Sexy and volatile: The Unicorns are here

New generation tech firms are dislodging the old guard, but can these startups justify their lofty valuations?

The sense that something phenomenal is afoot is pervasive for those close to the action. “It’s extremely exciting, like nothing I have done in the past,” gushes Ruchi Gunewardene about his involvement in a taxi booking company that’s gained phenomenal traction and scale in under a year after launch. Gunewardene is no perspective-less lightweight, having led multinational Coca-Cola’s South Asian units for over a decade. He now runs a marketing consultancy. Taxi booking firm PickMe, which is finalizing its third round of funding and where Gunewardene has invested at each of the earlier rounds, will be valued around Rs3.75 billion – a five times multiple on its Rs750 million second round valuation. PickMe’s chief executive expects the third round to be concluded by early March 2016.

Most disruptive tech firms – like PickMe – could not have existed a decade ago when the internet was slow, coverage patchy, and phones were devices for just calling and texting. But the confluence of ubiquitous and fast internet, and smartphones has dramatically reduced the cost of reaching millions of potential customers wherever they are.

“This business won’t survive without scale,” PickMe Founder and Chief Executive Jiffry Zulfer

Now there are also more “angel” investors who write small cheques funding startups’ risky first year or two. Launching a product’s beta version and securing angel investors to fine-tune and launch it is no longer difficult. Higher early stage startup failures quickly weed out those with faulty business assumptions, ones that don’t adapt quickly enough to unappreciated market realities and those startups where the promoters just can’t get things together.

Ruwindhu Peiris, an angel investor, agrees that valuations are a bogus thing. “It’s really a decision about how much money I am will ing to part with, and is it enough cash to get to the next round or is it going to come back to me?” If the business isn’t able to raise a new round, the existing shareholders will have to financially support it until it can raise more money. Or else, they will lose their investment when the venture crashes and burns.

But it’s during later funding rounds when investors need nerves of steel and deep pockets. Technology and internet-leveraging startups usually gain traction against the old guard by bringing new efficiencies into a business. These new entrants will squeeze margins for more value addition or lower prices from the existing model; they cannot succeed without scale.

For decades, multiple taxi companies have shared the market, but PickMe – claiming nearly 4,000 taxis, mostly tuk-tuks, in their network vehicles – who now dominates the market thinks it’s no longer big enough for so many. “This business won’t survive without scale,” explains PickMe Founder and Chief Executive Jiffry Zulfer who thinks the market here is big enough for maybe one other taxi booking service. The world’s largest taxi booking company, Uber’s unit here and at least two other players – Vgo and Hire1 – are vying for a share of the pie.

IMG_2930One of the defining features of the technology-led model is the winner and possibly the runner up taking almost the entire market between them. Rarely can a third or fourth placed player survive. Businesses like PickMe, that connect taxis available for hire with users, thrive on the ‘network effect’ – the more taxis and travellers using their service, the more sense it makes for everybody else to also do so rather than do business with a rival.

PickMe, in less than a year, has built a dominant position, proving that the company that establishes itself early enjoys disproportionate rewards. When PickMe founder Zulfer met the first potential investors, he only had a prototype app. “It really was just a wild bet,” confides Gunewardene. “The platform wasn’t ready, and had it taken one year to develop, Uber would have entered the market before us.”

PickMe had the app running at scale within six months, after the first funding. By the time Uber launched in Sri Lanka, PickMe already had 2,000 taxis registered and thousands of daily users.

PickMe isn’t the only sexy tech startup., an online travel agency, may achieve a billion rupee valuation if the firm’s founders are able to deliver the growth they have forecast to secure their just concluded funding round. Co-founder Thushan Shanmugarajah says the firm received Rs150 million in funding, having so far depended on the founder’s capital and an interest-free loan from a friend. “The valuation will be finalized depending on our ability to hit targets. The best-case scenario is that we are valued just over a billion and the worse case is we are valued around Rs600 million.”

Airline and hotel reservations are a low-margin business, and Findmyfare’s model is to grab market share from travel agents by extracting efficiency out of the booking process, and offering convenience and lower prices to customers.

