the underlying sector experiences sustained growth. Over-hyped sectors like crypto can lead to failures, while resilient ones like e-commerce and fintech offer better outcomes.

2. Founder Execution:

   Strong leadership and execution can turn high valuations into sustainable growth. Conversely, poor governance and mismanagement can lead to collapse.

3. Investor Oversight:

   VCs with active involvement and governance frameworks can help startups succeed, while those with a hands-off approach may face setbacks.

4. Macroeconomic Environment:

   Favorable economic conditions can support inflated valuations, while downturns expose weaknesses in unsustainable business models.

VC strategies to inflate startup valuations can yield spectacular successes, creating market leaders and generating massive returns. However, these strategies are not foolproof and often backfire when business fundamentals, governance, or market conditions do not align with expectations.

Key VCs known for over-inflating their portfolio, and why?

Some venture capital firms in India have garnered attention for consistently inflating the valuations of their portfolio companies. This strategy, while potentially lucrative, is not without its challenges and risks.

One key example is SoftBank, known for aggressive investments in startups like Ola and Oyo. SoftBank's Vision Fund often injects substantial capital into startups, creating pressure to scale rapidly. While this can lead to massive valuation surges, it has also resulted in operational inefficiencies and unsustainable growth metrics for many of its portfolio companies. Oyo, for instance, faced scrutiny for high valuations despite mounting losses and operational challenges.

Another case is Tiger Global, which has been instrumental in India's unicorn boom. Tiger’s strategy of backing companies in early stages with inflated valuations helps create market buzz. However, this approach has occasionally led to backlash during economic downturns or public listings when companies fail to meet profitability expectations.

Firms like Sequoia Capital India are also noteworthy, albeit with a more calculated approach. Sequoia's focus on sectors with high future potential often drives up valuations, as seen in companies like Byju’s. While this helps these startups dominate their niches, it sometimes results in over-reliance on projected future growth rather than present profitability. These practices highlight the complexities of venture capital investments in India. While high valuations can signal optimism, they also amplify risks, especially when startups fail to meet the lofty expectations set by their investors.

Other Examples of Over-inflation

The following tables reveal that over-inflation typically occurs during growth and late-stage funding rounds, often fueled by VC enthusiasm, market hype, and aggressive scaling plans. Key indicators of over-inflation include misaligned valuations with financial performance, subsequent valuation corrections, and revelations of financial mismanagement or governance issues.

OYO Rooms

Paytm

Zomato

CRED

OfBusiness

GoMechanic

Apna

BharatPe

IRL

Byju’s

The Path Forward: A More Sustainable VC Model

To address the challenges posed by over-inflated valuations, VC firms should adopt a more sustainable approach to investing. This includes:

1. Focusing on Fundamentals: Valuations should be based on tangible metrics such as revenue, profitability, and operational efficiency, rather than on projections or market hype.

2. Strengthening Due Diligence: Rigorous due diligence processes can help identify potential red flags and prevent costly missteps.

3. Promoting Governance: VCs should play an active role in ensuring that startups have robust governance structures, including independent boards and financial controls.

4. Encouraging Sustainable Growth: Rather than pushing for rapid scaling, VCs should encourage startups to focus on building sustainable and profitable businesses.

Conclusion

In conclusion, while VC firms play a crucial role in shaping the Indian startup landscape, their strategy of inflating valuations has sparked a significant debate on its long-term effects. Firms like SoftBank, Tiger Global, and Sequoia have been at the forefront of pushing valuations beyond sustainable levels. Their aggressive funding models, though creating unicorns and high-growth companies, often lead to unsustainable scaling, operational inefficiencies, and financial crises. For example, Oyo and Byju’s, backed by SoftBank, faced steep valuation corrections after their rapid expansions failed to meet investor expectations. Similarly, GoMechanic and Faasos, backed by Tiger Global and Sequoia respectively, have faltered under the pressure of meeting inflated growth targets.

While these investments sometimes succeed in the short term, they frequently result in market instability and significant losses when companies fail to deliver on their promises. The recent trend of revaluation and a shift toward profitability over growth shows that the Indian startup ecosystem is slowly moving toward more sustainable models. For the future, a balance must be struck between ambitious scaling and maintaining a focus on business fundamentals to avoid further market bubbles and ensure long-term success.