Founders must manage their businesses in the short term to ensure they are around next week, next month, and next year. This means conservatively managing expenses and balance sheet. In these turbulent times, founders must be ready for the worse, such that even if everything goes wrong here (not that they will), they ensure they are still standing. You need to live to fight another day.
With the Russia-Ukraine conflict, China geopolitics, high inflation, rising interest rates, and tightening liquidity, we are entering an economic phase that many founders have never experienced first-hand. In the past months, the DSGCP team has been spending time with our founders to help them recalibrate their businesses as input costs have increased, the cost of borrowing has more than doubled and demand has weakened.
I expect these difficult times to persist given the global geopolitical and economic realities. The consumers I have personally spoken to are talking about cutting back, trading down, and making do with less. They are seeing increasing prices at the supermarket, at the stores, and everywhere else, reducing their ability to purchase. The daily news of large lay-offs in some of the fastest-growing companies has added to worries about job security. As the financial year end arrives, employees are seeking wage increases to compensate for material increase in the cost of living. This is only going to increase the cost base of companies that are struggling to maintain healthy margins.
My view is that things get more difficult before they get better. Consumer sentiment and spending have been mostly buoyant this year with COVID restrictions being dropped and people being able to get back to a normal life again. The last 2 years saw an increase in saving as people were stuck indoors. However, I believe that consumers will start cutting back as they plan for the short-term turbulence that is coming their way.
Markets are recalibrating
In the markets and sectors we invest in, consumer brands in India and SE Asia, we have seen a material slowdown in growth-stage investments as VCs reassess the market. I have spoken to a large number of senior partners in leading firms and it is clear there is a decline in risk appetite. Many complain about how their existing portfolio still needs to grow into their last-round valuations. We can all agree that over the last 3 years, valuations had become very frothy, especially in hot sectors. Valuations are correcting as a result. Growth stage consumer brands with net revenues of $20-$50 million and healthy gross margins are being priced at 3-4x net revenue versus 5-7x only 12 months ago. And these are companies with healthy gross margins and contribution margins. VCs are digging deeper in diligence and want to know your net sales, after discounts, and all trade schemes. Anyone can give a product away for free but are consumers willing to pay a fair price and are they repeating?
EV/EBITDA Multiple 2002-2022 India Consumer Discretionary
Koyfin, 14 November 2022. EV/EBITDA (TTM)
In India, valuation multiples for Consumer Discretionary companies had increased over the last 20 years (see chart above). Based on the current market, and assuming EBITDA margin of 20%, a EV/EBITDA of 20x implies a EV/Sales multiple of 4x. If EV/EBIDTA is at 40x, this implies a EV/Sales multiple of 8x. Do we believe that these are the right multiples on which to underwrite a consumer brand investment? I don’t know. Developed markets have historically traded at 13-15x EV/EBITDA and are now trading at 15-18x EV/EBITDA. Emerging markets with strong growth and younger demographics, will trade at a premium. In India, I am comfortable at 25-30x EV/EBITDA for the best consumer brands which triangulates to 3-4x EV/Sales if you can deliver 15-18% EBITDA. I will pay this price if the start-up can demonstrate real EBITDA. EBITDA as defined by GAAP! Not some new definition of adjusted EBITDA to take account of how this business model is different from the past. Cash is king and EBITDA is the best proxy for cash flows. I talk more about this below.
I urge you to review your current business plans and the plans for the next 24 months. Temper down growth expectations and recalibrate your business appropriately. You need to demonstrate unit economics and ability to generate cash. Why chase top line growth when you can grow at 30%+ with healthy EBITDA margins. This will mean looking at each line of expense and justifying why you are spending it. Remember, as a founder, you still need to be optimistic long term. But you need to manage your business in the current macro environment. Ask the difficult questions. Can you delay some investments? Does the spend on brand and marketing need to happen now? Be optimistic long term but pessimistic short term.
