[Editorial Notes : Recently, a few folks have suggested the government to launch a fund to invest in startups. At NextBigWhat, we certainly don’t believe that this will help solve a problem (read : What’s the role of government in startup ecosystem? Stay Away!). Here is a neutral piece written by Sumanth Raghavendra (Founder, Deck) with inputs from Ashish Sinha (NextBigWhat).

In the wake of the upcoming union budget, some of India’s “Startup Gods” are urging the government to follow the footsteps of the Singapore government and launch a fund that will invest money directly into our startups.

This is the actual statement – “the group recommended to the government the establishment of a fund of Rs 5,000 crore that it should use to invest along with other VCs. So, if a VC does a due diligence and decides to fund a startup, the government could come with matching resources from its own fund.”

In our opinion, this is a hair-brained suggestion and one that we hope the government will not focus on especially in lieu of other initiatives that are much more deserving of their attention.

The Startup God, Literally!
The Startup God, Literally!

Here is why: 

“Show me the money”: Is there a capital availability problem?

The short answer is NO.

There is a meaningful number of active VC firms operating in the country and each of these firms has substantial funds at play for investing in Indian firms. Also, capital is increasingly becoming global and there are many Indian startups raising money from investors outside India especially so as they increasingly straddle and target global markets.

What about early-stage funding? Isn’t there a shortage here?

Most folks would agree that the availability of early stage funding is better than it has ever been in the past. According to data from audit and advisory firm E&Y, investments in early-stage startups rose nearly 40% to 121 deals with the transaction value jumping 66% to $605 million (Rs 3,630 crore), compared with the same period in 2013. There are a number of micro-funds such as Blume Ventures and Kae Capital that have emerged in the recent past that only invest in early stage companies. Besides this, almost every top-tier VC firm has dedicated seed programs to fund early stage companies.

Does this mean that every startup that is looking for early stage funding is able to get it?

Not at all, it is still a competitive market and that is the way it should be – the fact that there is a set of criteria that one needs to fulfill to be able to raise early stage funding essentially means that there is a system in place and it is working. If a startup is not able to raise funding today, it is not because there is a problem with capital availability but rather because it hasn’t measured up the benchmarks expected by investors.

One point that might be worth putting in focus here is the sense of entitlement that many startups seem to be having of late. There is a deluded view that I have a startup that is in my opinion “innovative” and/or “disruptive” and therefore I am entitled to get funding just as say a startup operating in Silicon Valley would. This is a sad commentary on how our entrepreneurs are picking up the wrong lessons from their peers in SV – funding is always a privilege that needs to be earned and not an entitlement that one is born with.

Beyond capital availability, what are the issues with the government funding startups directly?

“Who is your daddy?” – Why should the government invest alongside VCs?

One rather bizarre aspect of this recommendation by our Startup Gods was that the government should “invest alongside VCs who have done the due diligence and have decided to invest in a startup.

If the idea behind this suggestion was that the government should bother itself with doing due diligence and “outsource” that to VCs, it is a badly thought-out one.

So, if a startup has already secured an investment mandate, why would it need to take money from the government?

The only party that this arrangement would benefit is the VC as this would ostensibly spread the investment risk as it would require the investor to put in a smaller amount of capital than she would have normally done as the rest is filled in by the government.

The truth of the matter is that this would not really benefit the VC either.

An investment call is a binary one – the VC puts in money in the expectation that the company is one worth backing and will eventually give her a multi-bagger return or she decides to pass on the investment if she doesn’t have this confidence on the team and their market. The only event in which a VC would want to take in “dumb capital” from the government or any other agency is she feels that there is a capital risk that she doesn’t want to take herself irrespective of all the other things about the company.

No good VC would ever make a “go” call when such a doubt exists – the result of this would be a race to the bottom where the government money is seen as “cheap money” that can subsidize the investor’s own risk and the only VCs who would take advantage of this type of scheme would be ones who probably shouldn’t be in the high-risk technology investment space in the first place. So there is an adverse selection problem that comes into play when the government invests alongside VCs. 

“The road to hell is paved with good intentions”– The moral hazard problems with the government owning a piece of a company

Another reason why the government should not take a direct equity position in a company is that it opens up several moral hazards both for the company and for the system, in general.

The most prominent one that comes to mind is the “agency problem” – when the government underwrites the cost of running a company, it leads to skewed incentives and risk-taking behavior both on the part of the entrepreneur and on that of the “professional VC” who has invested alongside. The problem with such a situation is that when one party in a transaction is insulated from risk, he or she may behave differently (and more carelessly) than expected.

The other side of the coin is what the government and its nominated representatives will expect out of a company which has a fiduciary obligation towards it – look no further than the vast array of struggling PSUs to ascertain why this mutant socialist form of capitalism has been largely debunked.

“Startups need help not hand-outs” – Money is not the answer

As an entrepreneur running a business in India, the influence of the government on my company’s operations is significant. But the one thing that I am clear about is that my expectations from the government don’t extend to expecting them to put money into my company for funding my ambitions.

I was appalled when I saw this statement from an Indian entrepreneur – “If the government can provide us with funding, it will go a long way in establishing the country’s startup ecosystem,” – what was most appalling about this statement was that it was made by a person who has already raised more than Rs. 25 crores from a top-tier VC! If you need the government to bail you out after having this kind of resources behind you, you should seriously reconsider your career options.

My expectations from the government are more along the lines of hygiene factors – clear-cut policies that cut out rent-seeking behavior, simple procedures for determining and filing taxes and fees and straightforward processes for filings. It would be nice to have reliable infrastructure in terms of roads and utilities but in a land beset with a million grave issues, it would be churlish to demand such things especially so as a pre-condition to creating world-class products, which I would like to believe is something that we will have to do despite of rather than because of living in a third-world country. 

Epilogue

So if the government shouldn’t invest directly into startups, what kind of role should it play vis à vis startup funding and encouraging entrepreneurial behavior?

As far as capital availability goes, the government should focus on non-equity financial instruments to foster innovation. This could be on two fronts:

Venture debt: Investing money into a startup as debt instead of equity takes the incidental moral hazards out of the equation as the entrepreneur is accountable for paying the money back. Actually, India scores pretty high on credit availability already – the government operates a scheme called CGTMSE – www.cgtsi.org.in/ – for venture debt up to one crore for startups without requiring any collateral.

Grants: Rather than invest alongside VCs, the government should come in to fill the gap in areas where VCs are loath to invest. These should be restricted to domains that don’t fit a traditional VC’s investment thesis – for instance, research-heavy initiatives, defense and security areas and ventures that can potentially have a ameliorating impact on macro issues faced by the country such as health hygiene and education. Ideally, these investments should also be in the form of debt but if that is not feasible, then the government should consider grants.

Finally, as far as the “Startup Gods” go, you are in a position where you have the ear of the government in some meaningful form or manner, please use this opportunity to present cogent suggestions that have the force of informed opinion behind them. Offering silver-bullet prescriptions that are blindly lifted from the playbook of countries like Singapore is a wasted opportunity and a pointless exercise akin to jerking off in the dark and convincing yourself that you have scored!

NB: Stylistic punctiliousness should not get precedence over what needs to be articulated with uncompromised honesty.

[Image credit : shutterstock]