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Funding forecast for startups in 2016 Expect a slowdown in the inflow of investments in 2016 until there are exits.

By Kashyap Deorah

Opinions expressed by Entrepreneur contributors are their own.

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Entrepreneur India

Thousands of US-based Internet startups have gone public since the beginning of the Internet two decades ago. Hundreds of Chinese startups have gone public in the domestic and foreign markets during the same time. For every Internet startup that has gone public, there are about 10 that have been acquired by them, thus providing exits to shareholders by way of cash or shares that can be traded for cash in the public markets.

How many Indian Internet startups have gone public in Indian or US markets so far? Wait for it. The answer is same as the number of fingers in one hand. In fact, no Indian Internet startup founded after the dotcom bubble burst of 2000 has gone public yet.

Liquidity is as essential to an asset class as water is to life. Liquid returns on investment continue to be a far out promise by Indian startups. Expect a slowdown in the inflow of investments in 2016 until there are exits.

Digital India has come of age. India has crossed the magic number of 20 percent Internet penetration in 2015, a milestone that the US hit in the late "90s and China reached in the late "00s. This has triggered an unprecedented volume of funds deployed into India startups over the last 18-24 months – nearly $8 billion.

The inflows from The Golden Tap have been compared with the US, China, Europe and other regions, and India has emerged as the most promising destination. In many ways, this is reminiscent of the first startup gold rush of 2006-2008 when over $3 billion of venture capital was invested in India.

Then too, there was hope due to record-breaking GDP growth and a new government that favored business. There were also new monies raised from foreign investors betting on India as a growing digital economy. Moreover, most of the money was invested in local consumer businesses with foreign equivalents.

What's New?

Here's what is different. The set of investors dominating the funding in this current wave is different from the ones in the last wave. Investors who entered India during 2006-2008 have 10 years of history to account for. That is multiple fund cycles.

Limited Partners (LPs) are expecting realized returns. Investors who entered after the Great Recession of 2008-2009 have only a few years of history to account for. That is less than a fund cycle. LPs have been patient with planting more seeds rather than harvesting the crop.

The recent slowdown in the Chinese economy and volatility in the US public markets have given investors the first reason to take a step back and re-assess whether it is the time to start charting the path to returns, if not bank actual returns.

For the party to continue, we need exits. And I don't mean private company buying private company with equities getting swapped, and money going from left pocket of investors to the right pocket while all involved go around chest thumping ominous valuation numbers.

That is consolidation, I mean real exits – IPOs or acquisitions by public companies. Of the 150+ unicorns – privately held companies valued at over a billion dollars – 100+ are in the US, 30+ in China and around 10 in India. This is commensurate with relative GDPs.

Now let us answer a few questions to rank the performance of the unicorns in the three regions. What is the ratio of unicorns that are profitable or likely to go public in 2016? India is farthest. What is the average percentage of the company that belongs to the investors, or the ratio between funds raised and valuations?

India is highest. What is the ratio of companies that are local adaptations of foreign equivalents rather than local innovations built ground up?

This is hard to answer but deserves a closer look. India is similar to China in that most unicorns are local adaptations. However, China has the history of local versions winning ahead of US originals in the long term.

India has ended up being the opposite. China's Google, Facebook and Whatsapp are not the US originals while India's are. China's Ebay, Amazon, Groupon and Uber have decisively been local players. We cannot say the same about India.

My take is that the trends are pointing towards the US originals winning ahead of local players in India. After all, unlike China, there is no sustainable competitive advantage that the local player seems to have along any of the key dimensions – talent, money, technology, infrastructure, regulation and economics.

I would argue there is a case to be made about consumers preferring western brands.

What's There in Store?

Here's what we can expect in 2016. As late stage funding slows down, many unicorns will merge with unicorn aspirants that are currently worth hundreds of millions of dollars. A few hyper-funded startups – unicorns or aspirants – will perish or get relegated into oblivion.

In addition to consolidation, many hyper-funded startups will go through down rounds – raising money at a lesser valuation than their previous rounds – in order to survive.

Any hyper-funded startup going for a billion dollar IPO in foreign markets will likely get egg on face given their current financial health.

Large IPOs in India are not possible because Indian public markets require three consecutive years of profitability. The best outcome for the industry might be an acquisition or two by public companies in US or China.

This would inject much-needed liquidity into a dehydrated market. As focus shifts from growth to profits in consumer businesses, several initiatives will be discontinued, teams downsized, prices increased and expenses decreased.

Angels and VCs who had participated in the momentum of 2014-2015 to burn money on growth will find themselves writing off their investments and going through a cycle of disillusionment. Among entrepreneurs,
the men will be separated from the boys.

Some of the best companies of the future will emerge from companies or entrepreneurs who have the grit to deal with the change in a powerful way. Companies built with the US or Chinese equivalents in mind would take the time to discover the unique characteristics of India that they need to embrace in order to get cash flows.

Some lesser known startups that have not yet raised large money will find themselves innovating their way out. Those who are able to do so successfully will emerge as strong consumer brands and pick up large checks towards the end of 2016.

Some of the startups that have been built with a focus on innovation, rather than adaptation, will get to scale and emerge as business leaders. We will discover that these companies were always there but did not get discovered during times of exuberance because they did not raise top dollars from VCs at mind-numbing valuations.

Such hidden gems are likely to come from the following market spaces – cloud-based global enterprise software, back-end infrastructure for consumer e-commerce businesses and B2B platforms that streamline a traditional industry.

The set of startups that appear likely IPO candidates at the end of 2016 would look very different from the current set.

Be Ready

To prepare for 2016, all startups need to answer the question – what if the last round of investment they raised remains the last round they ever raised? The better their answer to this question and the better their preparedness towards this possibility, the better their likelihood of building a solid business and actually being able to raise money at good terms in 2016.

Entrepreneurs will need to resist the instinct to go on a wild goose chase to find that one magic investor or two who missed out on the wave and are eager to invest in growth at all costs.

Moreover, entrepreneurs are required to shed past baggage of investors' misplaced philosophies, verbal commitments and promises that preceded external events that altered beliefs. Chances are, those investors are not going to call the entrepreneurs and tell them that things have turned 180 degrees.

As we enter 2016, it is time to shed borrowed beliefs and think for ourselves. It is time to stop trying to be someone else and be ourselves.

It is a great time to build a company. It is a great time to invest – A better time than it was in 2014 and 2015. Better time than it has ever been in India. Happy New Year!

(This article first appeared in the Indian edition of Entrepreneur magazine (December, 2015 Issue).

Kashyap Deorah

Entrepreneur, Writer

Kashyap Deorah is the author of The Golden Tap: the Inside Story of Hyper- Funded Indian Startups. He is a serial entrepreneur who has spent the last 15 years in India and Silicon Valley.
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