Is the SoftBank-OYO tango a Russian Doll Ponzi?

Let’s start with a pop quiz.

Which is the most valuable startup in India?

Until last year, the answer would have been easy—Flipkart.

Absolutely Obsolete Today

Now that Flipkart has been acquired and is no longer in the running, one might be tempted to name Paytm*. After all, the company was reportedly valued at $10 billion when it raised $300 million from Warren Buffett’s Berkshire Hathaway last year.

You could be wrong.

The correct answer could well be OYO.

If reports are to believed, OYO is in talks to raise a new round of funding that could value the company at a mind-boggling $12.5 billion, making it India’s most valuable startup by a long way.

In early 2015, OYO’s valuation was less than $100m. This means that the company’s valuation has jumped up over a hundred times in the last four years.

This is a staggering statistic for one singular reason.

No, it’s not that OYO is still a largely unproven business. Long-time readers of The Ken would be aware of the questions we have raised about its business model. Starting from questioning whether its original partial-inventory, minimum guarantee model was a Ponzi scheme that could easily be gamed to show increasingly larger traction without any real customer uptake. Even after seemingly moving away from this model, question marks still linger over its unit economics, total addressable market and demand elasticity.

The reason is that all the funding rounds through which OYO’s valuation grew from $100 million to what now looks like $10 billion-plus have been led by a single investor—SoftBank. The chart below illustrates OYO’s valuation leaps through the funding rounds led by SoftBank.

Very rarely does the same investor lead successive rounds in a startup—the maximum number of such rounds is typically two, and even if so, in the early stages of a company (seed and Series A or Series A and Series B). So not only is SoftBank’s hyper-bullishness unusual, but it is also an outlier in terms of the investor now owning nearly 50% of the company—typical ownership stakes for a single investor cap out at 25% or thereabouts.

Why? As it turns out, despite having a $100 billion fund with over 70 investments, SoftBank could be in a position where it needs OYO as badly as OYO needs SoftBank.

Say hello to what could be described as a “Russian Doll Ponzi”.

Here is how it works.

The Vision Fund – Half Goose, Half Gander

Folks often see SoftBank’s $100 billion Vision Fund as just another VC firm, only much larger. The Vision Fund is similar to other VC funds in terms of having a fixed tenure of twelve years, including an investment period of five years from its final closing. And like other VC firms, the fund’s managers are compensated through management fees and carried interest. But beyond this, the fund is structured quite differently from traditional VC funds.

Other than SoftBank itself (which has contributed $28 billion), the major limited partners (LPs) in the fund are the Middle-east sovereign funds—Saudi Arabia ($45 billion) and Abu Dhabi ($15 billion). These LPs, along with others, who collectively account for around 60% of the money committed to the Vision Fund by investors other than SoftBank, do not have equity in the fund. Rather, their money bears the form of debt-like securities that earn a fixed return of 7% annually.

This caps the upside that these LPs could potentially reap and allows SoftBank, whose own capital contributions are in the form of equity, to benefit from any gains beyond the fixed return. However, it also imposes an unusual and onerous requirement on the Vision Fund—unlike traditional VC funds that only need to provide a return to LPs at the end of the fixed tenure, the Vision Fund has to service debt by making coupon payments every year.

Given that a majority of the fund’s investments are in relatively immature companies (albeit those who are attempting to “put a ding in the universe” through seemingly crazy moonshots), they tend to be unprofitable and unpredictable when it comes to cash flows and returns. So from where does the Vision Fund get money to pay billions of dollars in interest every year?

Before we attempt to answer that question, we need to take a quick look at SoftBank itself.