Seeding startups at the base of India’s pyramid

David Bank 8th January 2013

A team of technology veterans has raised $8 million for one of the first funds making early-stage investments in companies meeting the basic needs of low-income customers at the base of India's economic pyramid.

The commitments, including from billionaire venture capitalist Vinod Khosla, will launch the Unitus Seed Fund, which is looking for start-ups providing products and services such as early childhood education, preventive health care, affordable necessities and income-generating opportunities.

The willingness of the investors to bet on higher-risk, early-stage ventures is an indicator of interest in the profit potential of base-of-the-pyramid, or BoP, customers around the world. In India alone, the approximately 835 million people with income of under $4.26 day in U.S.-equivalent spending power, represent $360 billion in disposable income, according to McKinsey Global Institute and Omidyar Network.

"Investors, entrepreneurs and businesses can create wealth for themselves by providing value to the masses," Khosla said in a statement. "The under-served populations of India represent not just a development need, but in fact form a series of large markets with significant and often untapped potential."

Khosla, a legendary Silicon Valley investor who is also making huge bets on renewable energy, was born in India and came to the U.S. for graduate school at age 20 (after the failure, ironically, of a soy milk company aimed at Indians without refrigerators, according to his bio). He was a founder of Sun Microsystems, Inc.

To be sure, there have been notable setbacks in pursuit of BoP fortunes. USF acknowledges that building high-volume businesses on narrow profit margins is "notoriously challenging" but "expects to deliver both strong financial returns and substantial social impact", according to its announcement.

USF, managed from Seattle and Bangalore, has already completed four deals and said it plans to make 10 new investments of up to about $100,000 each in 2013, with the possibility for follow-on funding. The fourth spin-out from the nonprofit Unitus Labs in Seattle, USF brings together players who pursued a sometimes controversial strategy that helped nonprofit microfinance organizations make the transition to licensed for-profit financial institutions.

"Our next effort is to demonstrate the efficacy of using equity investing in scalable for-profit companies that serve the same low-income customers," said Mike Murray, a founder of Unitus Labs and former Microsoft and Apple executive, who is a lead investor in the new fund. Another investor is Dave McClure, a prolific angel investor and founder of 500 Startups.

According to an SEC filing, USF has raised $6.25 million of a planned $25 million. Approximately $2 million more is committed in a parallel India fund led by Mohandas Pai, a former top executive at Infosys, the Indian information technology giant, and Ranjan Pai, no relation, the CEO of Manipal Education and Medical Group and one of India's richest men. Most other impact funds in India have been financed by foreigners.

USF is one of the first venture capital funds focused on early-stage start-ups focused on low-income customers. For bright start-ups, there are accelerators, competitions, bootstrapping, friends and families. Likewise, for proven models built for replication, there are "growth funds" and mezzanine financing. But there has been a chronic shortage of risk-capital for early-stage ventures that have demonstrated their product but are not yet ready for full rollout. The problem has been called the "pioneers gap", the "missing middle" or, in Silicon Valley parlance, the "Series A crunch".

The new fund will serve to help fill the pipeline for later-stage funds, such as Khosla's own Khosla Impact Fund or the separately managed Unitus Impact Fund. Khosla Impact, for example, typically makes investments in the range of $500,000, with follow-on rounds in some cases bringing the total commitment to several million dollars.

People ask me, 'Who’s going to be the Google of the base of the pyramid?' I say: 'We don’t need one. We can have strong operating companies, serving massively underserved consumers'.

Technology is essential for base-of-the-pyramid businesses, radically lowering transaction costs, creating more efficient supply chains and assembling data. That enables the low per-unit costs required for businesses serving millions, or tens of millions of customers. But there's a big difference between markets such as software, with low marginal product costs, and capital-intensive, low-profit basic services for low-income customers in remote regions. Early childhood and primary education, preventive health services and improvements in agricultural productivity have limited potential for the grand slam investments Sand Hill Road-style venture capitalists have historically aimed for.

