[Editorial notes: Guest article contributed by Sumanth Raghavendra, Founder of Deck.in. Sumanth looks at lessons entrepreneurs can learn from redBus acquisition – especially with respect to funding and importantly, what it means to be an India-only play.]
The acquisition of Redbus was formally announced last week – it was a blockbuster deal by any metric and predictably sparked off reams of print singing hosannas to the founders (undoubtedly richly-deserved) and existentialist questions on “what this means for the ‘Indian startup ecosystem’”.
While all of this was great, a slightly-deeper dive into the deal contours reveal some fascinating facets. I reckon that it might be useful to parse through these and present them as a series of non-obvious lessons for other Indian entrepreneurs.
Lesson 1: Hire a lawyer during your fundraise
redBus had raised $ 8 million dollars over three rounds of funding. While this is a fair amount of money especially so in the Indian context, it is by no means a large sum and is a fraction of the amounts raised by other Indian startups. Yet, the stake of the founders was very small at the time of the acquisition – less than 15% by some accounts.
While it might be fair to surmise that they diluted a lot of their stake by underselling the valuation at the time of the funding rounds, the real reason is elsewhere.
The real reason why the founders ended up with as low a stake as they did can be traced to the fact that their first round of funding had a “full ratchet anti-dilution” clause (*source). Anti-dilution is a fairly standard investment term which essentially safeguards the investor if a subsequent round is done at a lower valuation.
The standard way in which this clause is enforced is by following a mechanism called “weighted-average method” – this is a generally accepted way that is equitable to both the investor and the entrepreneur. However, the Redbus investor agreement had a “full ratchet” mechanism which is a death spiral to the entrepreneur.
I am not going to go into the minutiae of these clauses (for those who are interested, this blog post provides an excellent, succinct summary – http://www.feld.com/wp/archives/2005/03/term-sheet-anti-dilution.html) but this avatar of the clause is widely regarded as something that no entrepreneur should accept as this article explains – http://venturehacks.com/articles/terms-that-hurt – as it has a severe dilution impact on the entrepreneur’s stake if a subsequent funding round happens at a lower valuation (which is exactly what happened when Redbus raised their second round).
I am not going to speculate on whether the Redbus founders understood and appreciated the nuances of this clause when they signed the original agreement but one thing is for sure – they didn’t use a lawyer for their transaction. The Redbus founder actually went on record to explain how they did this deal without a lawyer.
As entrepreneurs, while it is nice to trust investors and work with them on good faith, it is suicidal to do so without having a lawyer in your own corner to safeguard your interests. Any half-decent lawyer would have pointed out the obvious pitfall in accepting a clause like this.
Lesson 2: Understand your investor’s imperatives
One question that has popped up regularly as a reaction to the acquisition is “why now” – why did Redbus choose to sell out now when there was presumably an opportunity to build a much more valuable and meaningful company in the future.
Now, while there might be many reasons why the stakeholders decided that now was the opportune time for an exit, it would be an exercise in speculation to figure out the actual reasons…but we do have one clue.
Redbus raised their first round in circa 2006 – which means that their first set of investors have been with the company for seven years or thereabouts. Seven years is the average lifespan of most early stage funds – by the end of this period, the fund managers are typically required to provide a return to their investors (LP or Limited Partners in venture capital parlance) and while some funds do let winning horses ride further in the expectation that a significant payoff will come their way at some point of time in the future, as these are “unrealized gains”, it is a far cleaner option to simply exit the portfolio and provide a cash return to the LPs. While there is no way to know if this was the primary driver for accepting the Ibibo offer, there is every chance that the timing helped line up the stars, in which case the Redbus founders might have been prompted to take the offer to provide a realized return for their early investors.
As entrepreneurs, what we need to keep in mind is that investors are bound by a timeline too and we need to keep these imperatives in mind when we take the decisions that we do.
Lesson 3: India/Bharat is a tough market. Understand your market’s natural limits.
While providing a timely return to investors might be one reason why Redbus cashed out, there could potentially be one another.
