History lesson 2.0: Why state governments should not be startup investors

With over $9 billion raised by startups in 2015, it was only a matter of time before the Indian government celebrated this success with an event called Startup India, Standup India. But one must also thank history for the lesson it provides. In the years between 1998 and 2010, there was smaller startup excitement that cropped up for governments. Like many things, it died without a whimper. The exuberance was born out of the boom created by the IT Services and the BPO industry, which at the time could do no wrong in terms of garnering media attention. So states like Andhra Pradesh, Tamil Nadu, Maharashtra, Punjab, Gujarat and Karnataka along with Small Industries Development Bank of India (SIDBI) became pioneers in setting up startup funds.

Back then, investments were limited to technology and the corpus of the fund was set between Rs 15-20 crore per state. The management of the fund was limited to state government-appointed fund managers. By 2012, most states had shut down their venture funding operations because the businesses, which they had funded, had failed to take off. With it, the entrepreneurs also disappeared into oblivion. The Reserve Bank of India clamped down such initiatives back then. Only Karnataka’s fund in the form of Karnataka Information Technology Fund (KITVEN) and Gujarat Venture Finance Limited survived and thrived. What went wrong with the others?

• State governments should never be investors

Sarath Naru, MD of Venture East says, “State governments never had the bandwidth to invest in startups. It makes sense if there is a national policy on startups.” He adds that it is better if governments operate as fund of funds rather than make direct investments in to startups.

Globally, the US is the biggest success story with its Small Business Investment Companies, which infuses debt and equity funds into companies. It has funded the likes of Intel, Sun Microsystems, and Apple long before they became household names. Israel too has the Yozma Group, which has been investing for the last 23 years. Singapore has a programme called ‘Spring’, which is running successfully. These programmes have been successful because the majority of the equity in the fund is privately owned. The government only matches a percentage of the total funds raised, and it leaves the management of the fund with private business.

The Indian states made the mistake of investing on their own in the previous decade. Hopefully, they will not waste public money again. However, they are planning to launch larger funds by tapping into the coffers of large nationalised banks, the Life Insurance Corporation of India, and SIDBI. Sources say that SIDBI along with Canara Bank’s Venture Fund have already created a corpus of Rs 1,000 crore as part of the StartUp India campaign, which is going to be a national fund of funds. It remains to be seen if this is going to be part of the Rs 10,000 crore fund announced by Prime Minister Narendra Modi last year.

“The opportunities from the state and national fund will not be limited to technology alone,” says Mohandas Pai, MD of Aarin Capital. He adds that the government was very clear that these will be fund of funds.

Even West Bengal has announced a Rs 200 crore fund for startups. Karnataka too is quietly awaiting sanction on a Rs 500 crore fund of funds. The question is what markets will these startups serve, and will a State Governments investment be limited within the State alone.

• States need to ease market access and create infrastructure

If they can keep their hands away from investing in startups directly, then they should perhaps invest in infrastructure. In Bangalore there is a startup born every day. No wonder there is an influx of so many young people in search of opportunities to that city. In large part, this is true because of the engineering ecosystem that has grown around Southern India. Karnataka has 190 engineering colleges, Andhra Pradesh and Telangana together have 500 colleges. Tamil Nadu too has 500 colleges. But if state governments across the country want to create entrepreneurship, then education and access to markets become imperative. Importantly, startups need to work with small and medium businesses in manufacturing, supply chain and retail. Not all startups can disrupt the consumer business because only one or two will thrive, as already seen in the e-commerce business. A R Jayakumar, CEO of KITVEN says, “Governments need to consider several things before they set up a fund. In the South, there is already an eco-system for technology companies along with educational institutions. This is another challenge governments face when they announce funds.”

• Taxation and listing

There were tax holidays provided to software technology parks and IT companies, especially when they made large investments in the previous decade. Will sops be offered by state governments? The confusion will get bigger with listing. Will the state government decide the exit strategies for a startup? It is not going to be easy with so many taxes. Last year, the Central Government along with the Reserve Bank of India and the Securities Exchange Board of India (SEBI) had already mooted a draft listing policy for startups. But the delay in rolling out the norms for listing was primarily because of the concerns raised by the tax authorities. R Natarajan, CFO of Helion Ventures says, “Several issues have been raised over the last six months. One of them is the origin of funds and their management. Secondly, it is about easing the exit procedures for investors who have funded the startup.”

In case state governments partners with several private funds, they will have to work with the Central Tax Authorities in clearing the origin of these funds to avoid any hassles of double taxation. Any incident can lead to embarrassment for local governments.

• Jobs versus entrepreneurs

Finally, every government wants to beat the drum of job creation. It has become an albatross around the neck for young startups. Funds should not be launched with this as a primary objective as it will kill innovation in an early-stage idea. The flak received by Zomato and Tiny Owl over the firing of several employees is a case in point. However, Narendra Modi’s spin on startups is all about asking Indians to be self-employed and becoming masters of their own fates. The narrative today is about becoming job givers rather than becoming job seekers. India is a nation of kiranas and small/medium enterprises; there are around 50 million of them across the nation according to reports by consulting firm PWC and rating agency CRISIL. Perhaps Narendra Modi is betting on a change in Indian attitudes towards entrepreneurship. But in what context will these government funds support failures of entrepreneurs? This will always remain a mystery. For now, though, it is the need of the hour because India needs to provide 300 million jobs by 2030. This mighty task will require joint efforts by all governments, institutions and society at large. Ratan Tata had mentioned at a Tata Motors press conference that while India was innovating in various fields, the challenge of job creation will remain the single-most-important factor for governments and industry.

YourStory’s take

Perhaps there is a case for presenting clarity. State governments cannot launch a programme for startups because the central government is doing so. This scenario becomes ugly when the state is ruled by an opposition party. Hopefully, these state government funds along with the central government fund will set a precedent to create a uniform startup policy. We wish it will not be as confused and delayed as the implementation of GST over state taxes. But like billionaire businessman and investor Vinod Khosla said in a conference last year in Bangalore, “it is not very good for governments to invest in startups because it destroys competition.” The central government seems to agree that it is not the government’s role to fund startups. During a Twitter discussion on Tuesday Amitabh Kant, Secretary of the Department of Industrial Policy and Promotion (DIPP) – Government of India, had the following response to a question on whether governments should be in the business of funding startups: “No. Govt should act as a facilitator and a catalyst. It should help in building the right ecosystem.” With the Startup Action Plan that will be announced on Saturday, the Narendra Modi government has a chance to rewrite history. Let us wish that startup funds will create a million jobs. As investor Mohandas Pai says, “A large percentage of the startups will fail. But ideas will be born too and that is the objective of the funds, to support these ideas.”

(Disclaimer: Mohandas Pai is an investor in YourStory)