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Zombie Start-Ups Give Investors The Shivers

Continuously raising funds, being top-heavy in terms of talent and unable to generate enough revenues to meet costs, these start-ups are spooking investors with their inability to justify their valuation

Zombie Start-Ups Give Investors The Shivers
POSTED ON October 29, 2022 6:43 PM

With Halloween around the corner, folks are busy finding innovative ways to spook their friends and family. The zombie avatar remains a favourite go-to costume for scaring the bejesus out of people. 

The start-up ecosystem, too, is seeing its share of zombies, which is unnerving many investors. The ongoing funding winter has seen many promising entities decelerate into zombie start-ups as investors take a cold hard look at companies' business models and growth potential before signing a cheque.  

But what exactly are zombie start-ups? 

As the name suggests, these are the walking dead in the sector. Or, to be specific, these are companies that raised funds at very high valuations but could not generate commensurate revenues or intrinsic intellectual property (IP)-led value against the capital raised. Typically comprising of late-stage start-ups, their characteristics include high cash burn, blotted headcounts and unsustainable unit economics.  

Once the external funding dries up, their growth rate stalls and their business model cannot sustain the company's organic growth. 

Elaborating on this, Dhianu Das, co-founder of Agility Ventures, claimed that during a boom period, many entrepreneurs raise more than they expect without having a definite business, growth plan or strategy to use the funds. "They generate revenue, sometimes breaking even, but not enough to generate a return for investors," he added.  

Spookfest In Start-up Sector  

Just like their lurching walk gives away zombies in movies, in reality, such start-ups can also be spotted easily by the keen-sighted. They often fail or delay the launch of new products, have little to no web traffic or sales in a year's time frame, and frequently downsize teams and space. Das added that these entities are often solely focused on raising funds successfully.   

Dhianu Das, co-founder of Agility Ventures
Dhianu Das, co-founder of Agility Ventures

According to industry experts, zombie companies are common when a downturn or recession follows a funding boom. This phenomenon was last noticed during the dot-com bust in 2000 and the 2008 global financial crisis. 

While Ankur Mittal, co-founder of Inflection Point Ventures has been seeing zombie start-ups more in the late-stage market in India; a situation he pegs down to the evolution in the ecosystem where a much-needed correction in terms of valuation and funding rounds is taking place. "It is due to this correction that many start-ups and founders are realising that they are headed towards the zombie phase," he added.

At the same time, he noted that the early-stage funding ecosystem is still thriving with an influx of innovative start-ups and good valuations. "As a healthy pipeline grows in the early stage, with a focus on sustainable and growth-focused business, the rise in the number of xombie start-ups in the late stage can be curtailed," he added.

Talking about this trend, Pratip Mazumdar, partner at Inflexor Ventures said, "When capital is abundant and easy, start-ups raise funding without working out if there is a need for it. This bloated cash balance incentivises some companies to engage in unsustainable business models. Once the funding environment dries up, such companies cannot sustain their business operations. Quite a few are expected to face challenging times, especially in sectors such as edtech, virtual events and kirana-tech space."  

Highlighting how the once alive-and-thriving companies can suddenly turn into a zombie, Das cited the example of Terra Luna. In May 2022, its market cap bottomed out by almost 100 per cent to touch $500 million from over $40 billion. Once touted as amongst the ten most valuable cryptocurrencies, it cruised at around $1 in May 2022, compelling crypto exchange Binance to temporarily suspends withdrawals on Terra.  

"We can expect to see some zombie unicorns in future with no business models. They may not be dying, but they will become irrelevant," Das added. 

Amit Kumar, senior partner at Ah Ventures agreed that there are many zombie start-ups in India across all sectors, as the country witnessed a funding boom in 2021, though he was unwilling to share their names. "Zombies may not die but fail to make the cut to the top and remain a mediocre company. It may become imperative for founders to cut costs or pivot to make the business successful and maximise returns for the investors," he suggested.  

Racing On A Short Runway 

Quantitative easing and low-interest rates are the primary reasons why start-up founders often become overcapitalised with a short runway, ultimately ending up as a zombie start-up.

This situation is compounded by the herd mentality exhibited by investors, leading to fierce competition among the founders for funding deals. 

Amit Kumar, senior partner at Ah Ventures
Amit Kumar, senior partner at Ah Ventures

The race to the top often sees start-up founders falling prey to the pressure of creating meaningless growth and burning cash to get sales. 

Mazumdar explained, "This leads to valuations of many start-ups running ahead of their business fundamentals. Founders who could not achieve a clear product-market-fit (PMF) incurred bad capital allocation decisions exhibited by unrealistic spending to drive short-term customer acquisition, incurring unnecessary costs in terms of operations, headcount and resources. When the markets inverted, some found themselves without enough runway." 

Caution! Zombie Start-up Ahead  

With the ongoing funding winter, it is quite natural for start-up founders to wonder whether they will join the league of zombies. However, experts believe they can avoid this by mixing realism with foresight.  

Mazumdar claimed that while smart founders raise capital ahead of time, they are pragmatic to understand that easy capital availability is not sustainable.  

"They are rational and keep in mind that the primary objective is running a business while building solid business foundations that can weather the economic storm. They ensure the right capital allocation and keep costs in control," he added.  

What goes up must come down. Hence, keeping a lean team and being conservative on acquisition costs are the key things to keep in mind while building and raising funds for a start-up. 

Das suggests that they should target to hit 20 per cent month-over-month growth on meaningful metrics. They should also have a clear road map that utilises the team's capacity and capabilities. This will secure their future in the land of living and thriving start-ups. 

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