Do not be afraid of the dreaded down round
With multiples contracting, valuations will correct. Even if you are growing profitably but raised your last round at an aggressive price, expect new investors to price it on today’s market. This does not signal that a business has been performing badly or is going to fail. A start-up will have to raise money across many rounds over many years. In some years you get a higher multiple and in others a lower multiple. I am not smart enough that I can time market cycles. I advise founders to raise what they need, when they need it (and a little more just in case). The valuation is what it is. It will work out in the long run. Every great company will have to navigate economic downturns, and it does so by ensuring it has the cash to operate through turbulent times. Companies facing the possibility of a down round need to ask themselves if the reduction in their potential exit from a down round or the risk of going bust, is worth having the cash in hand that investors are offering.
As important, please keep the structure clean and simple. In the last 23 years as a VC, I have seen so many fancy structures to address or overcome the perceived down round, including bridges with or without caps/floors, ratchets, multiples of liquidation preference, warrants, options and every other possible combination. You have a business in this macro environment, you need the capital today and the capital will get priced at today’s prices. You probably benefited when you were valued at 10x in the last round (which you knew was too generous) and this time you have to accept the fact that you will be diluting more than you like. If you survive, you have a chance to thrive.
Being a founder is hard and we are here for you
You are our partner. We are here for you in good times and bad. This is a reciprocal relationship and we put as much effort as into each portfolio company as we can. But remember it is a reciprocal relationship. Many times, DSGCP and the founders may disagree but we are working towards the same goal. What is right for the company. But there are rare occasions when relations get strained, like all relationships sometimes do. That’s life and we must agree to disagree. We allow the founder to take the final call.
Build your cash flow planning and monitoring muscle
People forget what the value of a business is. It is the present value of its expected future cash flows. CASH FLOWS. One thing I would like to recommend is to build systems to plan and monitor cash flows. We are seeing too many early stage companies who have the right product and right strategy suddenly go off track very quickly, surprising the management and the board. I personally have been surprised when companies, where I am on the board, that were apparently doing well in the past few quarters are suddenly under so much stress. This could be for many reasons, including poor understanding of working capital, unplanned capex, poor expense management and missing revenue targets. Our analysis has highlighted one common issue - many founders have not developed strong cash flow planning and monitoring muscle despite having a clear focus on their P&L. Please develop this competence as soon as possible. Where we have worked with founders to help build this system, it has been transformational on how the business is managed. The founders now have a totally different perspective on how to manage their business through this lens.
Not sustainability as in the three core concepts of environmental, social, and economic sustainability. That is ESG. At DSGCP, sustainability is the focus on building a business model that delivers sustainable growth. In the early years, you have the ability and luxury to grow 75-100% YoY from $1 million to $2 million to $4 million to $8 million. Once you get to some scale, say $15-20 million ARR but this depends very much on the specifics of each company, this growth is not possible nor advisable. Most business we invest in are not designed to grow at that pace after a certain stage and you risk breaking many things. We love business that can grow 30-40% year on year. The power of compounding is real and you will have a very large business 10 years later whilst taking less risk along the journey.
The future is bright
I spend a lot of my time meeting the head of strategy, CFOs and M&A heads at the large CPG companies. What is exciting, is that they are keen to acquire strong brands and businesses that fit their portfolio and strategy. They believe that many of the new purpose led insurgent consumer brands will continue to grow as consumers opt for brands that resonate with them. It has never been a better time to be an entrepreneur building one of these brands.
We are lucky to be investing in the two geographies that continue to show GDP growth and attract investor interest. India’s 1.4 billion and SE Asia’s 700 million population continue to drive development and value creation. Over the next two decades and longer, these markets will provide us with so much opportunity. Having lived and worked in the region for over three decades, I know how resilient the people are.
We at DSGCP are very optimistic, fully committed to the region, and continue to build our team in Mumbai and Singapore. The next two decades will see the emergence of insurgent brands that will become category leaders. We continue on our mission to identify, partner and grow alongside the best consumer entrepreneurs. Our secret sauce? Same as it was 10 years ago when we started the firm. Keeping it simple! Focus on working with the best founders. Focus on building businesses with strong unit economics and business fundamentals. Pay a price that is fair for all. Do not overpay. Do not underpay. Align with founders. Focus on sustainable growth.
Deepak I. Shahdadpuri