Venture Capital Drought: India's Startup Struggle

India's financial markets have had their dream run in the past few years. Over the past year, the Nifty 50 index, a benchmark index representing the performance of India's National Stock Exchange, has experienced a remarkable surge, climbing by an impressive 28%. 

This upward trajectory is not an isolated event but rather a continuation of a trend that has seen the index soar by an astonishing 90% over the course of five years. The surge in stock prices has left analysts at Morgan Stanley marveling at what they describe as a "dream run" for investors in the Indian stock market.

Fueling this surge in stock prices is the influx of domestic investments into the market, which has remained positive for three consecutive years. Domestic investors, including individual retail investors, mutual funds, and institutional investors, have shown increasing confidence in the Indian economy and its growth prospects, channeling their savings into equities in search of higher returns.

However, amidst the optimism surrounding the Indian stock market, a different narrative unfolds in the private markets.

While listed companies rejoice in their soaring valuations and the buoyant mood on the stock exchanges, the private market undergoes a period of correction following an extraordinary period of growth. Venture capital funding, which plays a crucial role in fueling innovation and supporting the growth of startups, has witnessed a significant decline. 

Last year alone, venture capital inflows into Indian startups plummeted by over 60%, falling from $26 billion in 2022 to approximately $9.5 billion.

In calendar year 2023 (CY23), India saw a significant shift in its presence in the world of venture capital (VC) funding, reflecting both challenges and opportunities for its growing startup ecosystem. According to global data from CB Insights, India's share of total global VC funding dropped to 2.9%, the lowest since CY19, reaching $7.3 billion.

This marked a significant decrease of nearly a third compared to CY22 when India accounted for 4.8% of the global figure with $20.6 billion in funding.

While the world welcomed 71 new unicorns in CY23, with 21 emerging from Asia, India contributed only two, a sharp contrast to the 22 unicorns it added in CY22. Moreover, India's share of total global deals also dropped, making up only 3.6% of all global deals in CY23, down from 4.2% in CY22. In the fourth quarter of 2023, India's presence in the top 10 global deals was represented only by Udaan's fundraising round of $340 million, though at a reduced valuation.

The funding pattern in CY23 also shifted noticeably. Late-stage funding, typically vital for the growth and expansion of established startups, accounted for only 9% of the total funding, down from 12% in the previous year. Similarly, mid-stage funding decreased, while early-stage funding saw a slight increase, rising from 75% in CY22 to 78% in CY23.

Late-stage startups struggled to raise funds without compromising their valuations, with some advised to return only when profitability was achieved. As a result, venture capitalists shifted their focus towards funding smaller startups with lower risks.

Despite facing economic turbulence, China outperformed India in VC funding, securing $27.4 billion in CY23, though experiencing a sharp decline from previous years. This narrowed the gap between the two countries in funding share. However, the decline in both China and India contributed to a significant drop in funding across the Asian region, falling from $105.7 billion in CY22 to $53.4 billion in CY23. Globally, the funding landscape for startups witnessed a downturn, declining from $426 billion in CY22 to $426 billion in CY23. Even the United States, a traditional powerhouse in VC funding, experienced a slight drop, securing $132 billion in CY23 compared to $132.4 billion in the previous year.

Why the Dip?

This sharp decline in venture capital funding reflects a broader trend of caution and risk aversion among investors, particularly in the wake of the uncertainty caused by the COVID-19 pandemic and its economic repercussions.
The downturn in venture capital funding has had profound implications for the Indian startup ecosystem, which has long been hailed as a hotbed of innovation and entrepreneurship.

The number of unicorn startups, those valued at over $1 billion, saw a notable decline in 2023, with only two new additions compared to the record-breaking numbers seen in previous years. Additionally, layoffs within the startup ecosystem surged, as companies grappled with the challenges of scaling their operations and achieving profitability in an increasingly competitive market.

“The valuations in the private market were delusional. Corrections will happen,” says Ashish Gupta, chief investment officer at Axis Mutual Fund.

The root cause of this turmoil can be traced back to the exuberance of the private market bubble in 2021, fueled by a frenzy of investor interest and an abundance of capital from venture capital firms and other investors. Startups, emboldened by lofty valuations and the promise of exponential growth, raised substantial amounts of capital at increasingly high valuations, often without a clear path to profitability. However, as market conditions shifted and investor sentiment cooled, many of these startups found themselves overvalued and struggled to justify their lofty valuations in the eyes of investors.

The Reserve Bank of India's decision to raise benchmark interest rates further exacerbated the challenges facing startups, making it more expensive for them to borrow capital and invest in growth initiatives. Additionally, the introduction of taxes on non-resident angel investors in unlisted firms added further uncertainty to the startup ecosystem, deterring foreign investors from participating in funding rounds and potentially driving startups to seek capital from alternative sources.

Despite these challenges, India's tech ecosystem remains resilient, buoyed by a combination of government initiatives, a large pool of skilled talent, and a growing base of consumers. The first quarter of 2024 witnessed a slight slowdown in startup funding, with a 27% decline compared to the previous quarter. However, early-stage funding saw a modest increase of 28%, indicating that investors remain optimistic about the long-term prospects of the Indian startup ecosystem.

Late-stage funding experienced a more significant decline, dropping by over 46% in the first quarter of 2024. This decline reflects a broader trend of caution among investors, who are increasingly focusing on companies with proven business models and a clear path to profitability. Despite the challenges, India remains a formidable contender in the global funding landscape, securing the fourth-highest position globally in terms of total venture capital funding.

In conclusion, the Indian stock market presents a tale of two realms—where optimism and exuberance collide with caution and correction.While the listed market continues to surge ahead, driven by positive sentiment and strong domestic inflows, the private market grapples with the aftermath of a correction and the challenges of navigating a more cautious and risk-averse investment landscape. However, amidst the challenges, opportunities abound for resilient startups and investors alike, as India's tech ecosystem continues to evolve and adapt to the changing dynamics of the global economy.