After the Frenzied Fundraising of 2021, What's in Store for Start-ups?

There has been, ever since India’s economic reforms began, a ‘before and after 1991’. Likewise, there will be a ‘before and after 2021’ for the start-up story. It’s the year when the country’s venture capital and start-up worlds found themselves lifted centre stage into the country’s business and economy, not by design, but by the unintended devices of a pandemic and the government’s policies.

The Covid-19-induced digital shift placed many consumer tech categories, which includes edtech, payments and e-commerce, at the top end of a tailwind. The wind travelled quite well, blasting throughout the past year to bring a lot more people online while the existing ones became increasingly well-versed with digital transactions. Consequently, start-ups in these segments bypassed usual growth cycles to achieve economies of scale and the momentum spilled over to other sectors as well. Simultaneously, the results of the US Federal Reserve slashing rates began to reflect as investors, flush with excess liquidity, flocked to Indian markets to take advantage of this unprecedented new opportunity. The Chinese government’s crackdown on internet companies also helped push significant global money into the neighbouring Indian market.

This confluence of domestic and external factors shaped up a landmark year for venture capital and start-ups in India.

“In the 2012-13 time period, we clearly saw that the elements to scale companies were present. In 2017-18, we saw companies were genuinely getting scale, not just consumer-tech companies focussing on India, but also enterprise tech firms focussed on global markets. The normal next step of that trend are three things: More global investors identifying that opportunity, more high-quality founders identifying that opportunity, and more exits because public markets, strategic investors, etc. also want a piece of that opportunity,” says Anand Prasanna, Managing Partner at Iron Pillar, a mid-stage venture capital firm.

According to a recent report from investment firm Orios Venture Partners, 46 out of India’s 90 unicorns were created in the 12 months of 2021, the first 44 born through a decade or more. Technology start-ups together raised a total of $42 billion in 2021, up from $11.5 billion in 2020. Along with this, a total of 11 start-ups, including eight unicorns, raised somewhere around $7.16 billion through public offerings.

This is not all. PGA Labs, the market research unit of Praxis Global Alliance, states in a recent report that over 45 start-ups are likely to enter the unicorn club in the near future. According to research firm Tracxn, nearly 45 per cent of ‘soonicorns’—or companies about to reach the coveted $1 billion valuation—were created in 2021.

However, history teaches us that the pendulum keeps swinging both ways. Financial markets go through ups and downs. What’s an exorbitant up change today gets settled tomorrow. In this process, some changes unsettle the existing system. And when the correction kicks in, will the ensuing flight to safety shake up this ecosystem once again?

“At the end of the day, this kind of over-enthusiasm has to end somewhere. Whether it will end this year or not, I do not know, but it will end sometime. People who have invested through multiple cycles and still see the potential in the country will stay. They see the signals rather than the noise. I do not think many of the guys investing in India have that sort of an experience. The moment there is a wobble, how many of these guys will get nervous and run away is a big question today,” says Parag Dhol, Managing Director at Inventus Capital Partners, an early-stage investment firm.

Dhol, who began venture investing in 1993, says the number of people who stay could still be good enough for the Indian VC ecosystem to sustain at a decent pace. As per Tracxn data, the number of first-time investors grew to 1,145 in 2021 from 708 in 2020 and 691 in 2019 while the number of international investors betting on Indian start-ups jumped from 697 in 2019 to 990 in 2021. The ratio of US investors in Indian markets grew from 44 per cent in 2019 to 53 per cent in 2021.

These may not be completely unfounded fears because there are historical precedents. Has the bull cycle shown enough to draw a trend line? The oldest start-up unicorn stock listed is just six months old, some of those that followed, including the much-anticipated Paytm listing, turned out to be duds for investors. With a bevy of loss-making start-ups queuing up to hit the public market, these optics may not be good enough for retail investors to trust them for years before they come out of the red. Meanwhile, the exponential consumer tech growth may also see slight correction when the pandemic subsides.

But like Dhol says, it would be too early to be talking about a private market correction and that long-term investors with several cycles of investing experience will continue to believe in India’s ability to generate long-term value for stakeholders. Private investors look for companies that go after large markets. India, being an emerging market, they understand that the realised market value is only a fraction of its true potential. They look at unit economics, operating leverage, and path to profitability. The blockbuster IPOs of Zomato and Nykaa prove that public market investors understand these metrics, too, and appreciate long-term cash flow capabilities of these businesses. Most importantly, they understand that companies need to have a credible path towards profitability for investors to take them seriously.

“You should expect causalities, especially in consumer tech where a lot of segments are winner-take-all. With the amount of cash that is thrown in and private market money being raised, I don’t think 2022 would be the year where you would see causalities. It may be 2023 or beyond, and a lot of that depends on what happens to Fed policies,” argues Iron Pillar’s Prasanna.

