Funding requirements for startups in India have traditionally been satisfied by the hedge fund/private equity route, and in certain cases by angel/seed investors. However, amidst the global slowdown, funding has dried up amongst the emerging startups and the majority of the funding has been restricted to the top players in the market who have a significant market share in their respective sectors. Further, in light of the boom in startup activity over the past few years, startups have both found it increasingly difficult to raise funds from investors and continue in business in what has become an increasingly competitive market driven solely by profitability.
As a result, M&A activity in the Indian startup sector has picked up considerably over the past financial years. The startup ecosystem has seen some major M&A deals over the last year (including the merger of eBay into Flipkart, Axis Bank’s acquisition of Freecharge, Sokrati’s acquisition by Dentsu, Ebix Inc’s acquisition of ItzCash, Zomato’s acquisition of Runnr, etc.).
While the reasons for the flurry in M&A activity in startups have been mostly multi-fold, mid-tier startups (with considerably lesser market presence) are preferring to get acquired by other startups, since they are struggling to raise funds from investors. Owing to the distinct nature of these startups, such M&A transactions vary significantly from a traditional M&A transaction.
Compared to traditional M&A transactions, wherein the primary driver for such deals may be the consolidation of businesses/synergies in operations/achieving efficiencies, etc., M&As in startups are primarily orchestrated by investors to preserve/enhance their investments. Investors in such startups expect returns by the fourth/fifth year of their investment, and in the absence of a viable business plan which could indicate profitability of such startups within an agreed time period, prefer that their investment remains preserved by the acquisition of such startups by a bigger entity instead of shutting down such startup, thus resulting in a total write-off of their investment.
A number of Indian M&A transactions in the startup sector are also driven mostly with the need of acquiring skilled staff. Therefore, from the perspective of an entrepreneur of a struggling startup, an M&A makes much more sense rather than shutting the startup due to lack of funding. Valuation methodologies also differ significantly, insofar as M&A in startups are concerned. Almost every startup remains unprofitable till date due to high operating costs and dwindling revenues, and therefore, other metrics such as the viability of a sustainable business plan, lifetime value/anticipated value of customer base, leadership talent and other unique parameters (dependent on the sector), etc. decide valuations rather than cash flow or revenue in a traditional M&A deal.
All in all, it is clear that M&A in startups is now a viable alternative for investors in case they believe that the startups are haemorrhaging cash or are proceeding in a less-than-desirable manner. The aggressive manner in which Softbank tried to orchestrate the doomed Flipkart-Snapdeal merger is a testament of the fact that unlike the trends in the past, investors will look at consolidation of businesses of startups in an attempt to preserve their investments.
The rise of M&A in startups raises an important issue regarding the modes of exit for an investor. Currently, as per Indian law, investors may exit either through an Initial Public Offer (IPO) or through a private sale to a new investor. However, such exits are still challenging under Indian law, considering the complex IPO regime. While the government and the Department of Industrial Policy and Promotion have taken multiple steps to assist startups, including easing tax compliances and facilitating easier credit facilities for startups, complicated exit routes for investors will continue to be a bottleneck for PE investors in India.
A viable model would be to enable the process of direct listing wherein on a given date, the company simply declares itself to be public, without raising any money from the public on such date, thus allowing insiders to sell their shares whenever they feel like at the market price, without any underwriting, and without any roadshow being done by the company (as was done by Spotify recently in its IPO). A direct listing is, therefore, in effect, a simplified IPO and offers a host of benefits, both administrative and financial, to the company (as compared to a traditional IPO), including the non-involvement of investment banks, no underwriting of its shares, and no lock-in of existing shares of investors.
Going ahead, it is clear that struggling startups and their investors will be more open to consolidation as a survival strategy instead of simply shutting stop. It is hoped that the legal framework shall keep pace and be further simplified for facilitating both such M&As and also investor exits.
Atul Pandey is a Partner and Hirak Mukhopadhyay is an Associate at Khaitan & Co.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)