“At the early stage of the business, what matters in gross booking value. This is about volume and market share chase,” Shanmugarajah concludes. In the financial year ending March 2016, expects gross bookings to touch Rs1.3 billion and net revenue (after paying the airlines and hotels) of around Rs60 million.

Shanmugarajah and Co-founder Abishek Sithampalam have to deliver Rs3.6 billion gross and Rs150 million in net revenue in the financial year ending March 2017 to meet targets they have agreed with investors in their first round of venture funding. Shanmugarajah also says there are other performance criteria, which they aren’t prepared to reveal.

“Entrepreneurs and investors argue: How can you justify your valuation?”
Thushan Shanmugarajah

The third firm on the cusp of joining the billon rupee valuation club is a micro lender using an algorithm to evaluate loan applications called Rukula, which has been in business only a few months. Rukula Founder Reeza Zarook, who was also behind the now Dialog-acquired ecommerce venture, grants micro loans without collateral based on the premise that people are honest and would pay back even if a financial crises makes it difficult for them to fully honour an agreed time schedule.

Zarook is cagey about the first funding round he is about to close, except to say it will raise between $2-3 million. If new investors acquire 30% of Rukula for $2 million (nearly Rs300 million), the firm’s valuation is within a leap to a billion rupees. If the stake on offer is smaller or Zarook manages to raise more than $2 million, Rukula’s valuation could surpass a billion rupees.

Three firms – PickMe, Findmyfare. com and Rukula – may join the billion-rupee valuation league when they finalise their next funding round or if they are able to meet performance criteria agreed with investors over the next year. Because these firms are privately held and nervous startup founders are unwilling to spill details about their backers, there is no sure way to know if other firms have already breached the billion-rupee valuation mark. The tech industry, investors and the media are celebrating sexy tech startups worldwide. Privately-held tech firms valued at over a $1 billon are referred to as “unicorns”, and these include six-year-old taxi-hailing company Uber valued at $41 billion and Airbnb, which helps homeowners rent their places to other travellers, valued at $26 billion. Together, the valuations of just these two firms equal Sri Lanka’s current annual GDP.

800_8562Tech firms seen as the ones with the brightest prospects here are far less valuable than the herd of international unicorns. As the first Sri Lankan tech startups hit a billion plus rupee valuation in the next months or year in relative terms, it may be useful to view these as Sri Lanka’s unicorns. These firms embody many of the traits of global unicorns. They are disrupting established industries by bringing new efficiency. PickMe and intimidate incumbents in the taxi business and travel agencies. Their deep pockets, ubiquity and sexy image are hard to beat.

Only two Sri Lanka firms John Keells Holdings and Ceylon Tobacco Company have public market valuations over a billion dollars. Even a billion rupees, however, is a significant size here. Only around 190 of the Colombo Stock Exchange-listed firms are valued at over a billion rupees. If PickMe achieves the performance criteria its promoters have agreed with shareholders in a year, it can secure its Rs3.75 billion valuation, making it more valuable than all but the largest 100 listed companies at current market prices.

PickMe’s rise has been meteoric. It was valued at Rs750 million when it concluded its second round (series B) of funding in September 2015, just three months after launching the taxi app. It raised Rs150 million in that round, where all first round investors and four new investors including MAS Capital and Hirdaramani Investment Holdings joined.

Its Series B round valued the firm at five and a half times the Rs133 million it had in the Series A round in February 2015, just five months before. Payments specialists Interblocks, Lanka Orix Information TechnologyServices, John Keells Holdings Deputy Chairman Ajit Gunewardene and his brother Ruchi Gunewardene invested in the first round.

All PickMe’s Series A and B investors have chosen to not have their stakes diluted by new investments. Zulfer refuses to identify the new investors in the third round that he is about to close. Events in the startup landscape are unprecedented for two reasons. First, it’s a grand experiment without precedence. None of these tech firms – burning cash like it’s free to grow so big – have clear notions about profitability that justify their valuations. All investors have, as proof of early successes, is market share boosting land grabs, intimidated competitors and the adrenaline rush they get from seeing the impact of these.

