Why the Indian Start-up Story is Wobbling

A combination of global macroeconomic events is pushing the greed- and risk-driven start-up growth play to a wall of fear and self-doubt, forcing founders and investors to tighten their belts and brace for yet another explosive chapter in their lifecycle

By: Binu Paul

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For Prateek Jain, the current start-up funding crunch brings home a feeling of familiarity. In 2016, when the start-up ecosystem underwent a harsh phase of layoffs and shutdowns, funding dried down for his beauty services start-up StayGlad. He was forced to halt operations briefly before he found a willing buyer in Quikr. About 50-odd start-ups, including 20 venture-backed ones, had died in the home services space in a span of six to nine months. Urban Company, then known as UrbanClap, survived, and turned a unicorn in April 2021.

Today, Jain looks at the situation through an investor’s lens. As a Principal at growth-capital fund The Fundamentum Partnership, he advises entrepreneurs to do ‘everything’ to survive if their conviction on total addressable market, or TAM, and business models is rock-solid. “These cycles are bound to happen. Founders need to calm down and go back to basics. If the TAM is large enough and if the business model is robust, do everything to survive and ask existing investors for support. If they’re not willing, cut costs to the bone and operate with the leanest team possible. If your competitor has raised money, it’s a good sign because you’re in a business that makes sense. Survive for the next 10-12 months, and you’ll get another shot at glory,” he says.

These cycles are bound to happen. Founders need to calm down and go back to basics. If the TAM is large enough and if the business model is robust, do everything to survive and ask existing investors for support. If they’re not willing, cut costs to the bone and operate with the leanest team possible. If your competitor has raised money, it’s a good sign because you’re in a business that makes sense. Survive for the next 10-12 months, and you’ll get another shot at glory.

Prateek Jain
Principal
The Fundamentum Partnership

The message is unambiguous: control cash burn, conserve cash, hire diligently, and extend the runway as far as possible. The fundraising environment is clearly witnessing an early, unexpected winter, after a blockbuster year of $42 billion of investments and 42 unicorns. In January-May 2022, a total of $16 billion was raised by start-ups. That’s a significant drop from $20 billion in August-December of 2021. Sixteen companies entered the unicorn club in January-May 2022, against 26 in the preceding five months. Reason? A combination of global macro events—the war in Ukraine, rising inflation, spike in interest rates, and dismal performance of tech stocks in the public markets—has cast a cloud over private market investing. Net result: venture capital (VC) investing activity has slowed.

VC firms have begun giving out alarm calls to their portfolio firms. In a 52-deck presentation sent out to its portfolio companies, leading VC firm Sequoia said: “We do not believe that this is going to be another steep correction followed by an equally swift V-shaped recovery like we saw at the outset of the pandemic.” Lightspeed Venture Partners said: “The boom times of the last decade are unambiguously over.” Silicon Valley-based start-up accelerator Y Combinator asked its large portfolio base to “plan for the worst”. And Japanese conglomerate SoftBank said the group may trim its planned start-up investments by more than half.

The situation has set off panic among start-ups, especially the late-stage ones. At least 24 venture-backed firms have announced layoffs; around 10,000 people have been fired by tech start-ups since the beginning of this year. Well-funded firms including Meesho, Unacademy, Vedantu, and Cars24 are among those enforcing layoffs. Vijay Sivaram, CEO of manpower outsourcing firm Quess IT Staffing - Recruitment & Search, says that some moderation is happening in terms of what talent and how much talent is required in start-ups that have raised capital in recent times. “When access to funding is easier, a surplus of capital flows to some start-ups and there is a tendency to hire more people than required. In some places, excess hiring has been done and it is getting moderated now,” he says.

When access to funding is easier, a surplus of capital flows to some start-ups and there is a tendency to hire more people than required. In some places, excess hiring has been done and it is getting moderated now.

Vijay Sivaram
CEO
Quess IT Staffing

The layoffs are also a result of a greater focus on profits, a practically unknown phenomenon for start-ups till lately. A little over a month after sacking nearly 1,000 employees, Unacademy Co-founder and CEO Gaurav Munjal told his employees in an internal email: “We must learn to work under limits and focus on profitability at all costs.” What that also means is that working in a start-up has suddenly turned risky for employees, especially those in the sales and marketing teams that were driving growth.

