India Financial Services – Disrupt or Be Disrupted

Matrix India recently hosted two firebrands of the financial services world, Mr Sanjay Agarwal, founder AU Small Finance Bank and Mr Sharad Sharma, founder iSPIRT Foundation, Volunteer at India Stack, for a no holds barred discussion at the Matrix Rooftop in Bangalore. Here is an excerpt from the evening and some of our learnings for fin-tech entrepreneurs.

Part 1 of the two-part series features the untold story of AU Bank, in the words of Sanjay Agarwal himself, as below:

Sanjay Agarwal – on his background and early days before starting AU:

“In my early Chartered Accountancy days, I started out by doing audit work, taxation, and managing clients. I had studied hard and was naïve and enthusiastic at that time hoping, to solve the world’s problems. This pushed me to work harder and I had a desire to do something more.

I believe that we are the choices we make. While evaluating various choices, I eliminated all the options that I didn’t want to pursue e.g. to work for a fee or commission and then I started digging deeper on what really interests me – that was when the concept of AU Financiers was formed.

In 1996, as 26 years old, I began approaching HNIs to raise capital, as back then, there were no VCs. I was fortunate to raise INR 10 cr at a 12% hurdle rate and I had to secure the funding with a personal guarantee. But what is the guarantee of the guarantor? No one questioned this at that time. So, I technically became one of the first P2P lenders, and structured a product that didn’t exist– short term, secured and at a 30% rate of interest. That was the start of the AU journey.”

The Early Days of AU:

“I started off AU as a one-man army. I was everything from the treasurer to the collector. Slowly we built our team and rotated the 10 cr of capital to disburse 100 cr of loans – not a single rupee was lost. There were several challenges at that time for e.g., there was no CIBIL score, financial discipline was lacking, people were still learning how to take a loan and repay it and customer ids didn’t even have a photograph. But somehow, we managed.

The period from 1996 to 2002 taught me everything I needed to learn – how to lend, how to collect, how to manage people, read people’s body language, and most importantly how to manage yourself in different situations. I follow all of that until today, and my team also benefits or suffers from those learnings of mine even today. In those 7 years, we would have dealt with 2000 customers out of which 500 defaulted. That was the ratio of defaulters – 25%. But we managed and there were actually no NPL’s.”

Partnering with HDFC Bank

“In 2002, retail credit was beginning to take off, but our HNIs started pulling their money out, as they wanted a higher return. However, at that time, the most premium bank in the country, HDFC Bank, appointed us as their channel partner. The model we followed was very simple – AU was responsible for sourcing the customer, KYC processing and doing on the ground diligence while loans were booked on HDFC’s balance sheet. HDFC is perceived to be a conservative bank, and it is – however, they gave me Rs 400 cr, on a net worth of only Rs 5 cr! They made an exception in our case due to our strong track record, through execution, sound knowledge of the market, and most importantly our integrity.

By 2008, our net worth had increased to Rs 10 crore through internal accruals. At that time, HDFC told us that we can’t give you any more capital, as we were overleveraged, and that we now needed to bring in equity capital if we wanted to grow.”

Growing the balance sheet and partnering right

“I had two choices at that point, I could continue in Jaipur, keep my ambition under control and live comfortably or figure out what else is possible. I chose the latter and this marked the beginning of my partnership with Motilal Oswal. Its easier to raise equity now, back in the day shareholder agreements used to look like loan agreements with min IRR requirements, etc. As luck would have it, a few months after we raised equity, the Lehman Brothers crisis broke out and most banks stopped funding. We were supported once again by HDFC – they were our saviour and I will cherish my relationship with them always. Once the market settled down, having survived this negative environment, there was no looking back.