There is a largely-held belief that India is still in the nascent stages of market penetration for e-commerce and specifically for bus travel too, there is a lot of headroom to grow (online is only around 5% of total transactions) but there are two points which seem to imply that perhaps at least some of this bullishness is unwarranted:
- Slowdown in growth: Redbus had revenues of Rs. 12 crores ($2 million) in FY11 – this grew to Rs. 32 crores ($5.4 million) in FY12 implying 171% growth YoY. In FY13, the revenue grew to Rs. 55 crores ($9.2 million) implying a growth of just 68% – a sharp fall from the comparable figure in the previous year. While one might justifiably argue that attempting to extrapolate a pattern from three data points is statistically risky, there is no denying the fact that in percentage terms, Redbus show a sharp decrease in revenue growth for FY 2013 compared to the previous year, arguably much more than what could be reasoned away due to the smaller base in the previous year.
- Push, not pull: One of the points that has been bandied about a lot about the growth of Redbus is around how the company has not spent a dime on marketing and the growth has been entirely organic, driven by word of mouth boosted by achieving deeper engagement with existing customers. However, in the recent past, Redbus has started spending money on marketing and specifically on advertising on mass media vehicles including TV ads. This implies that Redbus felt that organic growth was no longer sufficient on its own and the numbers had to be bolstered by push marketing.
Both of these points, individually and together, tell us is that customer acquisition was not just slowing, it was becoming increasingly harder and more expensive. While it might be nice to talk about the “enormous size and potential” of the Indian market, it is probably not a stretch to conclude that penetrating this market is by no means, an easy task and there is a good chance that the immediately addressable market is a sliver of the total market. Also, as echoed by the state of telcos in India today, it might not be too difficult to achieve early success in a category-defining market in India but it is quite difficult to keep this going on an ongoing basis over a period of time.
The other part of this is that as far as profitability goes, Redbus has just about gotten started – they had a bottomline of $100,000 in FY12 and less than $2 million in FY13. For a company that has 26 offices, over 500 employees and millions of dollars of funding, these results are certainly not anything to write home about especially so as it has been the market leader and has been in operations for over seven years. While they could have presumably sacrificed profitability in favor of growth, these numbers are still underwhelming. Again, this could point to the fact that India is a tough market in more ways than one.
For us entrepreneurs, it is a clarion call to assess/reassess if it makes sense to attempt an India-only play and if one continues to do, attempt to understand what the market’s natural limits are and ensure that our per-unit economics make sense within that canvas.
Lesson 4: Fundraising in India is hard, very hard
By all accounts, Redbus is a marquee Indian startup – the founders have done wonderfully well to establish a meaningful business and a well-known brand and the company has been lauded by everyone from the Indian and international press to MIT (which recognized Redbus as one of the most innovative companies in the world). Despite this, it boggles the mind that the company started its fundraising efforts for its Series D in November of last year and wasn’t able to actually close that round in the subsequent eight months.
One would have guessed that it would have been fairly trivial for a company of this stature to raise a new round if it so desired. The fact that it didn’t actually close a round in eight months from the time they started looking for it can give us an idea of how hard it is to raise funds in India.
Even though the company apparently got eight termsheets for this planned round, the fact that they chose to take the Ibibo offer instead of any of these options implies that the offers weren’t particularly attractive by themselves and empirically so, relative to the Ibibo offer.
The lesson is simple – if you get a chance to take money and if the terms are broadly equitable, take it, even if you feel that other things like valuation are sub-optimal! Also, keep in mind that if you are in the market to raise funds, it is a long and time-consuming process, so don’t get into it in an unprepared or half-hearted manner and don’t leave it for too late.
Lesson 5: If you are an investor, requiring traction to invest in a company carries the risk that you are already too late
While the early investors of Redbus were undoubtedly the big winners in the exit, probably recouping their entire fund corpus in this single deal, for the investors in the subsequent rounds, the returns weren’t quite as impactful.
Admittedly, this is at least partially a function of deal mechanics over multiple rounds but what is interesting is that the firms that did invest in the later rounds are not significantly different from the one that invested in the early rounds. All these firms are ostensibly early-stage firms that make seed stage bets in promising companies.
The difference, I guess, is that the first investor backed the company when it was still a fledgling entity on the promise and potential that it showed whereas the subsequent investors came in only after the company had already demonstrated traction and executed their plans. So perhaps, there is a lesson in this for Indian investors too – bigger returns mandate bigger risks – if all the ducks have already been lined up, you are already too late!
*: redBus Story – “we had a term called full ratchet. Which means that if we raise capital at a lower valuation than the previous round, then we have to make it up to them.”
[Reproduced from Sumanth’s blog.]