The fascination with tech startups stems from the perception that somehow Sri Lanka is missing the kind of entrepreneurship that fuels innovation in places such as Bangalore, Telaviv or Silicon Valley.

In its 2021 budget, the government allocated Rs10 billion to establish five technology parks in the districts of Galle, Kurunegala, Anuradhapura, Kandy and Batticaloa where startups will have access to fully-fledged infrastructure. In addition, funds were allocated for the Information Communications Technology Agency (ICTA) for expanding the fibre optic reach, and for low-interest loans to entrepreneurs, all directly or indirectly expected to improve the environment for Sri Lankan tech startups.

A couple of technology trends are helping fuel fast-growing tech startups that small and medium-sized businesses, in general, cannot match. The first is cloud computing which allows businesses to lease computing power as and when they need it rather than having to buy expensive equipment. The second is open-source software freely available and used widely not just by startups but also by large software companies.

In spite of taxpayer-funded largesse and advantages of the cloud and open-source software that were not such strong incentives just a decade ago, the Coronavirus pandemic has decimated tech startups in Sri Lanka. Hard numbers on the pandemic’s impact on tech startups are difficult to come by, but experts estimate at least half the startups may have run out of money during the lockdown and in the months since. ICTA had estimated Sri Lanka had around 400 tech startups. If indeed the pandemic has run half of these out of businesses, the impact would have set back the tech ecosystem by several years.

Prajeeth Balasubramaniam is an investor in tech businesses, both early-stage ones with only a prototype to show, and businesses with revenue and a clearer path to profitability.

Balasubramaniam, who had returned from overseas to take over the family business in 2002, received odd looks and rejection when at that time he asked startups if they ‘wanted some money?’ The big break came after Balasubramaniam in 2010, co-founded Blue Ocean Ventures (BOV) partnering Rajan Anandan, then Google India’s Managing Director and part of the Indian Angel Network.

Balasubramaniam and Anandan’s Blue Ocean Ventures and other partners’ business plan competition, Venture Engine in 2012, was a success not just for the firms that got over Rs100 million in angel funding, but also due to the electrifying effect the competition had on the start-up scene here. Venture Engine has since been an annual event.

Tech startups until then found it challenging to access the scattered part-time investors. And when they did, startups lacked the charm to get investors to open their wallets. Besides investing, Balasubramaniam and other angels coached startups and often assisted by connecting them to related opportunities.

“We introduced the angel investing idea eight years ago to fund startups”, Balasubramaniam points out. “But it took eight years to set up the country’s first angel fund,” he says referring to the Rs100 million fund established in 2020, weeks before the lockdowns to slow the spread of the Coronavirus pandemic commenced.

The fund is spearheaded by an outfit called the Lanka Angel Network, where Balasubramaniam sits on the board, and its Rs100 million in funding was raised in equal portion from 100 individuals for investment into early-stage startups. Due to the pandemic’s disruption, no investments have been made so far. “I can understand why it has taken us eight years whereas India also started at the same time. Singapore started way after us. They have enough angel funds.”

Young start-ups, which aren’t large enough for venture capital financing, now have the option of angel investors who besides investing small amounts of equity are willing to roll up their sleeves to advise and lend a hand to entrepreneurs. The analogy of Angels applied to investors in high-risk projects comes from Broadway where wealthy people – who see themselves as patrons of the arts – bankroll risky theatre productions. These usually elderly Broadway angels didn’t always get their money back but occasionally struck gold with some bright producer who made it big.

Startups come in various forms. A new hair-salon or a mom and pop restaurant too are startups. But LAN investors and Balasubramaniam’s Blue Ocean Ventures seek high growth companies with the potential to generate high rates of investment returns in a few years, and where an exit route is clear. To achieve such high growth rates, a company will usually have to deploy technology to solve a problem.

The failure rate in early-stage startups is high. Few survive because entrepreneurial zeal wanes against the tremendous odds of breaking into a market with an unavoidable lack of knowledge while trying to implement an unproven business plan. Secondly, entrepreneurs struggle to finance ventures beyond their savings, or what friends and family can afford to pocket out. There is a limit to these sources and the gulf between these and the capital market – the other proven funding source for businesses – is the equity gap.

The equity gap exists because the two equity sources – an entrepreneur’s network and the capital market – don’t overlap.

Investors call this period the valley of death. It’s when a startup is developing a product or a service and does not have any revenue or generates very little of it. Unless a startup ecosystem is able to fund companies though this cash burning and loss-making period, none will emerge from the valley of death into the welcoming arms of venture capital funds who may fund them from there.