Our next major investor was IFC. For the entrepreneurs here, I want to say that you have to be selective about your investors, who will help with not just capital – there should be added value they bring to the table apart from money. IFC was giving me 20% lower valuation, but I knew that I didn’t have any lineage to fall back on. As a first-generation entrepreneur, I had to raise money on the strength of my balance sheet and not basis my family name. I knew that partnering with IFC would shift the perception of AU within the industry, especially for PSU banks. After their investment, we grew from one bank relationship with HDFC to 40 bank partnerships. One thing led to another and Warburg Pincus, ChrysCapital, and Kedaara Capital all came on board after that.”

Consistent performance

“From 2008 onwards, we started diversifying from vehicle lending and got into other forms of secured lending like a loan against property, home loans etc. We never tried unsecured lending and never ventured into microfinance or gold finance. Those were very popular products at that time but focusing on what we were good at resulted in a consistently strong performance. We never had a bad year. In the world of finance, the margin of error is very less. If you have a bad year you can almost never come back. Good companies survive regardless of the market condition, you can never blame the market for your company’s poor performance. In 2015-16, we were a successful NBFC, our RoA was close to 3% with an asset base of close to 8,000 crores, with a RoE of 27-28% and everyone was chasing us – the question at that time before us was, what next?”

How we became a bank

“As an NBFC, it is very hard to manage a book of Rs 50,000 cr with the same efficiency and effectiveness as it’s a people dependent business, there are limits to the kind of products you can do and you can’t keep raising capital. Hence, we became a bank because we wanted to be there for the next 100 years and that perpetual platform can only be created through a bank. That is the biggest platform and it is not available at a price. It’s available through your integrity, business plan and execution. Today, we receive Rs 100 cr of money every single day. This is the same person who was struggling to raise Rs 10 cr in 1996, and is now getting money at the speed of Rs 100 cr every day – it feels amazing but there is a lot of responsibility!”

Part 2 of the two-part series features insights from Sharad Sharma:

Recognizing the Athletic Gavaskar moment in Indian Financial Services

“Indian financial services industry is going through its equivalent of the Athletic Gavaskar project of Indian cricket. The motive behind this project was to instil the importance of being athletic to successfully compete in the modern game. A new team was created with the rule that if you are not athletic, you cannot be a part of the team, regardless of other skills that you bring to the table. Virat Kohli eventually became the captain of this team and the results are for everyone to see. Similar yet contrasting stories played out in hockey and wrestling. In hockey, we lost for 20 years because we refused to adapt to the introduction of astroturf. However, in wrestling, the Akhadas in Haryana embraced the move from mud to mat with rigour, and Indian wrestling is already punching above its weight class and hopefully will do even better over time. The idea of sharing this is that similar to sports, sometimes an industry goes through a radical shift. Take the telecom space, for example, if Graham Bell came alive in 1995, he would recognize the telephone system, 20 years later he wouldn’t recognize it at all. The banking industry is going to go through a hockey/wrestling or communications type disruption and a lot of us are working hard to make it happen.”

Infrastructure changes lead to New Playgrounds

“All the banks and NBFCs put together are not serving the real India today. We have 10 million+ businesses that have GST id’s, out of which 8 million+ are big enough to pay GST on a monthly basis, but only 1.2 million have access to NBFC or bank finance. This is a gap that needs to be addressed and it cannot be solved through incremental innovations.

Entrepreneurs and incumbents should learn from what happened in the TV industry when new infrastructure became available. When India went from state-run TV towers in 34 cities to cable and satellite TV in pretty much every town, there was a massive new market that was unlocked that did not want to watch the same Ramayan or Hum Log TV serials. What transpired was an explosion of entertainment products because of the high demand stemming from the new markets and the TV channel players that reinvented their content is thriving today while others that did not, are barely surviving or have shut down.

So where does this leave the bankers? I think it is the biggest opportunity for the right banker who understands this problem, wants to serve this section of the market and is willing to reinvent the way they do their business and take advantage of the new infrastructure that will be available.”

