TODAY, WE HAD TO MAKE the difficult decision of parting ways with 20% of our talented teammates. We want to ensure that we help the impacted people in this transition respectfully,” Ankush Sachdeva, co-founder & CEO of ShareChat and Moj, said in a LinkedIn post in January. This was the company’s second round of layoffs after December (that had impacted 5% of the workforce) as parent Mohalla Tech joined a battery of start-ups scurrying to cut costs to survive in what is turning out to be a long funding winter triggered by rising interest rates and looming recession. Data from market research firm Tracxn shows funding for start-ups declined 37% from a record $42.4 billion in 2021 to $26.6 billion in 2022. In January this year, start-ups raised $944.2 million, 78% less than $4.3 billion in January 2022. “Even good companies may die in this downturn as investors are not willing to bet only on a company’s potential,” says Ritesh Banglani, partner, Stellaris Venture Partners.

This does not mean investors are not scouting for deals. More than $20 billion raised for India is yet to be deployed, but as Vinay Singh, partner at Fireside Ventures, points out: “The bar on investing big bucks has been raised.” The pandemic-led spurt in digital adoption had attracted massive funds to start-ups. But the trend has been short-lived. The narrative has shifted from growth at all costs to positive unit economics and path to profitability. “The year 2023 will be hard, inflation will be stubborn, series C+ (growth stage start-ups) will still get investments but bar for quality in terms of margins and profitability will be very high,” says Singh.

The funding freeze has left scores in the lurch as companies, including the supposedly well-funded unicorns, hand out pink slips to rein in expenses. Byju Raveendran, co-founder & CEO at India’s most valued edtech start-up Byju’s, described the company’s decision to lay off 2,500 employees last October as a “huge price to pay for walking on this path to profitability.” CIEL HR Services says Indian start-ups are estimated to have fired about 6,000 employees in October-December 2022.

Can the trend encourage start-ups to generate more funds internally instead of relying on investors?

Image : Photograph by Fortune India

Profitability Over Growth

With days of easy liquidity over and cost of funds rising, investors are becoming picky about spending every dollar. They are backing start-ups that are able to show a clear path to profitability. This is true not only in case of growth and late stage start-ups that typically rely more on foreign capital but also early stage start-ups where the most important investing criteria has been the potential of the idea. “There is sharp focus on companies that are on path to becoming valuable and sustainable. Companies focused on top line and bottom line or on path to profitability are getting investor interest. These firms are focused on unit economics, gross margins, contribution margins, which are becoming increasingly important,” says Padmaja Ruparel, co-founder of Indian Angel Network (IAN). Ruparel says late-stage start-ups will now raise funds for growth rather than plugging cash burn. “Early-stage companies will raise money for burn but they, too, will have to show a path to profitability,” says Ruparel.

Fireside’s Singh says investors infused $11 billion in series C+ start-ups in 2022 with ‘clearer’ lens on profitability. “We will continue looking for deals but will be measured at our pace,” says Singh, who is betting that the macro situation will stabilise only from second half of 2024 or early 2025. Pankaj Makkar, managing director at Bertelsmann India Investments, says late-stage investors are looking at the trajectory to good unit economics. “A lot of start-ups will course-correct to build much more sustainable businesses and get adequate funding. Those that are not able to do so may have to shut shop,” says Makkar. Deal-making will be slower this year and late-stage start-ups will find it tough to navigate the crisis. “Early-stage start-ups will get support from existing investors. It will get difficult to raise funds after series A and B,” says Banglani of Stellaris.

The funding winter has come as a reality check for start-ups, which were often following a set playbook — chase aggressive growth, overlooking other metrics crucial to building a sound business. The pandemic-led spurt in digital adoption that opened floodgates to easy funding and led to unrealistic valuations added to the bubble. Signs of the impending turmoil started becoming apparent around the middle of last year. In May, Gaurav Munjal, co-founder & CEO at Unacademy, wrote to employees that the company should learn to work under constraints and focus on profitability at all costs. “We flourished in an environment where resources and capital were abundant. Now, we must change our ways. Winter is here,” he said. Start-ups like KreditBee and PhonePe have been able to attract big-ticket funding in such an environment purely on merit, say analysts. “Many of them are generating enough cash flows. PhonePe is one of the biggest start-ups in India. It is looking at an IPO (initial public offer) and PEs (private equity investors) want a play in it,” says an analyst who did not wish to be identified.

Rajiv Srivatsa, partner at Antler India, says only serious founders are willing to start up this year. “Valuation expectations are more stable. People are more prudent in spending. The founders are more frugal,” he says.

Start-Up Strategies

With easy funding drying up, start-ups are getting prudent and spending on core projects while focusing on diversifying revenue streams. Mayank Kumar, co-founder & MD at upGrad, says their top priority at the moment is achieving growth at the right cost while ensuring profitability. “We will shift focus from non-core areas. This will increase operational efficiencies, reduce costs and allocate resources where they are most needed,” says Kumar. For high-growth consumer businesses, the ‘balancing act’ involves continuing the ‘hockey stick growth’ while achieving profitability. “That is the holy grail. Last year, all the founders went deep into the business in order to focus on profitability. That push continues. The results should be visible in 2023,” says Darpan Sanghvi, founder & CEO at The Good Glamm Group.

