End of the Runway: Is Covid19 a watershed moment for startups?

Contributed By : Rajendra Kalur, CFA , Director- CFA Society India

“We can ignore reality but we cannot ignore the consequences of ignoring reality”: Ayn Rand

My attention was drawn to a news item which said that India Nivesh, a newly established discretionary portfolio management service & brokerage outfit to shut shop. To my mind this is just the first of the many such similar reports that are going to come in. The reason is very simple. These are unprecedented times and not many outfits would have modelled this risk. With a global lockdown in place & hardly any operations running, the lack of sales & difficulty of accessing credit would make a lot of businesses unsustainable.

This is despite the fact that financial services industry is highly volatile and is prone to frequent outbreak of crisis like situations. In India we have gone through at least 3 of them in the last dozen years, i.e., one every four years. As Michele Wulcker in her book Gray Rhinos says humans are prone to be optimistic and it is this bias that makes them to ignore the risk despite it showing up in the face.

Currently in my review of business & financial models of start ups I find the same mistakes being committed. Most of these are mere excel extrapolations based on a certain growth rate built around normal operations. Very little recognition is given to the fact that the real world is far removed from the Excel sheets and can’t be modelled on the basis of a linear growth rate. The fact that there are several ways in which disruption can strike one’s business is not woven into the model.

These lessons aren’t recent ones. We have examples from giant ones now which had to almost close down due to sudden & severe events. Businesses like Amazon & Apple too went through such phases. It’s just that they were lucky to have recovered & grown into such gigantic enterprises. In Ben Horowitz’s book “Hard Thing about Hard Things” he writes how he had to go through a harrowing time after presuming that capital is infinite. In India we have seen start-ups being merged with more established entities as they ran out of cash.

While access to credit lines would be welcome in these conditions, a start up would find it difficult to service the debt. Further it’s only a palliative and not a cure. For Startups what’s needed is a more robust modelling methodology that considers extreme events. Peak cashflow requirements need to be calculated with care & projections are made to make the runway long enough till internal accruals are ready to take over.

While many say that predicting these extreme outcomes are difficult, one can still recognise that such events can occur & key to steer a new enterprise from such eventuality lies not in denying the risk. By accepting that these risks lurk in the shadows, one can make the model more robust and create contingencies to tackle them. This would also help possible investors to calculate the trade offs. No purpose would be served by not simulating these scenarios as the enterprise would soon reach the end of the runway leaving the founders as well as their backers disillusioned.