Dual-immersed entrepreneurs have the biggest advantage

“Entrepreneurs who are immersed in the messiness of both the new infrastructure and the old problem are “dual immersed entrepreneurs”. They are the ones that succeed when a market shift is underway. Today this is not happening. Some of our city-bred entrepreneurs are more comfortable with California rather than Bharat. And some of our sales-oriented entrepreneurs are intimidated by the messiness of the new technology infrastructure.”

New Playgrounds need new Gameplay

“In a world where eKYC exists, and we can transfer money through UPI from a phone, and sign documents digitally – we are ready to deliver financial products on the phone and this is the disruption that is required. Access to credit drives the economy and with this new infrastructure, it is now possible to lend to the real India. However, it’s easy to give money, but the ability to get it back and keeping defaults at a minimum is the real trick. Even there we are moving towards seeing a radical improvement. Debt providers now have powers they never had and defaulters are being brought to book. Customers are now incentivized to build their own credit history to get better and lower interest rates over time. A new Public Credit Registry is coming to enable this at scale. But the biggest innovation is related to the dramatic shortening of the tenor. One can structure a one-year loan into 12 monthly loans or 52 weekly loans. This rewards positive customer behaviour and brings about the behaviour change that is needed.

There is no secret sauce here, it requires gumption – like that shown by Reed Hastings, founder of Netflix. He disrupted the TV and home video industry by first having the wisdom to go from ground to cloud and then again when they started developing original content. In both cases, he had little support from the board or investors. If you can reinvent yourself before it becomes necessary, you’re a winner but this is harder to do for a successful company. The legacy of success provides resisters with the clout to block change. The real beneficiary of Aadhaar based eKYC in the telecom world was not the incumbents but Jio – eKYC allowed Jio to acquire customers at an unprecedented scale and they saved INR 5000 crores on KYC costs as well.”

About iSPIRT

iSPIRT is a non-profit think tank that builds public goods for Indian product startup to thrive and grow. iSPIRT aims to do for Indian startups what DARPA or Stanford did in Silicon Valley. iSPIRT builds four types of public goods – technology building blocks (aka India stack), startup-friendly policies, market access programs like M&A Connect and Playbooks that codify scarce tacit knowledge for product entrepreneurs of India.

About AU Small Finance Bank:

AU Small Finance Bank Limited (AU Bank) started in 1996 as a vehicle financing NBFC, AU Financiers and scaled to touch over a million underbanked and unbanked customers across 11 states of North, West and Central India, prior to becoming a bank in April 2017. During this time, AU attracted equity investments from marquee investors such as IFC, Warburg Pincus, Chrys Capital, Kedaara Capital and recently went public when its IPO was oversubscribed ~54 times. Over the years, AU Bank, led by its founder Sanjay Agarwal, has created significant shareholder value with its equity value growing from ~$120 million in 2012 to current market capitalization of ~$3 billion.

Please Note: The blog was first published and authored by Matrix India Team and you can read the original post here: matrixpartners.in/blog

Dymystifying Valuations & Investors – an opinion from an entrepreneur!

Valuations often have seemed to be a “Black Art”, but they seem to be crucial in determining your strategy for outside investment!

Are they really? How is the early stage entrepreneur going to decide what is reasonable?

Some other questions that routinely come up in the mind of entrepreneurs:

1. How does the process of creating value effect me, my co-founders, my team & investors?
2. How do I maximize value for everyone?
3. How do I get the best valuation in case of an exit?

Entrepreneurs need to understand how money works and see the world from the investors world.

One of the area VCs in the US once described to me this scene sometime back, just after their firm had decided to invest in the start-up:

“There was a lot of interest in this company, and the founders had a fair amount of leverage. They used every ounce of it to extract a higher valuation,” he said. We kept saying that our firm would bring a lot more to the table than money, and that the mentoring, strategic advice, network resources, and political capital we could offer were almost unmatched.”

“The founders however set all that aside and made it about the money. It left a bad taste in our mouth. The deal was still worth doing—barely. But we have less of an equity stake in the company than we would ordinarily want, and given all the other portfolio companies that need my attention, I don’t feel any obligation or desire to give these guys additional assistance.”

