Early-stage Funding the New Attractive Proposition For Indian VCs

The last few years have been no less than a roller-coaster ride for Indian startups. After a record high private equity-venture capital (PE-VC) investments in 2021, we saw total startup funding fall by 29 per cent in 2022. According to the Venture Intelligence report, PE-VC firms invested $46 billion across 1,261 deals in Indian companies in 2022, compared to $65 billion across 1,362 deals in the previous year.

Research firms are predicting the funding winter to last between 12 and 24 months. However, the decline is mainly seen in the growth and late-stage funding for Indian startups. Investors continue to bet on early-stage startups. Early-stage investments seem to be the new sweet spot for VC investments.

Investor interest in early-stage startups

“Funding winter usually affects more systemically important companies. In that sense, later-stage companies have a greater challenge than earlier-stage ones. The market is more demanding for later-stage companies to have strong unit economics, profitability, and controlled burn in times of crisis,” said Ganesh Rengaswamy, co-founder and managing partner, Quona Capital.

Investment in early-stage is today a safer choice since most late/growth-stage startups are burning cash and profits are nowhere in the picture. According to Entrackr, around 596 early-stage startups raised funds in H1 2022 as compared to the late/growth stage, which accounts only for 226 deals. One of the reasons

Sumegh Bhatia, CEO and MD, Lighthouse Canton, India feels that we will see funding play out based on both stage and sector of the startup. “While there is a lot of dry powder, certain sectors would find it easier to get funding than others. The reason for this could be two-fold, the positive/negative outlook on the sector, and the other being that in some sectors that received high volumes of funding in the last two years, many VC firms have already taken their bets and not made fresh ones,” he said.

Further, IPO is today a much sought-after route for existing investors in late/growth stage startups than funding rounds. “Given the track record of recent IPOs and subsequent share prices, there wouldn’t be a rush to get an exit via IPOs by late-stage startups. This sub-segment could be the most affected. Sustainably riding out this “winter” period would be of paramount importance,” he added.

Another reason for the shift is the scope of growth in early-stage investments. It gives them an opportunity to take the equity at a less valuation and then exit during the growth stage. This leads to higher returns.

Alternative sources of funds

We are also seeing the rise of alternative sources of funds. Many startups are looking beyond traditional capital sources to meet their working capital needs.

“When funding slows, companies tend to look to build additional capital buffer as a precautionary measure, and some look to delay equity fundraises till the time valuations become more valuable. This is where they usually turn to venture debt. Typically, more established companies have access to banks and various financial institutions for their debt needs. However, given that startups may not be able to demonstrate profitability, they are less likely to be able to raise bank loans,” said Bhatia, while claiming that Lighthouse Canton, India is starting to see more appetite from both startups and investors in the asset class.

Funding reset

Some analysts believe that this is not a funding winter. It is a funding reset that was in the making for some years now. “There is no funding winter. Startups with good founders/founding teams, strong execution capabilities, a viable business model, disruptive, unit economics, innovative products and services that meet the demands and aspirations of the market will always attract capital and continue to do so,” said Vinod Keni, managing partner, Indian Angel Network.

They believe that what we are seeing today would have happened even without the economic downturn. “The pace of investments over the past 2 years was an aberration and not sustainable, especially investments in startups with unviable business models,” he added.

India is today the third largest startup ecosystem in the world, with more than 84,400 such businesses operating across 656 districts in the country. The evolution of the startup ecosystem in India started after the Great Depression in 2008. The crisis led to the emergence of companies such as Flipkart, OYO, and Ola.

However, over time, unit economics, profitability and growth took a backseat. Today, the focus has shifted back to the right business metrics.

I think what is happening in India right now is just an investment view re-set i.e., Indian funds or funds focused on Asia/India are sitting on large corpuses and are recalibrating their investment strategies, said Kapel Guptaa, director – finance, MegaDelta Capital.

“This has meant that deal cycles have become longer with funds demanding a lot more validation on business metrics, unit economics, growth, and exit path before committing additional capital without being fearful of a global hedge fund coming in and writing out a cheque quickly. By design, such validation is sought more for larger/later stage start-ups and not as much at the seed stage and therefore impacts later stage startups more in their fundraising,” he added.

Market correction is the norm today and early-stage startups with innovative business models are having the last laugh. They are not only benefiting from an uninterrupted supply of capital but they are also being forced to create no-burn models. They are going to be the next wave of startups that will focus on demonstrating success that can be sustained through good and bad times.