The year 2022 was full of ups and downs for private equity (PE) and venture capital (VC) investors. The challenges posed by inflationary pressures, worries about economic recession, and uncertainty due to geopolitical factors impacted investments, exits, and fund-raising globally last year.
This global slowdown impacted start-ups' growth and funding in the country after a blockbuster year for VCs in 2021, as low-interest rates drove vast sums of money into their funds. In early 2022, it seemed that the flow of capital to Indian start-ups would buck global trends. However, things turned dreary by the second half of 2022 as the funding tap narrowed to a trickle.
Few investors continued their funding plans, believing the global slowdown would help founders focus more on building and strengthening their core business.
According to a report by Praxis Global Alliance, these investors pumped in around $41 billion across 1,350 deals in 2022. The India Investment Pulse Report noted that PE/VC funding is expected to reach $150 to $170 billion by 2027, with a ratio of PE/VC deal value to nominal GDP expected to reach 3 per cent.
Typically, VCs make money when the valuation of their investee start-up rises. This valuation is dependent on revenue and multiple. If the start-up's revenue doubles within two years, its valuation doubles, provided the multiple remains the same. This was the basis of many founders pursuing the growth-at-all-costs strategy, even if it meant cutting corners.
One reason the deal activity has started slowing down is that investors now want to be sure they are putting capital in fundamentally strong businesses where founders are clearly focused on unit economics and the path to profitability. In short, they simply raised the bar regarding the qualifications of investment opportunities and are no longer swayed by vanity metrics in the pitch deck.
A Cautious Approach
Typically, VC investments in early-stage growth-focused start-ups tip over on the riskier side. As a result, there are uncertainties over such organisations' risk-reward potential and future performance. When a VC investor bets on a company's growth potential, there has to be a certain level of exposure to risk.
Market, liquidity, exit, etc., are some of the critical external risks that VCs manage regularly. Now they are increasingly looking to reduce these external risks and prioritise factors that they can control.
Neha Singh, co-founder of Tracxn, says that overseas investors have become more cautious due to the current market conditions. "These funds had to incur significant losses in 2022 due to the sharp decline in the valuation of tech companies on both the public and private markets, as well as the underperformance of their investments in China. Some foreign VC firms have reduced their investment activity in Indian start-ups and are now focusing on businesses with strong fundamentals and promising future growth."
The VCs are also pulling out all stops to ensure that their portfolio companies utilise the investment to its fullest potential while practising fiscal responsibility to avoid excessive burn rates. Global limited partnerships (LPs) and general partners (GPs) were also concerned about the indifference towards due diligence processes and the high-burn model that many start-ups followed to capture the market—all in the hope that they would eventually be able to make a profit from the customers. A large market size does not always lead to a high propensity to spend and repeat purchases.
One founder anonymously revealed that the extent of due diligence in start-ups has tripled from 2021 when he raised seed funding. Today, there are a series of conversations about auditing, where PE/VCs are engaging with founders about the audit feedback rather than accepting it at face value.
Shashank Randev, co-founder of 100X.VC, a VC firm that invests in early-stage start-ups, notes that only the best companies will survive in a competitive investment ecosystem. Hence, founders must proactively know how to use capital to achieve excellence.
"Investors must also consider that their portfolio companies may be unable to secure more funding. Therefore, it again becomes crucial for founders to conserve cash and make it last as long as possible," Randev states.
VCs have started having tough conversations with the founders on the growth-at-all-cost approach, unit economics clarity, corporate governance focus, etc. Some, like Rockstud Capital, have stayed away from businesses where the dependency on external capital to grow is significantly higher. Instead, they have an ongoing conversation with all their portfolio companies and highlight the need to balance growth and unit economics to the founders.
They are also putting additional internal and external resources behind each deal—pre and post—to control better how the business is run. The most critical factors now include a founder's track record, their resilience when things aren't going that well, and the market potential of the unique business model.
After all, based on the principles of outsized returns, VC capital has a shelf-life of around seven years. And while the game hinges on valuation, they are aware that not every one of their investee companies will have a hockey stick growth.
Gaurav Thakkar, vice president of investments at Rockstud Capital, says, "We ensure that our portfolio companies have the right resources and processes in place as founders cannot focus on all the business aspects at all times.” He adds, "While these things take time to implement and give results, we ensure that the founders understand that eventually, all this will lead to building a fundamentally strong and sustainable business."
Still An Attractive Market
Randev, whose 100X.VC has invested in 22 start-ups as part of its ninth cohort, explains that the shift towards a cautious approach was a long time coming since there's a great deal of unpredictability when it comes to investments. However, he believes that ample funding is pouring into early-stage companies, especially those that tackle grassroots issues and don't get carried away by vanity metrics.
"Many investors are scrutinising profitability more closely post-Series A. However, the start-ups of the Indian ecosystem are on the right track and investments persist," he states. Randev adds, "We haven't observed any downturn in investments from the seed stage up to Series A, and funding remains robust for beyond stages, all the way up to the IPO."
For LPs and GPs, India also remains an attractive market even though historically, the exit landscape was a concern. Robust exit activity in the past couple of years via tech IPOs and large secondary deals gave them the confidence that the ecosystem is more mature than ever for investments. Some large exits include Razorpay's acquisition of Ezetap, Perfios' acquisition of Karza and Knowlarity's acquisition by Gupshup.
Sagar Agarvwal, co-founder and managing partner of Beams Fintech, states that in 2021 and 2022, the start-up industry saw PE and VC exits of $36 billion and $24 billion, respectively, while the median for exits between 2016 and 2020 was $13 billion. He expects India's market will mature further, accelerated by the rise of prominent players like PhonePe, RazorPay and Paytm, which are looking to consolidate the market.
As VCs become more discerning when it comes to asset selection, they are putting in place processes to have better control over deals with a stronger focus on operational excellence. With a laser focus on ensuring healthy unit economics and rationalised cash burns, they monitor that the funds are effectively being deployed to build customer centricity, not market dominance.
"The business model should demonstrate a clear path to profitability and intent to conserve cash to stretch the runaway," says Archana Khosla Burman, founder partner of Vertices Partners. She adds, "It makes sense for VCs to have a strong risk management framework in place which evaluates governance standards and structures, reporting mechanism, communications across all management levels, scope of constructive discussions, customer feedback, etc.”
The filtration process has become stronger as VCs want to ensure that the founder has all the right metrics in place and a clear vision on how they intend to build the business. Founders, too, have wisened up and are working towards these aspects rather than vanity figures. With the heady days of funding mellowing down, they are getting down to the brass tacks of running a profitable business than just keep trying to scale fast and fail fast.
