Startups wait for spring: Funding winter appears over but challenges ahead

After battling funding winter and scandals, the sector focuses on profitability

Inflated valuations, corporate misgovernance, cash burn, and the so-called funding winter were some of the defining trends in the Indian startup world in 2023. However, what could be perceived as a tumultuous year for the country’s startups was also a year of silver lining and sobriety for founders and investors alike.

The calendar year (CY) 2023 saw a series of valuation corrections, and several startups turned profitable after prolonged periods of losses.

Increased focus among startups and founders on governance and improving margins is again driving bullishness among investors as markets continue to recalibrate in CY 2024.

As such, funding and deal volumes are expected to show a resurgence as macroeconomic (macro) headwinds subside.

Funding resurgence & dry powder

Global macro headwinds and increased investor scrutiny, due to corporate governance lapses among several startups, impacted deal volumes during the past year.

However, a tilt towards achieving profitability, both on the part of founders and investors, has imparted some much-needed sobriety to the country’s startup world, said industry watchers.

While the number of deals took a hit, the bullishness of investors towards the Indian market remained, as evidenced by the unprecedented levels of dry powder raised by India-focused funds.

India-focused fundraising recorded the second-highest dollar value of funds at $15.9 billion in 2023, adding to the country’s growing pool of unallocated capital. The number of funds successfully raised also reached an all-time high of 102, according to the EY-IVCA (Indian Venture and Alternate Capital Association) report.

With almost a quarter gone by in 2024, this unallocated capital is expected to be deployed into startups with proper business models gradually. Deal volumes are also expected to revive, although not at the frenetic pace of previous years.

According to Sanjay Nayar, former chairman and chief executive officer of KKR India and now founder and chairman of Sorin Investments, startups will not be able to raise capital at unrealistic and inflated valuations as investors are now more focused on proper business models, paths to profitability, and the quality of founders.

“People want to cut cheques. It’s just that they are more discerning. But for good quality, founders and companies will be able to attract capital,” he said.

Nevertheless, investors are of the view that the Indian market provides opportunities that other markets do not.

“The geopolitical macro is in our favour. India’s sweet spot, which many people miss, is liquidity. You can build startups that consume a lot of money, but also ones that give back a lot of money to investors,” said Prashanth Prakash, partner, Accel, a venture capital (VC) firm.

“We (investors) now spend a lot of time in West Asia and Southeast Asia. But no other country has that flywheel of great entrepreneurs, enough funding, public market exits, and a supportive government,” he added.

Generative artificial intelligence, climate technology, and financial technology sectors are some of the hot bets that founders and investors at the world’s largest VC firms are expected to pursue next year, Business Standard reported earlier.

Other such areas include electric vehicles, space technology, cybersecurity, logistics, and supply chain.

In 2023, Indian startup funding fell an immense 72 per cent year-on-year (Y-o-Y) to a seven-year low of $7 billion. This compares to $25 billion that startups raised the previous year, according to data from Tracxn, a market intelligence platform.

However, this trend was not limited to VC. Other funding instruments, like private equity (PE), also witnessed funding crunch.

PE/VC investments in India fell 11 per cent Y-o-Y in CY 2023, from a total of $56.1 billion across 1,273 deals in CY 2022 to $49.8 billion across 854 deals in CY 2023, primarily due to a 33 per cent drop in deal volume, according to the EY-IVCA report.

“The year 2023 was slower in terms of total capital deployment. It has also been a much-needed sobering period for the VC ecosystem, after an unprecedented influx of capital in 2021. Late-stage capital, particularly from the US market, has not been very active this year,” said Ashish Kumar, co-founder and general partner at The Fundamentum Partnership, a growth-stage investment firm.

Challenges

Funding pangs aside, 2023 also saw several instances of corporate misgovernance pop up among startups like BharatPe, GoMechanic, Trell, and Zilingo, among others.

More recently, issues at huge startups like Byju’s and Paytm have also shaken up the startup world.

“These are bumps in the road,” said Sanjeev Bikhchandani, a serial investor and co-founder of Info Edge (India).

The recent incidents of corporate misgovernance, Bikhchandani said, are isolated incidents that do not have a bearing on India’s growth story.

“Ninety-nine per cent of Indian founders and startups are honest, well-governed, and compliant. We will see many startups coming up that are viable and sustainable, with proper governance,” he said.

Regardless, investor scrutiny has considerably increased as a result of such incidents. The time taken for investors to carry out due diligence has shot up, which has, in turn, affected deal volumes.

“The time taken for legal and financial due diligence has gone up considerably due to several cases of misgovernance that have been popping up. That period has gone up from two months to almost three to four months. On average, the time taken for deals to go through has gone up by 60–70 per cent," Fundamentum’s Kumar said.

Bikhchandani believes that the increased scrutiny is a positive for startups.

“Increased investor scrutiny must be there. It leads to better governance. As companies grow larger, there will be more investor scrutiny. It is natural,” he explains.

The availability of domestic capital is another pressing concern for the country’s startups.

“The need for funding among Indian startups far exceeds the availability of domestic capital. For the foreseeable future, we will be largely dependent on foreign capital in the VC industry. But the pool of Indian domestic capital will grow side by side,” Bikhchandani said.

Although most of India’s startup funding still comes from foreign investors, investors say that the share of domestic capital has been on the rise.

“A lot of our partners are domestic funds, which is a lot more now than what we would have seen three or four years ago. My view is that it will balance out in the next four or five years,” Prakash of Accel said.

Silver lining

While lingering concerns remain, last year was also one of the silver linings.

The year 2023 did provide investors with lucrative exits, even if it did not prove very fruitful for startups from a funding lens.

PE/VC exits in India surged by as much as 36 per cent Y-o-Y to $24.8 billion in 2023, up from $18.3 billion the previous year, the EY-IVCA report said.

Open market exits, comprising 52 per cent of the total exits, reached a record high of $12.8 billion, while buoyant capital markets enabled the second-best year for PE-backed initial public offerings (IPOs). Public listings numbered 30 in 2023, up from 18 in 2022.

This trend of exits is expected to continue into the new year. Positive macro conditions and a focus on profitability by startups have driven bullishness on public market debuts.

As many as 14 startups that are eyeing IPOs this year are pulling out all the stops to ensure successful debuts on stock exchanges.

A total of five companies went public in 2023, up from three the previous year.

Another prominent trend likely to play out in 2024 is an increase in the prominence of alternative asset classes.

“The industry is anticipating a strategic shift in investment approaches, a rise in sectoral focus, and a resurgence in alternative capital investments after elections,” said Rajat Tandon, president, IVCA.

“As we look to the future, with policy continuity after general elections and a high level of dedicated dry powder, India is poised for an upswing in PE/VC investments, signalling a convergence between seller expectations and buyer valuations,” Tandon added.

While traditional VC has become a bit harder to come by, founders are also looking towards alternative asset classes to meet their funding requirements.

Alternative avenues of funding, like venture debt and revenue-based financing, among others, are gaining prominence.

According to a recent report by alternative debt provider Stride Ventures, Indian startups cumulatively raised $1.2 billion in venture debt investments across around 175–190 deals last year, a 50 per cent rise from $800 million raised across 170-180 deals in 2022.

It is, however, important to note that venture debt and other such categories are much smaller compared to equity funding.

A recent phenomenon in the Indian startup ecosystem, venture debt registered strong growth on the back of a relatively smaller base.

The rise in prominence of alternative asset classes, the increased focus on measured growth, and an emphasis on proper governance are expected to give way to a pleasant spring for Indian startups, offering some much-needed respite from the chills of the funding winter.