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RBI Says Funding Cash Crunch, Global Macroeconomics Issues Continue To Pose Risks For Indian Startups, But Is it Just That Or Is The Venture Capital Ecosystem Equally To Blame?

RBI, Startups, Cash Crunch, VCs

The Reserve Bank of India (RBI) has highlighted in its Financial Stability Report for June 2023 that Indian startups are facing risks due to the cash crunch and uncertain global macroeconomic conditions. These factors may lead to a correction in the valuations of these startups.

“Tighter liquidity conditions, uncertain global macroeconomic outlook, and geopolitical fragmentation continue to pose risks that may trigger correction in valuations of these firms (startups) and a wave of consolidation,” said the central bank in the report. 


RBI’s View On Indian Startups

The Indian startup ecosystem has been grappling with global macroeconomic challenges and the ongoing Russia-Ukraine conflict since 2022. This has resulted in a severe funding shortage. In the first quarter of 2023, Indian startups managed to raise only $3 billion, compared to $12 billion during the same period last year.

The decline in funding during the first quarter was a significant 75% year-on-year (YoY), and the number of deals plummeted by 58% YoY to 213. The downward trend continued in May 2023, with funding and the number of deals dropping by 37.5% and 32% YoY, respectively.

The scarcity of funding has also resulted in substantial job cuts across the Indian startup ecosystem. Since 2022, more than 100 Indian startups have laid off over 27,000 employees. Even global tech giants like Amazon, Google, and Meta have not been immune to the slowdown, as they, too, have resorted to employee layoffs.

As a consequence of the challenging environment, the Indian startup ecosystem is experiencing a wave of consolidation, with major players acquiring smaller ones. While PhonePe had to abandon its acquisition plan of ZestMoney due to diligence concerns, Aurum PropTech is acquiring NestMoney for a mere $11 million. Other notable acquisitions include VLCC’s purchase of Ustraa, the Adani Group’s acquisition of Trainman, and CRED’s acquisition of Spenny.

RBI, Startups, VCs

Listed Startups Feeling The Heat

The slowdown has also impacted the performance of listed new-age tech startups such as Zomato, Paytm, PB Fintech, Nykaa, and Delhivery. The stocks of these companies have witnessed a decline, and major investors like Tiger Global and SoftBank have started offloading their stakes in these firms. The RBI report attributes this caution among investors to lacklustre stock market performance, particularly for new-age tech companies that heavily rely on foreign capital and are exposed to risks from tightening global financial conditions.

However, these stocks have shown signs of recovery in recent months, driven by changes in investor sentiment following their positive Q3 and Q4 FY23 results. For example, Zomato shares are trading over 26% higher, Paytm has seen a 60% increase, and Delhivery has gained over 16% year-to-date in 2023.

Valuation Markdowns

The adverse conditions have also prompted many prominent investors to mark down the valuations of Indian startups in their portfolios. Invesco reduced the valuation of food delivery major Swiggy twice this year, from $10.7 billion to $5.5 billion. Vanguard Group decreased the value of ride-hailing unicorn Ola by 35% to $4.8 billion. Neuberger Berman also marked down the valuations of two Indian portfolio startups, PharmEasy and Pine Labs.

Moreover, Prosus recently slashed the fair value of BYJU’S, which is facing multiple challenges, such as a debt crisis and investor pressure, to $5.1 billion. Earlier, BlackRock also marked down its valuation by 61.9% to $8.36 billion.

It’s important to note that the funding crunch and cautious approach of venture capitalists have impacted startups worldwide, not just in India.

Blame on Founders and VCs, Rooted in Overestimation of Indian Markets

The corporate governance issues within Indian startups are expected to escalate over time, and while founders often face blame, the venture capital (VC) ecosystem should equally share responsibility. The underlying cause of this problem lies in the overestimation of the size of the Indian markets by both founders and VCs.

India is undoubtedly a fast-growing economy with the potential to become an economic superpower in the future. However, the current reality does not match these aspirations. The target market, Total Addressable Market (TAM), in terms of revenue, needs significant expansion to justify the valuations of the startup ecosystem in the country. 

Indian Startup Miscalculation, VCs

It seems that many VCs have miscalculated this aspect (TAM) and potentially exaggerated the Indian opportunity to their investors and limited partners (LPs). In a relatively small market like ours, with limited end M&A opportunities, achieving substantial exits within a seven-year timeframe is challenging.

The life cycle of a fund expects founders to deliver exits, but building a resilient business in India requires time. It is rare to witness such success within a span of fewer than ten years. Considering that funds typically operate within seven-year lifecycles and push startups for exits within that timeframe, it becomes difficult to establish a solid foundation for a sustainable business.

Perhaps the fund lifecycle in India should be longer. Observing the ecosystem’s tendency to sell stories to their limited partners, founders are compelled to present narratives that attract funds. Unfortunately, many startups have secured funding based on decks that were almost delusional. Ideally, the VC ecosystem should help rectify such unrealistic expectations rather than fuel them.

For instance, there have been cases where startups claim that 30 to 50 crore (300 to 500 million) Indians will be investing by 2027, with aspirations of capturing 10% or more of that market. Such claims were made when the number of Indians filing income tax returns was considerably lower. 

Instead of blindly funding such ventures, investors should have questioned the validity of these projections. This exemplifies the illusory truth effect, where repeated exposure to false information leads to its acceptance as truth. 

Believing in a TAM that does not yet exist and relentlessly chasing it is a fundamental cause of governance issues both presently and in the future, which may not be resolved conventionally.

Although founders should not be excused for overselling their businesses to raise capital, as Charlie Munger aptly states, “the outcome is a reflection of the incentives at play”. If the incentive is to consistently oversell, the current situation is an unsurprising result. 

Therefore, the blame should not solely rest on the founders but also on the VC ecosystem that fueled this environment. This discussion holds significance because India requires a steady flow of continuous capital, rather than sporadic bursts, to realize its potential as an economic superpower. 

If investments are made, and businesses are built with incorrect expectations, resulting in misleading narratives, it can hinder the flow of capital and reduce the odds of achieving this goal. 

Historically, euphoric situations have led to excesses, such as the dot-com bubble of 1999-2000 and the real estate and infrastructure boom of 2006-2008.

The Last Bit, the overestimation of Indian markets, accompanied by misreporting and overselling, has contributed to corporate governance issues in Indian startups. While founders bear some responsibility, the VC ecosystem must also share the blame. To foster sustainable growth, it is crucial to align expectations, ensure transparency, and promote responsible investment practices within the startup ecosystem.


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