“These companies have raised larger rounds in the recent past. They are sitting on high cost structures, they understand they need to grow fast and raise the next round, which doesn’t come very easily now. So, it is only prudent for them to look to cut costs,” says Fundamentum’s Jain. “The key risk is that these companies are not profitable, so they cannot fund their own growth. Spending money for growth should be a lever that companies should be able to switch on and off depending on the external environment.”

Parag Dhol, General Partner at Athera Venture Partners (formerly Inventus India), says there are two kinds of start-ups. One, which has an established revenue model, can get to profitability and therefore commands a high valuation. Two, which got funded because it was a great storyteller, but has not made much headway in terms of real revenues. “In a downturn that lasts for a year or beyond, the latter kind of start-ups will go bust if they are unable to adjust the cost line or find additional revenue lines,” says Dhol.

There are some clear trends in late-stage deals. At 59, the number of such deals was higher in January-May 2022 compared to 36 in August-December 2021. But the total deal value has shrunk to $5 billion from $8 billion in the same period, indicating that VCs are investing much smaller amounts now than before in more matured start-ups.

Late-stage liquidity is becoming more and more uncertain. Start-ups are uncertain if they would get the valuation they think they deserve in the next funding round. [Renegotiations] are happening. Aggressive investors are asking hard questions. They’re taking more than usual time for diligence. They’re recalibrating strategies and evaluating external factors before committing anything,” says the founder of a unicorn who wished to remain anonymous.

BT has learnt that several late-stage deals including agri-tech start-up DeHaat’s planned round from exiting investor Sofina, and credit card platform OneCard’s new round from Temasek and GIC are stuck in deadlocks over valuation disagreements. As per sources BT spoke to, SoftBank is unlikely to make any new investments in the next one quarter.

The founder’s comments are corroborated by Raghubir Menon, Corporate, M&A and PE Partner, Shardul Amarchand Mangaldas & Co. “I see a number of deals happening where valuation haircuts are applied. In many cases, significant reduction is seen between what the understanding was at the beginning of the discussion and what it is at the closing. Companies have started to realise that easy money is going away from the table and, therefore, they need to be a lot more robust in the way in which they operate.” At the same time, investors are also holding on to new investments because there is no clear visibility into where the bottom is for public markets, and one cannot make a fair assessment on valuations if public markets are the benchmark.

There’s another nuance. With $18 billion pumped into late-stage firms in 2021, according to PGA Labs, many late-stage start-ups have comfortable runways today and are not attempting any new fundraise to avoid flat or down rounds. That is thinning the supply lines for VCs.

A series of financial frauds and corporate misconduct issues that rocked the start-up ecosystem in the past 18 months is adding to the stress. High-profile start-ups including fintech firm BharatPe, social commerce platform Trell and B2B fashion e-commerce firm Zilingo have come under the scanner with their respective founders battling allegations of financial irregularities and violation of corporate governance norms. Investors are taking longer-than-normal time for due diligence and are tightening the filtering parameters.

Irrespective of how long this cycle lasts, what is clear is that the world is entering a ‘high interest rate, low growth’ era, the impact of which is expected to set in by end-2022. The new environment calls for a fundamental readjustment for both investors and founders. This will be painful for those who haven’t seen cycles. For context, SoftBank’s Masayoshi Son briefly became the world’s richest man in 2000 after making hundreds of investments, only to lose 93 per cent of the company’s market value when the dot-com bubble burst. “A lot of India-specific fund managers and founders have not seen cycles of true-blood recession. So, the re-rating of growth expectations will be painful for many,” says a global late-stage investor.

Also, what’s playing out is partly the private market’s reaction to a public market slowdown. The macroeconomic headwinds have been inflicting severe damage to tech stocks across the globe. Indian tech stocks Zomato, PolicyBazaar, Nykaa and Paytm continue to fall in the public market. This relentless global trend makes it difficult for VCs to raise capital from LPs (limited partners). It could also force growth firms to invest money in safer stocks in the public market. If interest rates remain high for a longer period, global investors may choose to rebalance their portfolios, which can impact allocations for India.

In its letter to portfolio firms, Y Combinator summed up how this is contributing to the overall start-up funding environment. “Understand that the poor public market performance of tech companies significantly impacts VC investing. VCs will have a much harder time raising money and their LPs will expect more investment discipline. As a result, during economic downturns, even the top-tier VC funds with a lot of money slow down their deployment of capital (lesser funds often stop investing or die). This causes less competition between funds for deals, which results in lower valuations, lower round sizes, and far fewer deals completed.”