The point is that the founders undervalued the non monetary value resources the VC firm had to offer, or they assumed that mentoring and strategic support would inevitably be available from the firm. Given that the negotiation for money and term-sheets is a high stakes exercise with various emotions and personalities
present in the mix, one should not forget that the document at the end lays out how much equity and control a VC will have in return for its cash is all about assigning rights, carving out protections, and haggling over claims to future returns.

So these negotiations are fundamentally about picking the right long-term partner and forging a relationship that can survive the inevitable disappointments, resolve the unforeseen conflicts, and monetize the mutually earned successes to come.

Now as a management consultant, I have tried to put these dynamics into some of the mistakes and solutions of how to avoid them in this blog.

At the end of the day, term sheets can be difficult to understand, and you may need help determining what the various provisions—liquidation preference, anti-dilution protection, pay to play, drag along rights, vesting schedules, no-shop clauses, and so on—imply for your current and future rights and obligations. At the very least, you should contact other companies in the VC firm’s portfolio to find out what was negotiable, why they made the choices they did, and what terms were the most consequential in the months and years after the deal.

So try to check out various VCs and see who you can work with, who has done investments in your space (target market you address) and what it has been for others to work with them.

“Remember you are looking for a partner for the long term and people who you work with will matter in terms of bringing value to your startup especially

the non monetary type!”

So here are some things to consider –

Understand your leverage

One of the thing is the more alternatives you have which means number of other VCs who are interested in your startup, it gives your more leverage. Try to use this to fight for the terms that are important for you. Sometimes one common problem is running out of cash since its hard to forecast the burn rate, and too little willingness to give up equity. As a result, you may fail to take in enough money during early rounds of funding. So look for someone who is willing to fund subsequent rounds or offer bridge loans without significant dilution of founder equity. Its better to negotiate this during the first round of financing when you have numerous alternatives and could command a better price. Many founders have discovered that doing a slightly bigger first round than seems necessary—or perhaps negotiating an acceptable formula for future bridge loans at the outset—can pay off in the
long run: It’s bad when you have few options, but considerably worse when you are running out of options and out of money!

Its okay to look at the long-term goals of the VC partner and take the time to understand what the other side cares about and hope for from their investment which includes accepting money in installments tied to milestones with no dilution in equity.

“So don’t just focus only on your own options.

Understanding the other party’s interests can give you leverage”.

Strive to maximize thrust for win-win situation

Imagine you are the verge of closing a big financing round at the end of the month. When you pitched
last month, the business was gaining momentum and you are on target for all your financial projections. Since then, a major customer deal you were counting on falls apart, and a key employee is on the verge of leaving. Question would be if you would have any legal obligation to reveal this situation, probably not, but imagine you picked up the phone and revealed it. Maybe you think they may re-negotiate the terms of the deal. But most often than not, VCs would reward you for your honesty since they would like to put a premium on your trust! They would value your upfront gesture of delivering bad news as you would deliver good news to them!

Another thing would be around terms, to comparison shop, and to use whatever leverage you have to renegotiate the deal. Its all okay as VCs expect you to ask for better terms, but not after you have given your word on an agreement. The VC world is small and they all keep cross checking on each others deal flows all the time.

“In VC relationships, as in any long-term partnership,

It’s much easier to build  trust than to rebuild it.”

Focus on value and not valuations

If you’re selling your house, for instance, you might not even meet the buyers, and despite issues such as inspections, financing contingencies, and the closing date, the selling price is far and away the top priority. In this case focusing on a single, top-line number sometimes makes sense!

But in case of accepting someone’s money at a startup, the signed contract is the beginning of the relationship, so its a mistake to focus too narrowly on price and not enough on drivers of long-term value. Its like when negotiating a job offer, for example, people tend to obsess over the starting compensation, but factors such as geography, responsibilities, prospects for learning and advancement, and even length of commute can have a greater impact on their enduring happiness and success.

