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Secondaries and buybacks: Indian startups against the world

Adam Neumann, the founder of WeWork, has been in the news for a lot of things, one of which is his US$700mm secondary sale. A secondary sale, put very simply, is where one of the firms promoters/founders sells off a chunk of their ownership to get more liquidity. The secondary enables them to cash in a bit on their hardwork, while also diversifying their assets away from just one source. The size of the secondary is important however, with the market perceiving an over-sized secondary sale as a lack of a founder/promoter's faith in the company, something that might not bode well for the stock.


India however is seeing a whole different pattern emerge, with founders wanting to buyback shares of their firms from existing investors. On the surface this does look promising, reflecting the confidence founders have in their firms, but in truth might be the consequence of something deeply unhealthy in the startup ecosystem, and might also have some serious ramifications for the founders attempting these things.


One reason Indian founders feel the need to get back in the market and buy their own shares is that as the firm approaches late rounds, the founder has generally been diluted away very sharply. This could have a ramification on how the firm is run and the amount of control they have in it. A workaround was found here quite a few years ago, called dual class shares. What dual class shares effectively do is enable you to give away ownership without giving out control. Eg: Class A shares for example can have 10 votes per share, with Class B having 1 vote per share. Investors in the Class B shares will see all the same upside as the Class As do (adjusted for control premiums), but as is obvious by the vote differential, have a lot less control over the firm's decisions. Share structures like these are quite common in US and China, but generally aren't accessible to startups in India. While such shares, known as DVRs in India are allowed, they entail strong constraints on profitability, which make young startups unlikely to issue them.


The ramification of this measure has been that while startups overseas have been able to grow and raise significant capital without founders losing significant control, Indian founders see themselves with very low control, sometimes in single digits towards the last few rounds of their fund raise while their investors sometimes have mid twenty percent ownership. This means that founders have less to no power in deciding the direction of the firm, giving the control of these firms that we Indians built into the hands of generally foreign capital.


Which brings us to the last point, promoters wanting to buyback shares. Oyo's founder recently announced that we has borrowing US$2bn to buy back Oyo shares, and increase his stake from 10% to 30%. More power to him, and it is admirable to see a founder doing that, but it is also important to realize the factors that are causing Indian founders to do this, and the potential ramifications for them. US$2bn is an extremely high amount of money to raise, especially when the underlying asset you have is very volatile. More importantly globally we are in a very low rate environment, which has inflated the valuation of most startups beyond fair value, as we saw with the ~80% correction that the WeWork valuation took. In such a scenario being extremely levered can be risky, with the founder in a precarious position if his firm's valuation begins to slide, effectively having to cede more or all control, or finding himself in a debt that can't be serviced.


India is still in many ways is very nascent startup ecosystem, and with a long bright road ahead. But changes need to be made on the way founders can balance investments and control, to ensure that Indian founders and entrepreneurs can continue to enjoy the fruits of what they built, without putting themselves in grave financial risk.


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