As VCs Tighten Purse Strings, This Funding Winter Is Proving Colder for Late-stage Startups Macroeconomic factors-inflation, financial markets, geopolitical conflict-are impeding the global flow of capital from limited partners (LPs) to venture capitalists (VCs) to startups

In the weeks leading up to the current funding winter, the startup ecosystem was plagued by many issues, such as layoffs, lengthier funding rounds and risk aversion among investors, to name a few. Thus far, criticism for the same has largely focussed on startup founders and their faulty business models that prioritised rapid growth over profitability, incurring high cash burn in the process. While there is merit in that argument, many are now expanding its scope by contextualising these problems vis a vis larger macroeconomic factors—inflation, financial markets, geopolitical conflict—which are responsible for impeding the flow of capital from limited partners (LPs) to venture capitalists (VCs) to startups. To complicate matters further, the icicles of the resulting funding winter are puncturing the startup ecosystem more ferociously in the growth and late stages.

Onset of Funding Crisis in Startup Ecosystem

Private Equity-Venture Capital (PE-VC) investments in India during the quarter ended June 2022 (Q2'22), at $11.3 billion across 315 deals, registered an over 25 per cent decrease compared to the same period in 2021, shows data from Venture Intelligence. The Chennai-headquartered research service also found that the investment amount was down almost 30 per cent compared to the immediate previous quarter and marked three continuous quarters of decline.

Flow of Capital Obstructed

The funding crunch being experienced at present by Indian startups needs to be viewed from a higher vantage point by bearing in mind the flow of capital in the startup ecosystem: limited partners invest in venture funds, which then fund startups in India. For instance, Standard Chartered Bank, The Dai-ichi Life Insurance Company, Apple, and several other LPs provide capital to Japenese conglomerate SoftBank Group, which then invests in Indian edtech Unacademy and e-commerce platform Meesho. Of late, returns have plummeted on account of a host of market uncertainties, rendering the LPs rather unwilling to invest in VCs. This reticence on the part of the LPs has only been exacerbated over the past few months with VCs investments failing to transmute into profitable startups.

"LP is not just an ATM of a VC. His reputation is equally dependent on the choice of investment made by the VC. Therefore, the recent issues on governance, compliances, weak business models, etc have impacted the confidence of LPs and hence the VCs have tightened the purse strings. The power has shifted back to the investors and hence the founders will need to show their businesses are viable, scalable, compliant and unique," said Amarjeet Singh, partner and head, Emerging Giants and Startups, KPMG India.

As a result of LPs lately slimming down the flow of capital to VCs, the latter too have become cautious about parting with their less-than-abundant funds to avoid investing in business models where the central theme is burning cash to acquire and retain customers. In other words, as US investment firm Sequoia Capital told its founders in a 52-page presentation in May this year, with the macro uncertainty around inflation, interest rates, and war, investors are looking for companies that can produce near-term certainty.

Late-stage Startups Hit Harder

While the macro uncertainties-led current funding crunch is impacting startups across the board, early-stage ones are reportedly faring rather better than those in the growth and late stages. One reason is of course that the former generally raise capital from angel investors and early-stage funds, both of which are more concerned with the business idea and team and market size rather than testing profitability at such a nascent stage.

"The macro side challenge is primarily at the growth/late stage of investing where the public market crash has created a big gap in public and private technology valuation multiples. The valuation gap coupled with tightening monetary policy and the risk of an economic recession is forcing uncertainty in the late-stage venture market which is percolating down to the whole ecosystem," said Gaurav Chaturvedi, partner, Kae Capital.

In India, particularly, this divide between early and late stage companies is even starker, given that late/growth funding comes big VCs and hedge funds, which are primarily located abroad and therefore more impacted by the US and UK stock markets.

Additionally, since late-stage companies are currently undergoing value corrections, it has become harder for founders and investors to arrive at mutually acceptable deals and agreements. "At the late/growth stage, two things are happening simultaneously: valuation correction and a shift to profitability orientation instead of just growth. It is resulting in an expectation mismatch between investors and founders. Early-stage investments are about teams and markets primarily, the business models are a lot more fluid so it is less affected by the current turmoil," explained Chaturvedi.

He disagrees, however, with the contention that VCs are facing a funding crunch from the LPs' end and passing it on to the startups. "Most of the established VCs have enough investible capital available so for existing VC funds, the challenge is not for raising more capital to deploy," he said.

The Way Ahead

While startup founders have lately come under fire for major layoffs, even in cases where funding did not reduce significantly, to conserve cash for extending their runways and surviving the funding winter, one of Silicon Valley's top technology dealmaker, Bill Gurley, believes that such harsh steps are the inevitable business strategy for startups to avoid shutting down. "Similar to 2009, the founders and executives that run VC backed companies have been quick to recognize and adjust. They understand that the cost of capital just went way up and that high cash burn rates are now impossible," he recently said in a series of tweets (see below).

Having survived two previous market resets (2001, 2009), people frequently ask me how this 2022 market reset is different and how it is the same. The obvious similarity is that valuation multiples have collapsed. We went from a "glass very full" mindset to one with many concerns.

— Bill Gurley (@bgurley) June 15, 2022

These "adjustments", however, are being met with shock and surprise by the employee base. "Excess capital led to excessive showering of employee benefits and heightened expectations...There is no doubt that layoffs are brutal and real lives are negatively impacted. But not adjusting is a losing strategy for everyone. Layoffs are now widespread...The most dangerous move you can make is being a late addition to this list," he opined.