Second, to maintain momentum and keep acquiring scale, new investors have to pump money at a multiple much higher to the previous round. It’s an experiment in which investors have to willingly participate: boosting valuations, which generates media attention, makes it easier to secure new partnerships and attract the most talented employees who then build new features for the product, giving it an edge over rivals, which garners an even higher valuation when the business eventually runs out of money.

So-called ‘natural monopolies or duopolies’ can emerge if things go well. No such market dominance has emerged in Sri Lanka so far. However, the brightest of the tech startups are showing potential that they may be able to build dominant positions.

However, things will quickly spiral downwards unless the startup keeps showing new and existing investors even greater potential. For instance, PickMe’s valuation is up five times in the round it’s just concluding to the one before that. If an investor in its latest round expects a similar return multiple, PickMe must secure a valuation of around Rs18 billion in the next year. If it does so, PickMe will be worth as much as a top 40, large, listed Sri Lankan company like Nations Trust Bank or Aitken Spence Hotel Holdings.

800_9997-4The challenge that PickMe faces is that Aitken Spence Hotel Holdings’ profits topped Rs1.1 billion in the nine months to December 2015 and shareholders’ funds were Rs22 billion. In 2015, Nations Trust Bank had Rs2.4 billion in profits and almost Rs14 billion in shareholders’ equity.

Upstarts have unsettled the old guard, but there aren’t enough of them yet to make the old guard run scared. PickMe and Findmyfare have been disruptive, but few others have managed to scare incumbents.

PickMe’s promoters are diluting ownership to raise new equity to fund it. Hocus pocus valuations have also given way to logic. Gunewardene beams that there is now a clear dynamic. “We can make projections on the rate of acquisition. There is also a clear plan on what needs to be done to take it forward.” Gunewardene is implying that investors in later rounds, when the potential is clear, shouldn’t expect the same valuation multiple escalations. PickMe’s revenue is negligible and it’s losing money, so far. Because it now intends to charge commissions on taxi hires, revenue will trickle in soon. However, profitability will be elusive, and accumulated losses may be more than the capital.

Others who have been funding startups for longer believe rich baby boomers have blown the top off valuations. “They would have shunned away from this five years ago,” says Ruwindhu Peiris, a professional consultant and a founding member of a group calling itself the Lanka Angel Network, referring to the zeal with which the baby boomer generation is investing in tech startups. “They are cash rich; and they have already bought their first, second and third apartments. How many apartments can you buy anyway?” he says rhetorically.

Revenue poor and profitless firms with outlandish valuations were sexy once before, just before the turn of the century. Echoes of the turn of the century greed, a belief in one’s Midas touch and fear of missing out are driving valuations, argue sceptics. Fear of missing out is so pervasive that its acronym FOMO is understood widely in Silicon Valley.

_MG_3861However, there is evidence that a number of things are different this time, and history may not be about to repeat itself. Many of these technology businesses have real customers, in some cases tens of thousands of them. Clearly, they haven’t all figured out how to make enough money from their service offering, but it’s the potential to build scale that excites their backers. Quickly turning out a business is easier because the cloud allows new firms to expand their processing power and data storage at a low cost, and open source software cuts the time and cost of software product development. For businesses whose customers are all already online, social media offers an affordable marketing channel.

The potential some see in tech startups is stupefying. Social media site Facebook in 2015 paid $22 billion to acquire messaging service WhatsApp that had just $10 million in revenue that year. In the Sri Lankan startup scene too, evidence now suggests money hasn’t completely warped expectations.

Shanmugarajah says Findmyfare’s three-year track record didn’t have investors scrambling after the opportunity. The potential is clear.

Findmyfare’s 3% market share of outbound airline tickets and hotel bookings of an estimated 3,000 Sri Lankans who travelled overseas everyday could be grown. Their objective is to capture a 10% share in a year. In India, online travel agencies already have a 30% share of the market.

They also target only half of outbound travellers from here and exclude business, employment and pilgrims. So grabbing a 10% share actually means they have 20% of their target segment. As affluence increases, more Sri Lankans will travel more often.