"People ask me, Who's going to be the Google of the base of the pyramid?" said Will Poole, another former Microsoft vice president who is co-managing the new fund. "I say: We don't need one. We can have strong operating companies, serving massively underserved consumers."

Poole first identified the market potential when he headed Microsoft's Windows client-software business. His challenge: How do you grow revenues in a business that already commanded more than 90 percent market share? His answer: "You go to the next billion, where you have no share at all." That effort led to Microsoft's Unlimited Potential group, which sought to make technology relevant to the basic needs of that target population. Poole led the unit until he left Microsoft in 2008 to become an active impact investor.

In July, Poole joined the founder of USF, Dave Richards, a former executive at Real Networks. Real and Microsoft were longtime rivals: Poole and Richards testified on opposite sides of the European antitrust action against Microsoft. "Now we're conspiring for good rather than beating each other up with government regulators," Poole says.

USF already has $360,000 invested in four companies; those deals were done under the nonprofit Unitus Labs, which now will be repaid its capital but keep a small slice of future profits. One investee, Villgro Innovation Marketing distributes products to help dairy and other farmers improve their yields and incomes, including through local farmers who act micro-entrepreneurs to reach remote areas.

Another deal, a $100,000 USF investment in Hippocampus Learning Centers in February, is helping to expand a network of private kindergartens for rural and low-income students. Government-run schools start at the first grade, leaving parents few affordable preschool options.

"The money from USF came in at the right moment," Umesh Malhotra, Hippocampus's chief executive, said in an email. "We were running out of angel money, and the Series A investors were on the fence. USF coming in was the confidence shot we all needed."

The Series A financing in June will take the company through 2014, when it expects to have opened 200 centers with more than 6,000 kindergarteners enrolled for low monthly fees. It will need serious growth-financing to reach its eight-year goal of 100,000 centers and three million children.

Malhotra acknowledges the challenge. "It's a low-margin business, the impact of good education takes years to demonstrate, and the distributed nature of our business makes it difficult to manage operations," he says. "What attracts funders is potential scale, our ability to reach under served markets, and making a long-term impact."

Extending the privatization model from microfinance to education, health and even water could provoke controversy, as the Unitus federation, including Murray and Khosla, has learned from experience. In the last decade, Unitus Inc. helped nearly two dozen nonprofit microfinance organizations make the transition to licensed, for-profit financial institutions, including through investments in their balance sheets by Unitus Equity Fund. That freed capital from banks, dramatically increased microfinance lending and helped turn a once-cottage business into a major financial services industry.

One such deal proved an embarrassment of riches. Unitus Equity Fund and Khosla, along with Sequoia Capital, a premier Silicon Valley venture capital firm, and other investors, put more than $100 million between 2006 and 2008 into SKS Microfinance in Hyderabad. Sequoia's investment, in particular, was touted by Vikram Akula, then CEO of SKS Microfinance, as the "first purely for-profit private equity play" in microfinance. When SKS went public in 2010, Unitus's stake was estimated at more than $60 million, a 10-fold return on its investment.

The IPO riches contributed to an Indian government crackdown on microfinance. It also coincided with Unitus's conclusion that it had completed its work in microfinance and decision to lay off most of its nonprofit staff. All that led to a raft of negative publicity. Murray said the windfall was redeployed for social purposes and called the controversy "extremely offensive and inaccurate."

Unitus's dozen years of work in India gives it a strong pipeline of deals and network of business partners, Poole said. "There are definitely deals to be done," he said.

That said, the small size of seed-stage deals makes due diligence and technical assistance expensive for private-equity general partners. Poole and Richards are working for a fraction of typical venture-capital management fees in order to help prove their new model of investing in BoP startups. "Managing a small fund is not profitable for venture partners," Poole said. "But it can be very profitable for the limited partners."

David Bank, veteran Wall Street Journal reporter and author, is editor and CEO of Impact IQ, where this article was originally posted.