Start-ups: With Funding Drying up, VCs take Control

Every document is the outcome of a negotiation. In the world of venture capital (VC) funding, the character of this negotiation changes with cycles. After a year of breakneck pace of investing, which saw a record $35 billion of investor money flowing into Indian companies, the start-up ecosystem is staring at a dry spell. From what has been a founder’s market, the slowdown has caused a paradigm shift where the investors are deciding deal terms.

What has led to this shift? For that, a bit of history first. What we saw in the 24 months leading up to 2022 was a massive influx of capital into India due to excessive money in the global markets. Some of that capital ended up with large investment funds and big capital allocators globally, who have a share earmarked for alternative assets and emerging markets. Besides, during the phase of high liquidity, every investor wanted to diversify its capital pool, resulting in capital being exported to all countries. Consequently, a percentage of it came to India, the third largest start-up ecosystem in the world. For this emerging market, that number was significant.

When a flood of capital chases start-ups, the risk lens often gets impaired, views become biased, and growth, not profitability, drives investment decisions. It also creates a sense of FOMO (fear of missing out), where investors don’t want to lose an opportunity and, therefore, invest fairly quickly. “Last year, deals were happening over a weekend. You would meet a company on a Thursday or a Friday, and you had to decide by Saturday or Sunday because in most cases, they would have multiple term sheets. So, it was more about winning that opportunity by getting into that company. It gave very little soak time to understand and learn about the founding team and what they are doing,” says Abhinav Chaturvedi, Partner at VC firm Accel.

Herd mentality also reared its head. As venture deals stacked up, capital influx did not discriminate between the quality of companies and peer benchmarking increased, tech-savvy youngsters were encouraged to take risks, and a lot of talent crossed over from traditional companies to found start-ups. Consequently, a phenomenal number of start-ups emerged. Add the exponential pandemic-induced digital acceleration of businesses to the mix, and you have the recipe for an explosion of deals. Funding rounds were oversubscribed and start-ups were raising capital at all-time high valuations.

All of a sudden, the tap is drying up. A bunch of factors, mostly to do with global conditions and some local, too, has constrained the flow of money into India-focussed venture funds. Profits, unheard of as a considered metric, have begun to be looked at closely. Questions are being asked on the quality of start-ups being funded, and on the quality of due diligence being followed by VC firms. Questions are also being raised about the founders’ penchant to splurge on acquiring personal assets and lavish lifestyles, and the consequent breakdown of corporate governance norms.

Net result: despite VCs sitting on a massive pile of dry powder in India, investments have slowed.

How did the tide turn? That’s quite a story. As per Bain & Company’s India Venture Capital Report 2022, investments in India in 2021 grew nearly four-fold (3.8x) over 2020, faster than China’s 1.3x. Naturally, a degree of fear lingered about this bubble popping. That day came early this year when global tech stocks started to plummet. Historically, public market valuations govern private market valuations. In the case of two companies—one public, one private—with similar metrics such as product offerings, total addressable market, margins and customer acquisition cost, the private company is likely to fetch valuation multiples similar to that of its publicly traded peer.

After the US Fed instituted a string of interest rate hikes starting March 2022 to counter soaring inflation, marquee tech stocks began to fall sharply globally, forcing investors to reroute their funds to other attractive assets. Besides, many of the new crop of young investors that flocked the markets for tech stocks during the pandemic did not have the bandwidth or vision to hold on to their stocks long enough to ride a significant downturn. Consequently, unlisted tech start-ups, too, began to feel the heat in terms of growth and valuations.

The Fed has raised interest rates four times this year so far, which has significantly impacted capital inflows into emerging markets. Why? As ultra-loose monetary policies come to an end, the gap in interest rates in the US and emerging markets like India reduces, making the latter less attractive for foreign investors. Coupled with public market uncertainties and slowing of tech businesses with fears of a recession looming large, aggressive late-stage investors are cutting down on their private market exposure.

