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Monday, June 27, 2022

Why society gains when start-ups fail

Manish Sabharwal, Neeraj Kakkar write: The few that survive will raise India’s soft power and prosperity by using improbable ideas to solve impossible problems

Written by Manish Sabharwal , Neeraj Kakkar |
Updated: March 18, 2022 1:39:01 pm
The gift of middle-class parents for entrepreneurs like us was learning early in life that we don’t live in an economy but a society. (C R Sasikumar)

Superstar venture investor Vinod Khosla says, “Most people think improbable ideas are unimportant. The only thing that’s important is improbable.” India attracted immense fuel for improbable entrepreneurial ideas in 2021: Private equity investment was $77 billion, of which $42 billion went to early-stage ventures. As global financial markets swoon, every startup where salaries are paid by investors rather than customers is breathlessly rethinking business plans. But before the customary entrepreneurial schadenfreude peaks, it’s useful to remember that most startups are expected to fail, startups don’t socialise their losses, and startups will solve real problems for India.

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This article’s title draws from former Wharton professor Jitendra Singh’s thesis that society needs entrepreneurs to massively underestimate their odds of failure because only one out of 10 ventures succeeds. But since society doesn’t know which venture will succeed, it must encourage many statistically independent and genetically diverse tries by entrepreneurs delusional about their odds of success. This high failure rate is not a problem per se — society only needs a few successes to harness the gains of innovation, productivity and job creation.

Now let’s look at the three hypotheses about startups proposed earlier.

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Most startups are expected to fail: A new book, The Power Law by Sebastian Mallaby, makes the case that startup investing is unlike public market investing. He suggests public markets follow a “normal” distribution like human height — most people cluster around the average with a few exceptionally low or high. But venture investments follow a “power law” of distribution, that is, most go to zero but the tiny number that shoots into the stratosphere more than compensate for the losses or mediocrity of the many. Every startup that fails causes pain but economies that treat failure as a disease will never create innovation, immunity, and jobs.

Startups don’t socialise their losses: Corporate bank loans expanded from Rs 18 lakh crore in 2008 to Rs 54 lakh crore in 2014. This above-the-speed-limit binge to crony capitalists created bad loans that needed many lakh crores of government money to recapitalise nationalised banks. This money was diverted from government spending on healthcare, education and defence. The current venture capital binge will also create many write-offs but this cost will fall on consenting adults with broad shoulders — foreign institutions, angel investors and entrepreneurs with successful previous exits. The government bailout of bank loan losses corroded the legitimacy of entrepreneurship; the coming venture capital losses will leave behind assets, generate learning and breed valuable alumni.

Startups will solve real problems for Indians: India is poor not because of a shortage of land, labour or capital but a disease that results from how the three combine — what economists call total factor productivity. Ending our poverty needs higher productivity regions, cities, sectors, firms and individuals. A modern state is a welfare state that does less commercially so it can do more socially. It needs allies in reimagining financial inclusion, supply chains, distribution logistics, employability, retail, transport, media, healthcare, agriculture and much else. Many of our startups shall redeem their pledge to solve these problems “not wholly or in full measure, but very substantially”.

Three issues related to startups are worth flagging. First, the global capital supply fuelling startup funding faces challenges from fiscal and monetary policy normalisation: The rate-sensitive two-year US government bond recently touched a 1.6 per cent yield after being at 0.4 per cent as recently as November — because the risk-free return cannot be return-free-risk forever. Investors are returning to weighing financial sustainability and capital efficiency along with addressable markets. Second, this explosive startup funding has created excesses. Blood-testing company Theranos founder Elizabeth Holmes raised $700 million while crossing over from the acceptable hyping of her product’s future to lying about performance. She took the wrong lessons from Steve Jobs’s famous “reality distortion field” — Holmes admired him enough to dress like him — and ironically went to jail the same week that Apple’s market capitalisation crossed $3 trillion. Finally, private markets are not only delaying IPOs — Amazon went public within three years of starting with less than half the value of a unicorn — but unicorn IPOs’ underperformance suggests that public markets have a different calibration.

As the funding environment for startups changes, founders must remember the timeless political advice of “campaign in poetry but govern in prose”. Startups only reach their destiny when they stop being startups; convincing customers to cover their costs, assimilating non-founder leadership and institutionalising governance. The wonderful book Harsh Realities by Harsh Mariwala and Ram Charan chronicles the multi-year journey of Marico in creating a strong foundation with “a clear strategic direction, the right set of capabilities, a well-thought succession, high governance standards, and a value-adding board”. Building institutions is the work of decades and involves choices like the meritocratic selection — and the recent tenure extension — of N Chandrasekaran as group chairman by Tata Sons. It’s impossible to know if luck or skill matters more for entrepreneurial success in the short run. But in the long-run test of being a good ancestor, nothing matters more than wise governance and talent choices.

The gift of middle-class parents for entrepreneurs like us was learning early in life that we don’t live in an economy but a society. Our challenge was getting our parents comfortable with their perceived personal financial risks because the India of their youth had an unmeritocratic business regime where entrepreneurial success needed a surname, connections, or your own money. Economic reforms have blunted incumbent advantages by enabling partnerships between daring financiers and first-generation entrepreneurs. Most of these entrepreneurs will fail because they are driven by the magnificent but risky human impulse freedom fighter Ram Prasad Bismil called sarfaroshi, poet Mir Taqi Mir called junoon, and economists call innovation. But the few that survive will raise India’s soft power and prosperity by using improbable ideas to solve impossible problems.

This column first appeared in the print edition on March 10, 2022 under the title ‘Licence to fail’. Sabharwal and Kakkar are co-founders of Teamlease Services and Paper Boat respectively

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