Why VCs and PEs think funding winter is good, and will end the “drunken” over-investing

We’ve all heard about the startup “funding winter” of 2022 that has seen deals slow down after 15-18 months of frenzied activity. Reams have been written about the pros and cons, and how long the winter could potentially last.

At an industry conference organised by IvyCap Ventures, a bunch of venture capitalists, private equity, and strategic investors argued that a funding winter may, after all, be “healthy” for India’s startup ecosystem. It could not only end the “drunken” over-investing and irrational hyper-valuation of companies that defined the last two years, but could also lay the foundation for more principled, well-governed, and sustainable businesses that have a clear path to profitability.

Prashanth Prakash, Founding Partner, Accel (a pioneering early-stage VC fund in India) said, “There is now a realisation that the honeymoon of the Indian venture fund era is over. Companies have to start returning capital to their investors. There is no M&A market in India unlike in the US. If IPO is the only exit option, behaviour is being defined by that. Equity markets becoming a part of the VC industry is a big wake-up call.”

Batting for business merit more than vanity metrics, Prakash added, “There is a need to make sure that the best companies actually win on the merit of their execution and fundamentals rather than be unfairly elbowed out because of excess capital in the market. Winter is good for the ecosystem.”

Prakash also said that Accel has tried to be “the less drunk in this exuberant ecosystem” that saw VCs reward hyper-growth startups with sky-high valuations and fancy term-sheets, often at the cost of unit economics, product-market-fit, and other fundamentals of business.

Echoing him, Manish Kejriwal, Managing Partner, Kedaara Capital (a homegrown PE firm) said, “For us, it is an excellent time because finally, we’re relevant. We old-world PE types do due diligence for 6 months before we invest and we are relatively painful to deal with. Last year, we were uncompetitive because somebody [investor] came in and said we won’t do due diligence and gave 20 per cent more [capital] than us. And we lost some deals.”

“The exuberance has gone and we are back to reality. That is where we flourish. This is VC getting back to the humility of the PE ways,” he added.

Why the fuss about the winter though? Isn’t it cyclical for the ecosystem?

“It was a long time coming,” said Ruchira Shukla, Head for South Asia, Disruptive Technologies – Direct Equity and VC Funds, IFC.

She elaborated, “We should have expected this. The kind of free cheque writing that was happening was not sustainable and cash burn was totally ignored. That was not healthy for the ecosystem. Winter is actually a good thing for investors. We want the pricing to be right and the companies to be well-capitalised, and that is what separates the grown-ups from the kids on the block. Yes, there is a slowdown, and it will make everyone more rational and grounded.”

Change in Perspective

Because of the funding winter, the ecosystem has gone from looking at GMV multiples to revenue multiples, and, for the first time, “I hear people talking about gross margin multiples,” IFC’s Shukla shared. “Investors are becoming more demanding. People are once bitten twice shy. There will now be a lot more scrutiny on founding teams and their ability to run a ship,” she added.

Despite the comparatively slower deal activity, good companies will continue to raise capital. “Last two years were completely out of whack. Lot of companies were over-capitalised in the last 12 months. 70 per cent of the ecosystem raised so much pre-emptive capital because it was available cheaply. We are just getting back to reality,” said Puneet Kumar, MD, Steadview Capital.

He further shared, “Right now, the public markets are completely driven by macro factors, and as an investor, it is humbling. Tech was always seen as a counter-cyclical industry driven by growth. But now we realise it is not, and it is as much linked to macro and the monetary policies of countries, and so on.”

All investors agreed that even though the investing hyperactivity may have halted for now, there’s a lot of capital waiting to be deployed in Indian startups, especially because China has slowed down.

Kejriwal of Kedaara Capital explained, “We have a plethora of new capital coming into India – from pension funds to sovereign funds, whether it is Japanese money or Middle Eastern money. Large LPs had 80 per cent of their portfolio in China earlier. Their asset allocation has changed from 80-20 to 50-50. All the large PEs from Bain Capital to TPG have done that. They have a China+1 strategy and India is benefiting from that.”

In the last decade and more, every funding slowdown has been followed by a period of rationalisation. And this would be no different.

“There is a lot of dry powder [liquid cash in the VC ecosystem] but everyone is more cautious about how they deploy their capital,” said Payal Goel, Principal (India & SEA), Google Corporate Development. “A lot of VCs are now selecting their bets carefully and doubling down on those, while writing off the ones without sustainable economics. That is good for the ecosystem,” she added.

Balancing growth versus profitability will remain the core challenge for both startups and investors in this new funding normal.

Accel’s Prakash sums up aptly, “You cannot accept shortcuts because you want returns. That will come back and bite you someday. Early indicators of becoming a unicorn do not matter in the long run. What matters is can your company generate enough profits for another decade and return money to your investors?”