The developing situation forced several global investors, including SoftBank, General Catalyst, Coatue and Tiger Global to show restraint in new investments. For SoftBank, the poor performance of its tech investments was among the leading causes for the largest-ever quarterly loss—$23.4 billion—at its Vision Fund unit in the April-June quarter. The company marked down 284 companies in its portfolio during the quarter, which included hundreds of unlisted companies. SoftBank said it plans to trim its start-up investments by more than half. “In fact, our Vision Fund saw huge valuation loss. But unfortunately, unicorn companies’ leaders still believe in their valuations, and they would not accept the fact that they may have to see their valuation lower than they think. So, until the multiple of unlisted companies is lower than the multiple of listed companies, we should wait,” Founder, Chairman & CEO Masayoshi Son said after the earnings announcement.

With several global VC firms tightening their fists, the funding tap for start-ups has slowed globally and in India. As per data from PGA Labs, after three consecutive quarters of raising more than $10 billion, the total funding in the Indian start-up ecosystem fell by 46 per cent during April-June 2022 to $8.2 billion, from the peak of $15.2 billion in Q3CY21. The immediate impact of these factors has been on late-stage investments. As per PGA Labs, late-stage funding halved over the past six months—from $14 billion in the second half of 2021 to $7 billion in the first half of this year.

Unlike in 2021, investors are no longer scrambling over each other to write the largest cheques. They are taking their time to evaluate and undertake due diligence before making a commitment.

A closer look reveals tectonic shifts happening. In the thick of the funding frenzy, start-up founders were akin to kings. They had the luxury to choose from several investors and the expectations in terms of the rights they get, the valuation, the pace at which the transaction would be executed, and the level of commitment that the investor would need to demonstrate were founder-led. As the frenzy has cooled, the balance of power has moved to the investor. “When capital is scarce, the power dynamics would change. If you are losing money and you desperately need capital, the power dynamics will be very much in favour of the venture funds. They will put in structured clauses; there might be all kinds of acrobatics in the term sheets,” says Sameer Brij Verma, Managing Director of Nexus Venture Partners.

In the new scenario, investors are calling the shots and they sport a distinct view of the capital markets where deal negotiation dynamics and transaction structures of the past are changing. There is a more natural pace of deal-making, lower valuations, and liquidity preferences that determine the order and amount an investor gets paid in the event of an exit. “The negotiation position is always driven by the transaction dynamics. In 2021, transactions were oversubscribed in many cases, so the founders used to push harder for favourable positions. In 2022, deals are not as competitive, there is more balance. You will not see rounds being closed in a couple of days. Rather, you will see investors doing more work to ensure they are completely comfortable with what a potential investee company is doing and who their founders are,” says Manav Nagaraj, Partner, General Corporate at Shardul Amarchand Mangaldas & Co.

Investors and analysts also say the slowdown would lead to an increase in specific clauses such as redemption rights, which provide investors the right to force a company to repurchase its own shares after a specified period of time; clawback provisions, which allow investors to take back vested equity if founders quit or are fired; ratchets, an anti-dilution mechanism to protect early-stage investors from dilution by subsequent fund-raisings at lower entry prices; and tranched funding rounds where VCs split investments into parts, allowing them to disburse funds over time instead of all at once to reduce risk. “For VCs, this situation is better because I don’t have to negotiate so hard, [and] the starting points are automatically more sensible. People who see the light of the day can actually talk very openly about what will and will not be acceptable, and where we can actually close the transaction,” says Sandeep Patil, Partner and Head of Asia at QED Investors. Such a measured approach has had its impact. Deal valuations are decreasing, founder dilution is increasing, contract structures are changing, more things are coming into reserved matters, governance is becoming stronger, and marketing spends are coming down.

There are more nuances. “Resetting is not just about price discovery and valuation. We are also seeing structures where both sides (founders and investors) are beginning to take chances on future growth. On deals that require large founder dilutions, both the parties are looking at innovative models to see if there can be some sort of clawback provision or milestone-based incentive to increase founder shareholding within a pre-determined point of time. Of course, these are structured within the parameters of the law to ensure that if the company does better than expected, all the stakeholders in the company are rewarded,” says Nagaraj.

QED Investors’ Patil says start-ups with a long-term vision should not worry about diluting more in a cycle like this. “As long as you are building towards a long-term vision, it is fine if you have to compromise a little bit on ownership today because in tomorrow’s round, you will be able to claim that ownership back. Do it because the end state is still worth it. The terms may not be exactly as delightful as you wanted them in 2021, but terms are exactly that, they are terms till the next round happens and then they get changed. It is a transient matter. If the goal is worthwhile, terms are just a temporary effect.”

