As the world locked itself down in homes, there was a rise in e-commerce. Working and schooling from home prompted burgeoning investment in tech start-ups, particularly in ed-tech and health-tech. The digital sector was perceived as the only saving grace amidst the carnage in manufacturing and global trade.

Nobody could’ve imagined that a “winter is coming” (the adage made popular by the OTT series Game of Thrones) for these tech start-ups, but it did.

Being the third largest tech start-up hub in the world, India is often touted as “the global digital leader in the making”. But of course, the country could not avoid the “funding winter” in its digital start-up ecosystem. 

Widespread retrenchment across all verticals of the tech start-ups is now further shaking up the sector. The current turmoil needs to be properly evaluated to ensure the nascent sector survives through these challenging times.

The Slump In Indian Tech Start-ups

For the record, 35,000 Indian start-ups shut down in 2023, while the number of Unicorns (valuation over US$1 billion) fell from 44 in 2021 to 23 in 2023. Data suggests that 17,000 people were given the pink slip in the Indian tech start-up sector between January 2023 and January 2024. 

This is just the tip of the iceberg, as most companies followed a policy of “silent layoff” leading to high attrition rates with 41,208 employees “leaving jobs” in Bengaluru alone.  

The key factor is the 'funding winter' in the sector. However, some experts pointed out that India’s digital start-ups historically have shown pronounced business cycles, where any slump is followed by a quick high in very rapid succession.

Will this funding winter be over soon, followed by another high?

A quick look at Indian start-up funding shows that 2021 witnessed a three-fold jump in investments, compared to the previous year. Still, the funding in 2022 was roughly double the levels of both 2019 and 2020. But, what followed in 2023 was more than a two-time contraction. 

To be fair, this is not unique to Indian tech, but is a global phenomenon. However, some elements of this sharp drop are more pronounced in India. Venture capital (VC) funding is one of those.

VC Funding Sharply Dropped 

Venture Capital funding has drastically fallen to pre-2017 levels in the Indian market. There have been both decreases in the total value of the deals and the number of deals in 2023. The value of venture capital investments in India dropped by more than 64 per cent in 2023, compared to 2022.

If one compares the 2023 figures with the 2021 figures, then the drop would be a whopping 78 per cent. And not to forget, 2021 was the pandemic year when Indian start-up funding (and within that VC funding) was abundant and at a historic high.

Though start-ups at all stages were badly affected in 2023, the worst hit was the late-stage funding which shrank by more than 82 per cent compared to 2021. The seed funding has more than halved by the same yardstick of comparison.

This is terrible news because VC funding is one of the two major sources of funds for Indian start-ups, the other being the equity route.

As a funding winter sets in, the start-ups earlier contemplating the IPO (initial public offering) route naturally had to relent and postpone. The main reason for doing so is a drastic fall in their market valuations. 

A Case Of Overvaluation Or Misplaced Optimism?

As the world stood still during the pandemic, there had been monetary intervention at an unprecedented scale. Since COVID hit, the money supply grew by 40 per cent in the USA, 22 per cent in the UK and 20 per cent in the Eurozone.

With very little scope for actual economic activity, much of this money was being parked in investments in the digital sector. So, even while the digital sector was basking under its new-found glory, the slump was evidently forthcoming.

What accentuated matters is that some of the optimism around the digital sector was misplaced across the world. For instance, the ed-tech sector in the USA was the focus of investments during the lockdown period which witnessed a jump of US$ 6 billion within a year to reach US$ 8.2 billion in 2021. 

As it turned out, ed-tech never really took off, especially with physical schooling resuming post-lockdown. The ed-tech sector changed from being a sector of future growth to a bubble that burst in 2 years. Across geography, the story is exactly the same, including India.

A funding winter is a reality check that is likely to bring back the focus on fundamentals like unit economics and profitability for start-ups. All such basic economic fundamentals were conveniently forgotten when these sectors were flooded with money earlier.

The question is what did most of these big start-ups do with this surge of money? 

With fund flow overshooting the natural growth rate of their respective markets, most went on a mergers and acquisitions (M&A) spree. While some acquisitions were vertical integrations that added value, many were horizontal market consolidations. 

The focus was not on the growth of the market, but more on capturing existing market share, with the expectation that once markets grow, they will have the lion’s share.

Some of the big-ticket M&A deals in India, in the last couple of years, were in the tech sector. These include Facebook acquiring a 9.99 per cent stake in Jio Platforms, Zomato acquiring Uber Eats for US$ 350 million, RIL acquiring Vitalic Health (NetMeds), Prosus acquiring BillDesk for US$ 4.7 billion, Byju acquiring Aakash Educational Services for US$ 1 billion in cash equity, and Zomato acquiring Blinkit for an estimated US$ 700-750 million, to name a few. 

It is now an open secret within the start-up ecosystem that M&A is a well-recognised and convenient exit route for the original founders. Thus, the money being pumped in was not only benefitting the direct recipient start-ups but also smaller businesses that would not have survived by themselves. 

However, the amusing reality is that the valuations of the big start-ups (acquiring numerous smaller ones) were going through the roof, at least at that point in time.

With the market not growing to expected levels, the entire bloated valuation of the portfolio came back to bite them. It is perhaps no wonder that Paytm (with 16 acquisitions since 2017) and Byju (with 17 acquisitions between 2017 and 2021) are today facing an existential crisis. 

Regulatory hurdles or irregularities added to these companies’ woes, but the real Achilles heel remains the overestimated valuations.

Contextualising The Big Churn

The Indian tech start-up sector has essentially witnessed two short but tumultuous phases of churn—earlier via consolidation through M&A to utilise a sudden flush of funds and now via attrition in the time of a funding winter. 

Therefore, this stage cannot be understood and analysed in isolation. The flux and chaos (first with a fund surge during COVID and then with the funding winter as aftermath) should be analysed as a logically related and integrated continuum, to understand its impact on digital tech start-ups. 

Perhaps a more secular and balanced growth of investment (in the absence of the first COVID flux) would have been better for the sector. However, if funders and recipient start-ups still learn their lessons from the earlier overvaluation and growth overestimation, the next funding upcycle can be more balanced and stable for the entire start-up ecosystem.

 

(Amitayu Sengupta is a New Delhi-based economist with over a decade's experience in studying the digital sector. Views expressed are personal)