“It’s called the valley of death because only one out of 10 startups escape. That’s the global norm. For a startup to escape Death Valley and go on to create value, you need funding for the different stages of a business’s life cycle,” Balasubramaniam adds.

The equity gap exists because the two equity sources – an entrepreneur’s network and the capital market don’t overlap. However, since few businesses have grown big enough or choose to list here, and as the venture capital industry is small, firms here usually operate in a perpetual state of undercapitalization.

Getting this right is fundamental, Balasubramaniam argues. “Basically, it’s about growing the entrepreneurship and innovation landscape. Look at some of the most innovative countries out there. Their economies thrive because of disruptive startups.”

VENTURE CAPITAL

In more sophisticated markets venture capital and private equity help bridge this gap. Here the equity gap is so wide that entrepreneurs have to depend on retained profits and bank borrowing for growth. But startups are rarely profitable and banks aren’t comfortable lending to unproven ventures with weak cash flow and no assets to pledge as collateral. Undercapitalized companies have been a feature of the Lankan economy, as is the case in many poor countries. The result of the low level of economic sophistication is that attracting overseas investments is challenging, making capital both expensive and scarce.

So when a business does find traction here but runs out of precious owner financing and any angel funding, it usually settles in for a long hard slog to dethrone market dominants, because anaemic cash flows won’t allow growth at optimum levels. At least that’s how things have worked for most start-ups of the past.

Balasubramaniam’s Blue Ocean Ventures has invested $5.5 million in nine companies. In early 2020 before the Coronavirus pandemic hit, it exited nCinga which was sold to regional e-commerce heavyweight Zilingo at a valuation of $15.5 million. Balasubramaniam says that deal returned 25% of the capital of the fund’s investors, about $1.37 million. Three of the nine businesses have closed or are inoperative, and haven’t returned any money. Of the other five companies, Balasubramaniam says “two might just give capital back and three might give us some returns.”

BOV Capital also manages the $6 million Digital Innovation Fund where Dialog, Balasubramaniam and other BOV partners have also invested. These two funds are among the few options that companies with proven business models can tap. Besides these, a couple of private equity funds which fund more mature businesses compared to venture capital, make up the entirety of the ecosystem. Balasubramaniam has been championing the cause of building a startup nurturing ecosystem but has mixed feelings about the lack of achievement so far. First, Sri Lanka keeps messing things up, he points out. “Every year some kind of issue happens that affects businesses. I mean, there were two prime ministers at the same time, then bombs, then elections, and now covid,” he says without betraying any sense of frustration.

He is elated about the promised spending by the 2021 budget on nurturing the startup ecosystem, where he has been advising on policy for several years. “But here is the thing. I think there’s still a lack of understanding of why this ecosystem is not accelerating as fast as it should.”

Undercapitalized companies have been a feature of the Lankan economy, as is the case in many poor countries.

LLP STRUCTURE

BOV Capital is mulling the creation of a new venture capital fund but may base it out of Singapore and have a regal focus than have its legal structure in Sri Lanka and invest here exclusively. In Sri Lanka, venture capital funds between Rs50 to Rs200 million per investment and private equity investments are usually at least Rs300 million and can go up to Rs1 billion per investment. Both venture capital firms and private equity have been requesting the government to recognise Limited Liability Partnerships (LLPs) that would make it attractive for investors to register and manage funds from Sri Lanka. As Sri Lankan law does not recognise LLPs, all VC and private equity funds are registered overseas. The exception is the BOV Capital Managed Digital Innovation Fund which is managed by a Sri Lanka incorporated private limited liability company.

Both the BOV fund and the innovation fund had invested in nCigna, which they exited in early 2020. In an LLP structure, like the one the BOV fund is set up in Singapore, taxes are paid on the net gain. Whereas with the Sri Lankan Digital Innovation Fund the gain was taxed at three levels; in the hands of the company as withholding tax, in the hands of the fund, and then when its distributed, taxed again in the hands of the investors of the fund.“If an LLC structure is available then it takes into account my net gain or my net loss and then allows me to pay tax net of what has already been paid. So, I have a $10 million gain on a $20 million exit, I will pay tax on the $10 million and it will take into account the tax already paid too.”

An innovation ecosystem requires large and small investors co-financing companies at various stages of development. Venture capitalists and private equity are crucial components of this, but so too are large companies which nurture innovation and the public sector which can fund research. The latter have more patient capital and are not too focused on a profitable exit usually through a sale to a bigger company or an IPO within five years of investment. While the outlook for startups making it out of the valley of death is miserably low due to Covid, the ecosystem’s long-term problems like its tax structures and the availability of long-term capital from companies that have already made it and the public sector too need to align for a vibrant sector.