Amidst this fear and uncertainty, if you look closer, there are many silver linings for India that give hope that the current shift wouldn’t be as bad as the great recession of 2008-09.

For Indian VCs, 2021 was a dramatic year. Bain & Company’s India Venture Capital Report 2022 says the country’s active investor count expanded to 665 in 2021 from 516 in 2020. Several leading Indian VC funds including Accel, Elevation Capital, Chiratae Ventures, A91 Partners, Bessemer Venture Partners (India) and Blume Ventures have raised new funds in the past 18 months because LPs, especially global ones, saw explosive digital growth and consumer adoption during the pandemic, which would otherwise have taken several years. Besides, investors continue to be excited by India’s maturing digital infrastructure driven by UPI-led payment platforms and cheap internet data-driven digital adoption even in India’s hinterlands. As per an IVCA-Preqin Factsheet, Indian VC funds were sitting on $15 billion worth of dry powder as of September 2021.

While the capital in VC coffers offers a glimmer of optimism to early- to mid-level start-ups, the late-stage funding gap vacated by aggressive VCs may potentially be filled by global investing houses such as hedge funds, sovereign wealth funds and pension funds which were not very active in the Indian market, says a senior executive at a large global fund. “Large investors, especially listed ones, react to the market quicker than others. While they may pause and evaluate, many hedge funds and state-owned funds are keenly looking at India’s digital growth. They might ask harder questions, but are ready to invest top dollar,” he says.

And with geopolitical and regulatory risks in China rising, India remains the largest consumer market available for global investors. Despite the gloom, India’s digital GDP is growing at a phenomenal pace. Finance Minister Nirmala Sitharaman recently said growing internet penetration and increasing income levels will enable the country’s digital economy to touch $800 billion by 2030. A large digital economy can draw global dollars into India, especially when investors are trimming their China exposure.

“India absorbed $123 billion in the past two years vis-à-vis $200 billion in the past five years. Annually, this is about 1.8 per cent of our current GDP. With the coming of age of alternative investments, we expect the alternative asset penetration to GDP to go to at least 3 per cent if not 5 per cent. We see India’s absorptive capacity at $500-750 billion in the next five years,” Renuka Ramnath, Chairperson, IVCA and Founder, MD & CEO, Multiples Alternate Asset Management, was quoted saying in the IVCA-Preqin Factsheet.

Meanwhile, founders are exploring alternative financial solutions—venture debt, revenue-based financing, lease finance, subscription receivable financing, and inventory financing—to survive this phase without diluting much in a down round. Nikhil Aggarwal, Founder and CEO of alternative investment platform Grip, says the company has seen an uptick in demand over the past six months. “A noticeable change is that even more mature companies are reaching out to access alternative sources of financing. Companies that have raised over $200-300 million in capital are now discussing these financing options,” he says.

Ankur Bansal, Co-founder and Director of venture debt firm BlackSoil, says the company has received over 60 leads in April-May 2022, which is a 100 per cent jump in its quarterly leads generation compared to previous quarters. BlackSoil’s average deal size has grown to Rs 41.3 crore in the first five months of 2022 compared to Rs 22.1 crore in 2021.

“I strongly feel start-ups should use a combination of equity and debt because no single pool of capital is infinite. It’s heartening to see that during the downturn, we are seeing a lot more businesses combining both to create their financing mix,” says Anurakt Jain, Co-founder and CEO of revenue-based financing firm Klub. Jain says Klub has seen nearly 4x increase in demand for revenue-based financial solutions this year.

The learnings from the pandemic also turned out to be useful in managing this crisis. Covid-19 offered a survival playbook for start-ups involving cost reduction, operational streamlining and business pivots, which enabled resilience and growth. Most figured out innovative ways to shore up their core businesses, learnt to prioritise and minimise risks, and mastered the act of conserving cash.

Dhol of Athera is confident of Indian entrepreneurs’ grit: “If you roll back about two years to March-April 2020, the ecosystem as a whole dialled down cash burn, they cut people where required, took tough decisions in the middle of a pandemic, which is a [once-in-a-] 100-years event, and did that quite well. Yes, the markets came back much faster, it was easier on the recovery, but why would I assume the same set of entrepreneurs today won’t be able to cope with what’s not a [once-in-a-] 100-years event?” His prognosis is simple: Why will they not be able to react to an event that comes every three to five years, even if it lasts longer than pandemic-related fears?