Why Indian startups are facing a lack of vitamin C

Like the vitamin that helps the human body with its powerful antioxidant properties, a Series C round of funding infuses the right amount of vitality and energy in a startup that is raring to go. Why then is there a serious lack of high-growth funding in the Indian startup ecosystem?

After a tepid 15 months, 2017 seems to be the year Indian startups are feeling some fresh air coming their way.

Investors are finally opening their coffers to them, having invested over $6.5 billion in disclosed deals in the first five months of the year as compared to just $2.1 billion during the same period last year.

A large chunk of this $6.5 billion comprised the funding raised by heavyweights Paytm and Flipkart, which goes to show that the market for big investments is improving.

Let’s also not forget that VC firms are sitting with substantial dry powder which as per the last estimate was over seven billion dollars. So they have plenty of money to invest.

Klaas Oskam, Managing Director at Signal Hill Capital Advisory, says, “Most Indian Unicorns still have a very long and sometimes uncertain path to profitability. Despite that, in recent times, they have been able to raise very large amounts of capital, showing that market sentiment has improved and we are actually back to a risk-on type of market environment when it comes to Indian startups."

While most entrepreneurs chasing funds might disagree with this, yet, you will agree that the environment overall seems to have eased out compared to last year.

Though today let's talk about one thing that is pinching startups deeply, and that is the serious lack of growth capital being invested.

In the first half of 2017, of the total investments made across 405 startups, only five companies managed to cross the chasm and raise a Series C investment. But before we go into the lack of Series C, let's understand the basic definition of Series C and what it means. (Yes, as entrepreneurs, we've all had to relearn the alphabets and comprehend what Series A, B, C, D, E, F and beyond stand for.)

According to celebrated investor and entrepreneur Elad Gil, “Series C and onwards mean you need more capital to scale.

Purpose: The Series C is often used by a company to accelerate what it is doing beyond the Series B. This may include:

o  Continue to grow fast. You know where the profits are, but you are making the trade-off of losing money in order to win the market.

o  Go international. Launch your business in other markets.

o  Make acquisitions. Some people raise big war chests to buy a number of other companies.

Amounts: This can range from tens to hundreds of millions.

Who invests: This can be driven by the folks mentioned for Series A or B (see e.g. all the early stage guys who just funded Groupon), but often other sources of capital may invest in later rounds such as private equity firms, hedge funds, the mezzanine or late stage arms of Goldman Sachs, Morgan Stanley and other investment banks, or big secondary market firms such as DST or Tiger.”

(In India, Series C investments have often been made by Sequoia Capital, Accel Partners, Tencent, Lightspeed Ventures, Sands Capital, Softbank, etc.)

And just to get a better understanding how this pyramid is skewed against Series C, let’s look at last year's numbers. Out of a total of 1,040 investments made in startups, 705 were pre-series A deals, 102 were Series A, 53 were Series B, while Series C accounted for just 15 deals.

So why are the majority of the startups who managed to raise Series A and B experiencing such difficulty in raising more capital? I spoke to eight such startups in the last two days and here are some of the things they had to say (on condition of anonymity, of course):

1. High valuations in the earlier rounds have come to bite. Most investors are laughing at the numbers that they or their peers had doled out in 2014-15.

2. Startups haven’t achieved the steep targets promised during Series A and B investments, which is being seriously evaluated now.

3. Not many investors are ready to back startups with growth capital in India (more on this later).

4. The same investors who believed in your idea, and the valuation they approved, are now asking entrepreneurs to go and a chase much higher valuation to justify their last round.

5. From high hopes on the macro potential of the Indian market to the realistic number of people that are still transacting online, the big India story is yet to play out for startups.

What entrepreneurs did not mention but I gathered from conversations with bankers and startup analysts, is that there was this overriding hope in 2014-15 (mostly with early stage VCs) that follow-on rounds would come by easily, which, as we all know, did not happen.

One entrepreneur just closing his next big round from Middle East-based investors said that it was difficult for him to raise money in India as people did not believe in the deep tech work that he was doing. So he shifted base to Eastern Europe, with one division in India. He was thus able to raise funding relatively easily. This could be an exception but is also an indicator of the prevailing mood.

Hari Agarwal, Managing Partner at Janus Advisory Services LLP and previously CFO of Sequoia Capital in India, says, “Historically, companies took much lesser capital to scale and cash was truly a scarce commodity. Entrepreneurs were extremely cautious from the very beginning while burning cash; however, over the years, deal sizes have increased, leading to larger initial rounds of capital raising. As a result, companies are scaling the size of their operations sooner, i.e. in pre-revenue stage and burning a lot more capital than they did earlier."