“Entrepreneurs and investors have this argument: How can you justify your valuation?” he says about the question they kept facing. “Now I’m saying, we will deliver Rs3 billion plus gross booking by next year, so this then is my valuation. If I don’t deliver that, I will offer you more shares at the end of the year.” Shanmugarajah was then able to strike a deal.

“It’s really a decision about how much money I am willing to part with, and is it enough cash to get to the next round or is it going to come back to me?”
Ruwindhu Peiris

This focus on conditional valuations is the first sign that the market is maturing. PickMe’s Zulfer had it easier. Investors in the latest round weren’t demanding performance criteria be attached to secure the five times higher valuation he wanted. He has been confident enough to put everything on the block. “If we don’t hit our KPIs, there will be consequences.” The promoters will continue to control PickMe if they generate planned growth. If not, the investors would receive more shares, putting them in control of the business.

“Any company receiving a high valuation will have to prove itself at some point. That can happen at Series B or C, where investors will demand KPIs that justify the valuation and prove businesses fundamentals.”

The second reason to suggest that valuations are tightening and the market is maturing is that multiples are declining for firms with traction.

Ehantha Sirisena, who is raising a round of funding for cloud-based restaurant management firm Omak, which has market dominance in Sri Lanka, says investors are no longer so willing to offer eight times the revenue multiple he received in a Series A round. He has signed up more than 300 restaurants here and in Indonesia to the service that manages orders, inventory and billing. He expects to use the money he will raise to add more features to the product and expand in the region.

“Now we are looking at a projected 4 to 5 times revenue valuation. People are trying to be more realistic,” he says. However, he has been unsuccessful in securing his new funding round as fast as he would have liked. One of his challenges has been coordinating the response to the new investment round from 18 investors of the group calling itself the Lanka Angel Network in Omak. It’s taken him months without still having been able to close the deal.

800_0629Lanka Angle Network (LAN), a group of over 50 individuals organised informally, have played a dynamic role in sparking interest in startups. Their organised hackathons, an annual competition to recognise new entrepreneurs and readiness to provide pure risk capital to back dynamic startups helped spark early activity.

However, the group may soon become well known for the investments they missed, including PickMe and Findmyfare, than for their inability to close deals fast enough. Startups can burn though a round of funding in six to eighteen months. Few can wait six months for their shareholders to get their act together.

Peiris sees other challenges too. “I think a few of us are being conservative, and we know too much for our own good,” he says about the deal flow that has relatively dried up for LAN. Baby boomers driving up valuations, LAN members taking too long to close deals and entrepreneurs getting smart about valuations are all to blame. Of late, some startups have been getting an investment bank to prepare their Investment Memorandum, explaining the market opportunity and directing potential investors to the bank for the negotiation. “Any ecosystem will mature, and we are going through that right now and people need to learn that the hard way,” according to Peiris.

As the Lanka Angel Network’s mood becomes cautious, a few other groups of investors are stepping into the breach. The first are a few baby boomers. Zulfer’s father-in-law reached out to Ruchi Gunewardene, who was a classmate. Within half an hour on a Saturday morning, Zulfer was at Ruchi Gunewardene’s home showing off the PickMe app, a knockoff of Uber. Ruchi, on a call, introduced Zulfer to his brother Ajit who met him later that morning. It only took ten minutes for Zulfer to convince Ajit to fund the business.

The next group is the family offices and the island’s large apparel groups who fund startups with zeal. A third emerging group is listed firms like Guardian Fund Management, which has been scouting private equity opportunities for some time. Angel investors who sparked the startup eco system are now seeing the opportunities pulled from under their feet by latecomers who are willing to make bigger and bolder bets.

All this interest has been liberating for the unicorns and the would-be herd. Only a few years ago, entrepreneurs had no options, only their savings and family support. Naturally, banks don’t lend to businesses without a cash flow to pay back the loan.

Now, with investors throwing money at startups, they can remain private for much longer. The outsized risks of these volatile unicorn firms will be contained, should some flame out. Unfortunately, however, only a circle of connected and wealthy insiders will benefit from any outsized returns these unicorns generate too.