Why society wins when start-ups fail

Superstar venture capitalist Vinod Khosla says, “Most people think unlikely ideas aren’t important. The only thing that matters is unlikely. India attracted immense fuel for unlikely entrepreneurial ideas in 2021: private equity investment amounted to $77 billion, of which $42 billion went to start-ups. As global financial markets slump, every startup where salaries are paid by investors rather than customers is rethinking its business plans breathlessly. But before the usual entrepreneurial schadenfreude peaks, it’s worth remembering that most startups are expected to fail, startups don’t socialize their losses, and startups will solve real problems for India.

The title of this article is inspired by former Wharton professor Jitendra Singh’s thesis that society needs entrepreneurs to massively underestimate their chances of failure because only one in 10 businesses succeed. But since society does not know which business will succeed, it must encourage many statistically independent and genetically diverse attempts by delusional entrepreneurs about their chances of success. This high failure rate is not a problem in itself — society only needs a few successes to exploit the gains in innovation, productivity and job creation.

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

Most startups are expected to fail: a new book, The Power Law by Sebastian Mallaby, shows that investing in startups is different from investing in public markets. He suggests that public markets follow a “normal” distribution like human height – most people cluster around the average with a few exceptionally low or high. But venture capital investments follow a “power law” of distribution, i.e. most go to zero, but the small number that springs into the stratosphere more than makes up for the losses or mediocrity of the larger number. Every startup that fails causes pain, but economies that treat failure like a disease will never create innovation, immunity, and jobs.

Startups are not socializing their losses: Bank loans to businesses have gone from Rs 18 lakh crore in 2008 to Rs 54 lakh crore in 2014. This above-speedline frenzy for crony capitalists has created bad debts that required many lakh crores of government money to recapitalize nationalized banks. This money was diverted from public spending on health, education and defence. The current venture capital frenzy will also create many write-offs, but that cost will fall on willing, broad-shouldered adults — foreign institutions, angel investors, and entrepreneurs with successful past exits. The government bailout of bank loan losses has corroded the legitimacy of entrepreneurship; future venture capital losses will leave behind assets, generate learning and form valuable alumni.

Startups will solve real problems for Indians: India is poor not because of a shortage of land, labor or capital, but because of a disease that results from the way all three combine – what economists call total factor productivity. Ending our poverty requires more productive regions, cities, sectors, businesses and individuals. A modern state is a welfare state that does less commercially in order to be able to do more socially. It needs allies to reinvent financial inclusion, supply chains, distribution logistics, employability, retail, transportation, media, healthcare, agriculture and many more things again. Many of our startups will redeem their promise to solve these problems “not entirely or to a full extent, but in a very substantial way.”

Three issues with startups are worth pointing out. First, the global supply of capital that fuels startup funding faces the challenges of fiscal and monetary policy normalization: the rate-sensitive two-year US government bond recently hit a yield of 1 .6% after hitting 0.4% last November – because risk-free return can’t be risk-free return forever. Investors are returning to weigh financial sustainability and capital efficiency with addressable markets. Second, this explosive seed funding has created excesses. The founder of blood testing company Theranos, Elizabeth Holmes, has raised $700 million while going from acceptable hype about her product’s future to lying about performance. She learned the wrong lessons from Steve Jobs’ famous “reality warping field” – Holmes admired him enough to dress like him – and ironically went to jail the same week that Apple’s market capitalization crossed. $3 trillion. Finally, not only are private markets delaying IPOs — Amazon went public within three years of starting with less than half the value of a unicorn — but the underperformance of unicorn IPOs suggests that public markets have a different calibration.

As the funding environment for startups changes, founders should remember the timeless political advice to “campaign in poetry but govern in prose.” Startups only reach their destiny when they stop being startups; convince clients to cover their costs, assimilate non-founding leadership and institutionalize governance. The wonderful book Harsh Realities by Harsh Mariwala and Ram Charan chronicles Marico’s multi-year journey of building a strong foundation with “clear strategic direction, the right set of capabilities, thoughtful succession, high governance standards and a value-added board”. Institution building is the work of decades and involves choices such as the meritocratic selection – and recent term extension – of N Chandrasekaran as group chairman by Tata Sons. It is impossible to know whether luck or skill are more important for short-term entrepreneurial success. But in the long-term test of being a good ancestor, nothing matters more than wise governance and talent choices.

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

Sabharwal and Kakkar are co-founders of Teamlease Services and Paper Boat respectively.

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