He goes on to say that typically, 12-15 years ago, Series C signified that the company was already bringing in revenue and wanted to raise Series C primarily for geographical expansion or building operating capabilities by hiring top talent. "In the current business environment, the significance of a Series has become irrelevant. A series signifies how much capital has been burnt to sustain operations. Typical deal sizes for Series C have also increased from $8-12 million 12-15 years ago to $20-40 million in recent times. When this happens, anyone who is putting $20-40 million to work will have a very high bar for evaluating an investment. More so because companies are still not showing enough traction with customers despite burning so much capital,” he adds.

Klaas elaborates: "The lack of Series C is because most growth equity investors (PEs) need better quality businesses that have strong moats around their business and are either already delivering operating profits or have a relatively short (six-eight quarters) path to operating profitability and a clear path to an IPO or M&A exit in four-seven years."

Further, he says, "In the absence of attracting interest from growth PE investors, businesses need to attract the attention of mid-stage venture investors in India, and here it is true that the local ecosystem is relatively thin. Hence at this stage, if one dominant source of funding (Tiger Global) goes slow, that does have an impact on the market. That said, we are, in recent times, seeing several situations where Asia and China-based VCs and hedge funds, as well as some US VC/PE funds without a presence in India, are stepping into the Series C and D void left behind by Tiger.

“So, first and foremost, it comes down to the fact that the ecosystem has to build businesses with better fundamentals, which are more innovative and better protected from global competitors and their deep pockets."

Another factor weighing down funding at this stage is that when it comes to actual exits, whether through M&A or IPOs, the Indian startup ecosystem still has a long way to go.

Klaas adds, “For an investor to buy into a business at the Series C stage at a reasonable, typical $100-125 million post-money valuation, this Series C investor actually needs at least to see a $400-500 million (in particular, accounting for dilution from just one, let alone multiple subsequent funding rounds) type of outcome to achieve his target returns. As we all know, whether it is through actual M&A, IPOs, or secondaries, till date, very few Indian startups have actually delivered that type and size of the outcome, and time to scale is proving to be a lot longer than in China.”

Nevertheless, one blue-chip investor I spoke to said that for good companies who are performing well, there will be no lack of investment (his portfolio companies have raised money and are in the process of closing investments). He disagreed with the notion that there is a lack of growth capital available and that investments have not been forthcoming for companies that have performed and delivered on metrics.

Klaas adds that overall, there is a lot of optimism riding on the Indian startup ecosystem, “Let us not forget that India is a relatively young ecosystem, overall GDP and GDP per head are low, and hence many businesses are still in the build-out stage. So once again, given the strong fundamentals and a tail wind, the situation is bound to improve substantially."

I spoke to Rajesh Yabaji Co-Founder & CEO at BlackBuck, one of the five Indian startups this year who have closed a Series C round. I was curious to know what worked in their favor? How did they clinch the deal?

According to him, it was straight-forward. He tells me,

“We were able to deliver a strong value proposition as a marketplace and a clear path to profitability. The space we operate in is so unorganised and large that the upside is visible. And our performance so far spoke of our capability and commitment."

Klaas sums it up quite pertinently, "It is only after achieving positive cash flow that an entrepreneur is really in control of his/her own destiny." So, in many businesses (e.g. most enterprise plays, niche consumer plays, online content startups, etc.) rather than pushing out this point by over-funding the business and chasing growth at all costs (sometimes the right strategy in large, winner-takes-all-markets), most entrepreneurs during the mid-venture stage should have a laser focus on product/market fit, continued differentiation, profitability, and using that to deliver a strong revenue growth.

He adds, “The funniest part is that those are the types of businesses that private equity and IPO markets love and for which there is always an abundance of liquidity."

It’s time all of us in the Indian startup space relook at the definition of success, rather than benchmarking success on A, B, C, D, E, F rounds of fundraising at an exorbitant valuation. Let's focus on the fundamentals of our businesses.

The last one-and-a-half year has been a huge learning for me having raised A and B in a short span of time (shall discuss more in later articles).

In the chase to keep everything running and meeting the expectations the world sets for us as entrepreneurs, let's not miss our laser focus on our own business fundamentals and differentiation. This will help us rework on our own definition of success.