More than one VC has identified this shortsighted emphasis as founders’ biggest mistake.

“Entrepreneurs focus too much on valuation and not enough on control,” one VC told me. “It’s amazing how much control founders are willing to sacrifice in order to obtain a $4 million valuation instead of $3.5 million. These numbers don’t matter much in the long run, but the impact of diminished control can last forever.” The tendency is especially remarkable when you consider the passion most founders have for what they are trying to create, for their company’s mission, and for their vision of its future. Once founders have sacrificed board control or ceded voting rights on too broad a category of decisions, those decisions are, of course, technically out of their hands. Most VCs are very reluctant to use their control rights to contravene the wishes and objectives of management, but if conflict or a breakdown in trust between management and the board occurs, founders may find themselves severely constrained, if not replaced.None of this means you should ignore valuation—it’s an important consideration. But it’s a mistake to confuse it with value, given that most founders also care a lot about factors such as their role, prestige, self-identity, and autonomy.

“To maximize valuation without regard for non-financial considerations

is to sign something of a Faustian bargain.”

Strive for Understanding not Conflict

Even when control is not the concern, you ought to pay close attention to terms other than valuation; there are additional provisions that can have a huge impact on how much money you’ll eventually see. And if you look at them carefully, the terms a VC firm proposes can help you understand its unspoken concerns and assessments of your start-up’s future.

Well as in any relationship you need to look well beyond the contract and far beyond today. The lessons offered above are targeted toward those who are striving to create strong partnerships with VCs—but they are relevant for anyone negotiating in a world where a signed contract is not the end but merely the beginning.

So folks go develop products & solutions and please don’t forget to connect your wares to a customer persona and a pain-point they may have to resolve and rest will follow!

I will do more posts on understanding terms like liquidation preference vs. participation for example in term-sheets from the perspective of an entrepreneur.

Tête-à-tête with Ram Shriram

A mentor and guide to many, Ram Shriram, managing partner at Sherpalo Ventures and one of the first investors at Google, addressed a rapt audience last week at the Bangalore office of [24]7.  Opening the hour long session with his reaction to the start up scene in India, Ram Shriram applauded the dynamic vibe of the IT capital of the country, even as he lamented the lack of infrastructure and the paucity of good Universities to channel the talent of the nation.
A few snippets from the conference for those who missed it.

Announcing the CIO Mentorship Program for Enterprise Product Startups

A ‘startup’ is a company that is confused about – 1. What its product is, 2. Who are its customers, 3. How to make money.

– Dave McClure

As a startup we all struggle either with the Market Fit, the right price for the product and finally the sales. There have been times when we have wondered if the product is perfect or I could have added some new feature, all the while loosing time to launch the product. When the product is out we wrestle with how to sell – Free, Premium or Freemium models and wonder, when will we get to close the big orders. We wonder why our product is being outsold by our competition – What does he have that I don’t.

We sometime wish that how wonderful it could be if we could share our thoughts, bounce our ideas with someone who could understand us and help us in a sustained long term manner, in short become our Guiding Lights as Mentors.

To help startups with just this dilemma, we are pleased to partner with CIO’s of leading Indian Enterprises to put together the CIO Mentorship Program. Where some of the very recognized CIO’s of the Industry from Hero Motors, BMW, Ericsson, Matrix, Max NewYork Life, Moser Baer are ready to use their collective wisdom and experiences to help the startups scale over a sustained time period of 5 months.

If you are brilliant Enterprise Product who is willing to take advice, implement advice and share your pain points then this is just the opportunity. So if you are operating in HR, Education, Data Analytics, Cloud, Mobile applications, CRM’s then you need to apply here. This is only open as of now for companies in NCR region. The last date of getting the entries is 17th Dec. Only the short listed companies will be contacted for the event on 21st Dec in Delhi NCR.