There is now a greater degree of emphasis on governance. Cap table structures, terms of ESOPs, and terms of management and employee incentives are important discussion points that are finding their way into the documentation process. The time taken to close a transaction has significantly increased. “Governance standards are being very, very clearly articulated upfront… global governance standards are beginning to find their way into early-stage companies,” says Nagaraj.

Investors are also looking at cost structures of start-ups, ensuring that luxury expenses are cut down before making a financial commitment. An increased degree of realism is expected in business models. “We do see more realism on the terms of deals, capital being raised and also a greater focus on unit economics compared to 2021. We feel this phase may lead to much healthier businesses getting built, thus being a net positive for the ecosystem,” says Mayank Khanduja, Partner, Elevation Capital.

Verma says Nexus advises its portfolio companies to focus on getting to positive unit economics, be capital efficient, and try to have enough runway for 30 months. “If there is an opportunity to raise money, do it at fair valuations. Don’t worry too much, just be very realistic and look around opportunistically for smaller companies to buy, which can be strong additional teams,” he says.

The slowdown is also partially due to the absence of late-stage companies from the funding market. Most leading growth and late-stage start-ups have capitalised, some over-capitalised, during the high of 2021. They are now focussed on building businesses and do not want to go to a market where valuations are constantly questioned. They are also exploring M&A opportunities.

The capital story is resetting, and so is the talent side. People are finding safety in ongoing jobs, and potential founders are shelving their start-up plans for a better day because capital has shrunk and the talent war has reduced.

Vishal Gupta, Managing Director and Partner at Bessemer Venture Partners, says it is less expensive to build a company today than two years ago. “All corrections are great… a lot of businesses become successful post every correction because it is a great time for businesses as talent is better priced. Aggressive investors leaving the market doesn’t mean the opportunity does not exist. It means that you could invest at more reasonable prices, which is great for investors and founders. For founders, when you raise too much money at too high a valuation, the pressure is immense to be able to continue to perform and continue to grow the valuation; it is not easy. When the pace becomes higher, continuing to do that on a sustainable basis becomes harder and harder,” he says.

The lack of capital also discourages copycats and imitators, which is good for founders. A corrective cycle is the time when good companies get more customer attention because everyone’s marketing budgets are down, and customers don’t have as many distractions. It’s also an opportune time for start-ups to get genuine feedback, which helps them build genuine products.

Nexus’s Verma says investors with long-term views on India and committed teams on the ground would continue to get bigger and better as they would have built the muscle memory on how to address a slowdown and the investment professionals would get more mature.

Patil of QED Investors says the cycles will change and balance will favour good founders eventually. “As a founder, you need to find genuine merit in what you’re building; what you build should fill a value gap. Have a clear vision on how long it would take you to build this solution and scale to a meaningful level. Define or build a hypothesis on what the end state looks like and think through the pathway. When you are thinking of a journey of five or 10 years, then the current capital situation is just a cycle that you are living through. Today, the balance is not in your favour, it’s in the favour of investors. Tomorrow the balance will shift again because ultimately it is a cycle,” he says.

The good news is that the capital pool targeting Indian start-ups is pretty solid. Unlike the previous cycles—the 2008 global recession or the e-commerce bust of 2015-16—Indian VC funds today have a substantial war chest at their disposal. As per data from Venture intelligence, investors have raised $10.2 billion in the past two and a half years with $4.7 billion coming in just the six months of 2022. It means good quality firms can actually become more accessible to some of the investors in this cycle simply because investors would have found it extremely hard last year to get allocation in good companies.

“At the end of the day, investors who have raised capital will also have to deploy. There may be a slowdown for one or two quarters as many companies have already raised capital, but things will change soon. There will be some degree of clarity in one or two quarters in terms of how the overall external environment and overall public market is going to behave. Based on that, investors will start investing very actively,” says Varun Gupta, Executive Director for Digital & Technology Investment Banking at Avendus Capital.

There is no ideal situation to financial cycles, and there is also no perfect balance when it comes to venture capital. A little bit of excess capital in the system is good because more start-ups get funded, which encourages more innovation. A shortage of capital is also good because it enforces more discipline. Therefore, what is really ideal is to go through both cycles.

There’s just one caveat: only the fittest survive.

@binu_t_paul