With US central bankers setting their sights on a rate hike in the coming months, the era of easy money may be coming to an end. But what has come into the market will stay, Harsha Kumar, Partner at Lightspeed India Partners, points out. “One thing we have observed traditionally is that when the market shifts, even if things simmer down, they don’t simmer down all the way. There are some changes that are here to stay, and they will stay. Capital that has entered the market is here to stay. It’s not just going to go overnight. Same thing with cheque sizes. It wouldn’t drop all the way to what it was two-three years ago. Investors will probably get more practical. You may not see as many investors coming in, but the ones who are here will stay and when the market turns around, you will see more of them coming in,” Kumar says.

While the historic start-up funding run is likely to continue unaffected for the near term, it’s the early-stage, smaller funds that are now staring at an existential crisis. They realise that what got them here wouldn’t get them there if they don’t adapt.

According to a report by industry body Indian Private Equity and Venture Capital Association (IVCA) and consulting firm EY, the average ticket size of early-stage deals has grown to $4.1 million in 2021 compared to $2.8 million in the January-July period that year.

Several leading growth-stage and late-stage investors are now actively looking at early-stage start-ups. SoftBank, whose average ticket was above $100 million, is now writing smaller cheques to enter companies very early in their lifecycle. With its Surge start-up accelerator programme, Sequoia too is building an extensive early-stage portfolio. With exits at an all-time high, there is so much secondary money going around as well. Young founders prefer going with a larger fund that can write subsequent cheques or with serial entrepreneurs who have been there and done it a couple of times.

“How would you keep yourself relevant in that scenario when the ecosystem itself has a lot of money? Initial rounds, especially for small funds, become a challenge. Founders would always want to have a larger VC on their cap table who can provide a lot of money subsequently. This will force smaller funds to be more and more specialised. Speed as a weapon can be used if that’s sustainable,” Dhol says.

According to Venkat Vallabhaneni, Managing Partner at Inflexor Ventures, micro funds play an operator’s role in their portfolio and that’s the difference they bring on to the table to early-stage founders. “Funding sizes have obviously gone up; everyone needs to adjust to that fact. We have moved up a little bit in terms of deal sizes and investment stages,” he adds. Inflexor Ventures’ ticket sizes, for instance, have doubled over the last four years.

Average late-stage fund round sizes are also growing. In fact, in the January-July period of 2021 it was higher than the average cheque sizes of the past two years combined. Late-stage cheques size grew from $88.7 million in 2020 and $90.9 million in 2019 to $217.6 million in 2021 January-July.

As industry matures, layers of investor hierarchies are also beginning to appear transparent. Prasanna says that there will be some early stage and growth stage funds in the top tier, some who straddle the spectrum from early to growth, but in the late stage, it will be a completely new ecosystem. “There will be a set of firms, not the usual suspects but global funds, asset managers or large families who have never been into this space before. We would see more and more unusual names coming to the late stage when these companies become solid,” he adds.

Meanwhile, the growth is also attracting legacy businesses to the digital front. Tata made three big-ticket acquisitions last year—bigbasket, 1mg and CureFit—to accelerate its super app play while Reliance has invested in quick commerce firm Dunzo, lingerie retailer Zivame, subscription-based hyperlocal grocery delivery platform Milkbasket, furniture retailer Urban Ladder, and e-pharmacy Netmeds. Legacy companies are, thus, disrupting the digital space by investing in and expanding some of the key vertical categories while also offering attractive exit opportunities to early-stage investors.

“Incumbents will try to hop on new ideas, and if they can’t, they will try to acquire companies. Start-ups win basis their speed and ability to take risks which incumbents are unable to. This is how mature markets behave. If anything, it is a good sign. It means that the market is ready now, there is enough talent that these incumbents can hire to build on new ideas and market them, and if they are unable to do that, there is enough liquidity that they can acquire companies. This is just net-net positive for the ecosystem,” Lightspeed’s Kumar says.

Inflexor Ventures’ Vallabhaneni is of the opinion that the increased noise in the market and the trust that larger investors bring to the ecosystem have got more domestic investors upbeat about this asset class. His early-stage investment firm raised an oversubscribed fund of Rs 600 crore during the pandemic year, fully from domestic investors.

“The actual momentum has picked up in India. A lot of family offices and private investors are taking notice of alternative investments. They used to be quite resistant to look at alternative investments. There was a slight slowdown of growth in the US over the last two quarters, but we have not seen that in India. It could be that we are lagging behind the global trend. But I feel the healthy trend will continue, though it may not be at the same pace,” Vallabhaneni says.

Today, India is the third-largest unicorn hub after the US (487) and China (301), and in 2021, one out of 13 unicorns globally was born in India. India as a growth story is expected to continue even if there is a slight short-term correction.

In a nutshell, the market is predicted to continue to grow, with a lot of things going for it. The pace of venture capital flow is expected to continue and there will be a lot more large rounds as companies continue to scale. This will, in turn, enable more and more Indian companies to expand beyond borders.

“The sentiment is positive. Unfortunately, there is a history of three cycles of private investments in this country that broadly disappointed investors. But this time, that story can be different. For the first time, we are seeing massive companies being created and massive exits are happening. Global investors look at India as a large emerging market which is going to deliver at some point in time, and seems like the time has arrived,” Iron Pillar’s Prasanna adds.

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