We like sitting with the founder till the IPO baton has passed. That's our DNA: Karthik Reddy

Karthik Reddy, Co-founder and partner, The Blume Venture. Image: Joshua Navalkar

Early-stage venture capital (VC) firm Blume Ventures was co-founded by Karthik Reddy in 2011. It was the first ever VC in India to fully raise the first fund from domestic investors. This paved the way for several homebred VC companies to open shop at a time when there was a lot of scepticism around venture funding due to poor returns.

In an interview, Reddy talks about the secretive world of venture capital funds and explains the power law and the randomness of success in VC investing where early-stage investors depend on gut instincts more than financial data to find the next unicorn. He also throws light on the dark side of startup investing.

“I feel this IPO price optimisation is a silly exercise and I keep telling founders, what's your gain in this? You're the one holding the bag. You're the CEO. You have very little to sell. You're not trying to optimise in the OFS. Who are you trying to solve for? Why are you trying to solve for everybody else on the capital table who's left the building?” Reddy acclaims rhetorically in a conversation on Pathbreakers in April.

The Blume Ventures co-founder and partner believes founders must optimise for their new set of retail shareholders, who have to be with them for the next five to 10 years, when they go public. “So, if you're doing right or wrong by them, eventually, karmically, it is going to come and get you,” he adds. Part one of edited excerpts:  

Seed-stage strategy: ‘You don’t bet the house on one company’

At the seed-stage, you rarely know. So, you will take an established team where you have a lot of faith on the market opportunity and double the size of the bet. Instead of playing $2 million, you would play for $5 million. It's a manifestation of your confidence that I think this team has a better chance of building the billion-dollar business versus this team. As we've grown in fund size, we don't keep all of this capital for that early risk. We're keeping more and more for later risk because you'll get these things wrong, and history has shown that. That's the nature of venture capital.

You don't go and bet the house on a particular company. You watch it through the various stages and ideally double down as the company goes deeper, and does better and better. By the way, there are funds in the West, from what I hear, which won't do anything after seed. They don't keep reserves, so they just spread their bets along the way. Like, Y Combinator started an Opportunity Fund and then derailed the effort because they said the incentives are not aligned. They don't do a follow-on check. It works for an accelerator. It might work for a fund which has no intent to sit with the founder after six months to a year. We've discovered in Blume; we like sitting with the founder till the IPO baton has passed. That's our DNA. So, we should plan for a fund which allows us to continue playing into the best company.

Power law: ‘That’s the nature of the game’

If you look at data collected in the West, first, venture capital firms consistently show that the top five to seven companies in a fund will return 80 to 90 percent of the capital. Mine happened to be a little bit more fragmented because I built a wider base of companies in a very different era. [17 of Blume Ventures’ 78 portfolio companies generated about 98 percent of the total gross returns]. It exactly might play out that way in Funds II, III and IV. It's not going to be easy to beat conventional wisdom. India could be a little different, but Fund I didn't prove that for sure and I think that's the nature of the game.

Also read: Pandemic market fit is over. Edtech will live: Sajith Pai, Karthik Reddy

Late-stage deals: ‘People do play funny games’

At the late stage, people do play these funny games. It's no different from the public market bubbles in the last 25 to 30 years. So, therefore he [Aswath Damodaran] is saying they're no different from traders because they're simply trying to ride the price curve and just pump up the price and try to see if they can sell it for a quick profit, which is exactly what traders do. Yes, in boom cycles it feels that way because the underlying math does not justify the price. I think public markets mentality sometimes seeps into late-stage private markets because everyone's looking for a quick flip and a quick turnaround. It's also, by the way, if you notice, the point at which most public market investors by DNA—hedge funds, late-stage public market investors—start walking into private markets. The market is already corrupted for quick returns. That's exactly what happened in the 2019-21 buildup. Despite the hiccup of the pandemic, people thought this is a never-ending thing, and it's also driven by liquidity. People are willing to take crazier risk.
 
At the early stage… it's not like I'll ever have crazy liquidity. I'm a small fund, finite size, finite time period… so I don't play that end of the curve at all. Ironically, I get hurt by that end of the curve; I get diluted, I get crushed. I go down the liquidity preference stack and then if that company goes kaput or gets sold for less, I’m at zero. So, what's happened? You've corrupted the founders to take more and more money and use it more liberally to get growth. They could otherwise pace themselves much better and do it close to profitability. So, I love Deepinder. As a founder, you see his behaviour change. In the last two to three years, the public market said we don't want that kind of growth; he corrected and turned to profitability. Fascinating, right? It's sad that it has to sometimes wait till a downturn. In a crazy bull market, everybody looks at each other and behaves badly. The excuse is that the other guy is doing it. So, it's a different type of normal.

Risk aversion: ‘The market is very cautious now’

There's a fear… knowing everything you know that's happened in the last two to three years, can you be sure that the next cheque you write doesn't go through the same cycle? So, you're guarding yourself against I don't want that to happen to me. It is not like there's no capital [for late-stage deals], it's risk aversion. There is a lot more risk appetite for things which are far more stable today. So primary players till two years ago were buying secondary positions. Why? Because it's a proven model and it's profitable.
 
Primary players who were supposed to do Series B and C are buying stuff which is pre-IPO. So, they're just shifting themselves on the risk curve because you don't want to risk $20-30-40 million on something which looks like these four to five risks are not stripped out entirely. So, that's where the market is very tentative, very cautious, and this happens every cycle. I don't know why people don't learn. That's where the late-stage investors are stuck.
 

IPO: ‘Price optimisation is a silly exercise’

When a company is reaching a point where you're too small for private equity, you're too stable for venture capital to get excited and you are close to profitability, you might as well push yourself and get to four quarters of profits and go and stake your luck in public listings. In large companies, they're all greedy, everyone is trying to optimise the listing price. And so, you are trying to perfect the price in public markets, not realising that in public markets also people need to make money. If you strip out all the juice, what's there to squeeze? And then the retail investor says, “You took away all the juice, I only have the downside and you have not protected that either. That's not the stock I want to buy.” I'm not saying give a ridiculous discount, but when you raise money at a crazy private price, you're tempted to optimise the public class.

Half of the new-age tech IPOs have been priced ridiculously, as the market shows you. That's my limited point. Eventually, markets rule. Who are you trying to fool? If you correct those mistakes, they'll reward you as well. Zomato is a great example. I feel this price optimisation is a silly exercise and I keep telling the founders, “What's your gain in this? You're the one holding the bag. You're the CEO. You have very little to sell. You're not trying to optimise in the OFS. Who are you trying to solve for?” If there's greed, it should be for the company and then for yourself. Why are you trying to solve for everybody else on the capital table who's left the building? Founders have to optimise for their new set of shareholders who have to be with them for the next five to 10 years. So, if you're doing right or wrong by them, eventually, karmically, it is going to come and get you.