Razorpay is exploring ways to diversify revenue streams. Managing director & co-founder Shashank Kumar says the difficult environment will persist for at least another year or two and start-ups which are able to turn current circumstances into an advantage will emerge winners. “Start-ups that have a good grip on fundamentals with solid unit economics, controlled (cash) burn, good product(s), acquisition engine and longer runway will race ahead. Our priority remains creation of customer-centric innovative payment and banking solutions for our business partners. While we continue to innovate across verticals, we are also exploring options to diversify revenue streams,” says Kumar. IPO-bound MobiKwik is focusing on maintaining a strong balance sheet, says co-founder & COO Upasana Taku.

According to a survey by financing platform Recur Club, about 60% founders of tech start-ups recognise that raising equity will not be easy in 2023. The dip in fund-raising in 2022 has already impacted growth of digital businesses. Recur Club’s proprietary data indicates that median growth in revenue fell from 103% in 2021 to 48% in 2022. A study by venture debt firm InnoVen Capital shows tightening funding environment has made founders prioritise profit over growth for the first time in seven years. Profitability and PMF (product market fit) are top two priorities of founders in 2023, it says. “In last two years, as capital was cheap and easily available, a lot of people were going for what can be loosely called unsustainable growth. The market is no longer impressed with that. It is saying growth is important but only when balanced with a long-term profitable outcome,” says an analyst.

In an internal memo to employees in early February, Unacademy’s Munjal said the company’s cash burn has dropped significantly, while EBITDA margins have improved. “But we must continue to focus on profitability, because when Unacademy does an IPO, it should have at least four quarters of profitability. We have decided to not do cash appraisals this year. Instead, we will reward stock options to everyone based on performance,” says the memo.

The Good Glamm Group’s Sanghvi says the company has reduced discounting and curtailed marketing costs to ensure positive margins from all initiatives. It has also slashed the number of new projects and renegotiated deals with vendors and freight partners at group level. “We unlocked cost synergies,” says Sanghvi.

Aaditya Sharda, co-founder at Infra.Market, is prioritising scale and efficiency. “Investors eventually seek a sound profitable business model. The funding winter is a good opportunity to focus on recalibrating objectives and long-term plans,” says Sharda.

Budget Blow

At a time when start-ups needed a helping hand from government, Union Budget 2023 dealt them a body blow by proposing expansion of the scope of angel tax to cover foreign investors. Start-ups raising funds from foreign investors in excess of fair market value will also come under angel tax — start-ups facing angel tax notices have to pay 25% investment raised as tax and twice that as penalty for violating the exemption conditions. So far, the provision was applicable only to resident investors. Siddarth Pai, founding partner at 3one4 Capital, has explained in a blog that Section 56(2) (viib) of the IT Act, 1961, seeks to tax the difference between the issue price of securities sold by an unlisted company and its fair market value. Start-ups usually raise funds at a higher valuation than the fair market price; the excess valuation reflects their growth potential. Explaining the implication of broadening the scope of angel tax to foreign investors, Pai says investments by likes of Tiger Global and SoftBank will now expose start-ups to angel tax. “Many investors are regulated by securities regulators of their respective jurisdictions. Yet, their investments will expose the start-up to angel tax,” says Pai. The bulk of funding for start-ups, particularly growth to late stage firms, comes from foreign investors. An analysis of largest funding rounds of 2021 and 2022 shows single-digit contribution by Indian funds, says Pai. The government has maintained that DPIIT-recognised start-ups will be exempted but experts say the criteria to avail the exemption are onerous. “Start-up India has long suffered this shame of tax on capital receipts that has driven entrepreneurs to foreign companies. The proposed move will accelerate the trend,” says Pai. The investor community is in talks with government. Pai is hoping that finance ministry will issue a notification exempting foreign investments from angel tax.

The Budget also failed to accommodate expectations of the broader start-up community which had been hoping for proposals like a more liberalised ESOP (employee stock ownership plan) framework among others. “While the finance minister touched upon areas like skill-based training and special allowances for MSMEs and agriculture accelerator funds, more inclusive areas like higher allocation for the start-up fund, simplified tax regime and higher tax exemptions/relaxation on ESOPs would have offered more rounded growth opportunities,” says upGrad’s Kumar.

“If you consider the funding environment, the race to create 100 unicorns took place as a result of significant fund inflow in 2021. And for past one year, overall funding has been down by 33%. This is because markets are not giving growth so much weight and are prioritising profitability. This may force a lot of start-ups to look at profitability alone. And they may have to sacrifice growth for profitability due to lack of access to capital. So yes, I wish there was something that could have helped in internal allocation of funds to start-ups in a bigger way,” says Vineeta Singh, co-founder & CEO at SUGAR Cosmetics.

As start-ups navigate the crisis triggered by the economic downturn, they will have to carefully pick their battles to emerge winners.

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