Putting things in perspective in the Indian startup ecosystem

Welcome to this edition of Hedwig—a newsletter that gives you a bird’s eye view of the Asian startup and investor community. In the final part of the VC edition of Hedwig, we will look at the Indian startup ecosystem—how it has fared and what to expect.

Late last month, Zinnov and nasscom published the India Tech Startup Landscape report for 2022, with some very interesting findings 

• India has 25,000-27,000 active tech startups—the ones that were founded between 2012 and 2022 and managed to survive multiple ups and downs

• Over 5500 of these startups have raised a total of US$73 billion in funding till 2022

• India currently has 89 unicorns, of which 23 joined the elite club last year

• VC investments in Indian tech start-ups dropped 24% to US$18.2 billion in 2022, and two-thirds of this funding went into non-unicorns

• 1400 unique start-ups were funded in 2022, 18% higher than a year before

• 1.6X increase in unique and active VC and PE firms, compared to 2021

• 18% of all start-ups, and 20% of all unicorns, have at least one-woman founders

In 2023, local tech startups are expected to grow sustainably, even though the year has started slow for the start-up ecosystem, the Nasscom-Zinnov report notes.

Well, speaking of 2023, the mood in the startup ecosystem isn’t that great indeed.

If you just google Indian startup funding in January or February, you will be flooded with headlines highlighting funding drop, slump, and fall. Not a single startup has yet reached a billion-dollar valuation this year. Besides, different media publications have mentioned different funding numbers, which makes the startup scene all the more confusing. 

We will go with the numbers published by DealStreetAsia, which collates data for all Asian markets. Indian startups raised a total of US$1.15 billion in January and US$866 million in February from VCs and PEs, compared to the US$1.25 billion and US$1.3 billion they received from investors in December and November, respectively, last year. So there has been a gradual decrease in the past few months. 

In fact, this downward trend has continued since the last quarter of 2021. In the last quarter of 2022, startup investments went up, but only compared to the quarter before. 

Source: DealStreetAsia

One thing stood out in February 2023 though: Growth startup deals—series B and beyond—saw an uptick, raking in a total of US$367.6 million through eight transactions. This was 12% higher than US$327 million from 12 transactions in January. Meanwhile, early-stage deals continued at the same pace.

To make sense of what is happening in the Indian startup ecosystem and understand whether things are really as bad as they seem, The Content House spoke to Atit Danak, Partner and Global Head-Innovation & Start-up Collaboration at Zinnov.

The interview has been slightly edited for clarity and brevity:

How do you look at what happened in the Indian startup ecosystem last year? What are some of the things that stood out?

We need to see things in perspective. When COVID-19 hit in 2020, everybody expected doom because somewhere human behavior was not taken into account. In 2021, again, there was a lot of over-excitement for the same reason. 

People become pessimistic before bad things actually happen. Similarly, they become over-optimistic when they expect a rebound. That’s a classic speed gap problem. Besides, everyone starts saying what everyone else is saying, without looking at the data long enough to take a decision. This kind of ecosystem becomes an echo chamber.

So 2020 and 2021, both were exceptional years. As things began to change last year, we saw a lot of correction and a lot of normalization happening after two exceptional years. Consequently, 2022 became an exceptional year. 

That is why we have done our analysis in the context of 2019 and the 4-year average of 2019-2022 to normalize the data and see if what happened was really good or bad, and how worried or excited should we really be. 

Personally, I think whatever happened in 2022 has happened for the best. Any financial market, the faster it goes up, the faster it comes down. It's just the nature of the beast. 

In 2022, there was a fundamental correction in public market valuations and consequently in private market valuations. For startups, it was more of a financial valuation problem than a recession problem.

The other thing is, in 2021, there were a lot of things being done by startups, purely because their peers were acting and reacting in a certain way. The decision-making was not the most rational or thought-through from a spending perspective. And I think that was the biggest mistake new startups and investors made in 2021.

2022 is when the rationalization came that what happened was not correct. The baseline is shifting in terms of Indian entrepreneurs and investors becoming more aware that they should not get caught up in a wave without understanding the logic or the reasoning behind it. 

In the last six months, there has been a lot of chatter on profitability rather than growth. But there is still a very good chance that in 2024, that will be reversed when they start focusing on growth and not on profitability. 

The question is, will that change to the same level as in 2021? We don't think so. This time around, we believe, it won't be as bad as the previous years. I will call it one key change, which will happen in the coming months.

We are optimistic about 2023 because we believe this correction is for the best. 

What else makes you optimistic about 2023?

The public markets have started to turn, and the companies’ multiples are starting to reach closer to pre-pandemic levels. Right now, they are below the pre-pandemic levels, but still, people are more pessimistic than they should be, despite the growth rate being in the same range. 

Tech markets have also started to turn since October-November last year. Anyone who invested then has gained 30-40% on their tech stocks. And we are waiting to see how that shapes up by March end. 

The premise is, as soon as that happens, investors and founders will be a lot more confident about valuations. They will be able to sign deals and take decisions on investments and exits. Right now, founders are more worried about investor sentiments than market sentiments and market recession.

The third reason we believe the market will bounce back is that even during a recession, tech spending continues. In the US, a recession would mean, growing at 1.5% rather than 2%. And that would mean the tech spending would go down from, say, US$1 billion to US$ 0.8 billion. It’s just slower growth. Tech spending and the focus on digitization continue to be on the positive side. The fundamental premise that the world will adopt more technology, hence startups should be there, has not changed. 

Do you think if the market rebounds this year, we will see over-excitement again?

I don't think so. We'll see normalization. The challenge will be different. Fund managers are now competing with each other to give a certain internal rate of return (IRR) to their limited partners, and their focus is on selling the next fund. That's their simple playbook. 

In 2020, deployments (of capital in startups) were slow which means the IRR was impacted. In 2021, the problem was they invested at such a high valuation that some of their investments will be either written off or recalibrated. There again, they will have the IRR problem.

That is the reason why investors were very, very slow in 2022. They have to fix their IRRs, overall. But they are doing it in a world where they have access to a lot of capital. I think, while the correction is happening, investor sentiments will be very critical because if they become super aggressive again, we might see them going back to the 2021 behavior. 

My guess is it will take some time for them to solve for IRR. There'll be a lot of competition to make investments, but few VCs will offer better valuations compared to others.

The challenge for startups will be talent. How do you get the right people at cost-effective prices and keep them long enough to deliver value? Both on the engineering side as well as the marketing side. Because as investors look to improve their IRRs, the pressure to hit better business metrics is mounting.

Key takeaways from the Nasscom-Zinnov report

• The early-stage startup community is thriving. For context, in 2022, seed and early-stage investments rose 20% over a year ago period, 1300 new tech startups emerged, and 47% of VC investment deals involved a start-up raising the first round. 

• Startups are focusing on improving business metrics as well as on building relationships with investors.

• At least 70% of founders expect their revenues to grow in 2023.

• Startup investments are expected to be higher this year than the 5-year average due to the availability of dry-power, a strong funnel of seed and early-stage start-ups, rising tech spending by customers, and better clarity and confidence on market shifts.

• The competition for deals will intensify, with higher participation from Indian institutions.

• Deep-Tech, SaaS, and B2B will continue to attract more investments.

That’s all for the final part of the VC edition of Hedwig. For a periodic overview of different segments of the Asian startup ecosystem, subscribe to Hedwig.

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