Why Start-Ups Are Melting Down

PEs and VCs are taking a closer look at their bouquet of investments.
Leading voices in the sector are categorical that cash-burn rates -- that's blowing up equity to acquire market share -- as a business model can't continue to be the polestar.

The mess on account of the failures of the Silicon Valley Bank, Signature Bank and the epitaph of Credit Suisse -- now acquired by UBS -- has unsettled India's start-up ecosystem that is already struggling against the 'funding winter'.

Let's look at the numbers for calendar 2022.

According to EY (India Trend Book 2023), the total private equity (PE) and venture capital (VC) investment activity stood at $56.5 billion, a year-on-year (YoY) fall of 26 per cent; start-up deal-making at $18.6 billion was lower YoY by 35 per cent.

This slowdown has affected the fund-raising plans of many entities.

There are no two ways that the headwinds from what's happening worldwide will dampen the mood, but to what extent is moot.

The panic reaction to the current meltdown by start-ups has more to do with the fact that they had parked deposits of nearly $1 billion with Silicon Valley Bank.

As Minister of State for Electronics and Information Technology Rajeev Chandrashekhar correctly summed up: 'The issue is, how do we make start-ups transition to the Indian banking system, rather than depend on the complex cross-border US banking system with all of its uncertainties in the coming months?'

It may also be opportune to raise the point: Despite having a vibrant start-up world, why the overdependence on offshore investors?

The head of a large PE has it that one of the main reasons is the lack of a mature exit market, undersupply of other PEs and VCs for a higher funding round, a well-developed market for initial floats, and opportunities for mergers and acquisitions.

This insufficiency deters PEs and VCs' realisations; and in turn, discourages limited partners or (LPs).

Then you have a historically complex regulatory and fiscal environment, which has been difficult to negotiate.

Another key factor for the dearth of home-grown PEs and VCs is the lack of availability of institutional capital -- which is concentrated with a few financial institutions -- and limited participation by local insurance firms and pension funds.

Then you have taxation -- it has to be a fine balance that encourages investment in and by the PEs and VCs as well the generation of government revenue.

First and foremost, a low or moderate capital gain tax, which does not dishearten investments or leads to capital flight from the country, is essential.

Indian investors need to pay 27 per cent tax on capital gains for unlisted investments. This has to be looked at for Indian Alternate Investment Funds (AIFs) so as to help them compete fairly with global players.

Insurance firms, pension funds, and banks need to be encouraged to funnel more long-term capital to AIFs.

Matters have not been made easy for foreign players either.

Take what amounts to an angel tax -- in the Union Budget for FY24, start-ups raising fresh capital in a new round at a higher valuation are to be subject to capital gains tax.

It's ironic that this has come through even as we take pride in the sky-high valuations of our start-ups and the jobs they are creating.

All this even as more than 1.6 million Indians have given up their citizenship since 2011 -- 183,741 in 2022 alone (it was 163,370 in 2021). The United States remained the preferred destination.

This is not to suggest that it will be business as usual for start-ups.

With the uptick in global interest rates over the past year, PEs and VCs were anyway taking a closer look at their bouquet of investments.

Leading voices in the sector have been of the view that this was to be expected; and most are categorical that cash-burn rates -- that's blowing up equity to acquire market share -- as a business model can't continue to be the polestar.

In the case of fintechs, the regulatory topography is fast changing, too.

The release of the Working Group's Report on Digital Lending through Online Platforms and Mobile Apps made clear in its executive summary that the pandemic-led growth of digital lending had led to the unbridled extension of financial services to retail individuals, 'susceptible to a host of conduct and governance issues'.

And that on a larger canvas, digital innovations along with the possible entry of 'BigTech' may alter the institutional role played by existing financial and regulated entities.

Specifically, 'A fall-out of this may get reflected in blurring of regulated and unregulated financial institutions and activities.'

'Such developments spurred by mere commercial considerations would pose regulatory challenges in ensuring monetary and financial stability and in protecting the interests of the customers.'

The regulatory road map was made clear; it would play out at three levels -- regulated entities of the Reserve Bank of India; other regulated and authorised entities; and unregulated entities, including third-party service providers functioning in the digital financial realm.

All of which underlines that it's time for a relook at our home-grown funding ecosystem for start-ups.

Feature Presentation: Ashish Narsale/Rediff.com