After 2021 boom, how 2022 could be a year of reckoning for Indian startups

After the boom of 2021, when 44 Indian startups became unicorns, the markets are more selective and investors less enthusiastic in participating at unrealistic valuations

The year 2021 saw a host of large startups hitting the public market to cash in on their big private valuations. But the script went awry for most of these issues.

Software-as-a-service (SaaS) startup FreshWorks hit the jackpot when it listed on Nasdaq last September. The market capitalisation of the company, the first SaaS player to go in for a public issue, was $13 billion after listing. But the euphoria did not last long: Tech stocks fell amid inflation worries in the US, and company’s market value plunged to just $4 billion, but is now at around $5.7 billion, regaining some lost ground.

The story of India’s startup poster boy, Paytm, was similar. The fintech startup, which had a valuation of $16 billion before its initial public offering (IPO), hit the primary market with an issuance market cap of $18.6 billion. The hope was that investors would lap up its shares at a hefty premium.

But Paytm founder Vijay Shekhar Sharma’s reading proved incorrect, and his merchant bankers’ estimates overpriced. The IPO barely scraped through and the stock listed at a huge discount. The company, which has lost over two-thirds of its market cap since, now also faces regulatory challenges, with the Reserve Bank of India (RBI) prohibiting its payments bank from acquiring new customers.

Of the seven key startups that hit the markets in 2021 and raised over $7 billion, the shares of at least three — Paytm, Policybazaar and CarTrade Tech — are currently trading at a substantial discount (see chart on page 14). Some others, like Zomato, which saw a bull run initially, have fallen significantly and are trading at a small premium to their issue prices.

 

Now, 2022 is a completely different story for startups. Private equity (PE) and venture capital (VC) funds, which were splurging last year, have tightened their purse strings. Getting investors to lead a funding round is getting tougher, as many are choosing to wait until valuations correct. Many are now asking tough questions on business models and subjecting them to close scrutiny before writing cheques.

They are also advising the startups in which they are invested to reconsider their IPO valuations or postpone their issues. Some investors are also accusing the Securities and Exchange Board of India (Sebi) of being lax on startups and allowing unrealistic valuations with no profitability in sight.

“In the current macroeconomic scenario, investors have to be hyper aware. You cannot subscribe to unsustainable valuations of companies with weak business models,” says Parth Gandhi, founder of India Media and Entertainment Fund, and former senior partner of AION Capital. “The fear of missing out on a deal is now replaced by the fear of being suckered into a deal.”

Bala Deshpande, founding partner of MegaDelta, which has invested in startups, concurs: “It is clearly time for a correction in startups’ valuations. Future IPOs will not sail through without that. Private valuations of startups have to be in sync with their true market valuations.”

Moment of truth

Startups raised a record $35 billion in 2021. That was more than the combined value of their fundraising in the previous three years. As many as 44 new startups became unicorns — or, those with valuations of over $1 billion — which was more than the count in the whole of the last decade. In January-March 2022, 11 more startups joined the unicorn club.

According to this year’s Economic Survey, until January 13 this year, 83 startups in India had a combined valuation of $278 billion, which is 3.5 times the amount invested collectively by PE funds. 

But 2022 could be a year of reckoning, especially against the backdrop of the Russia-Ukraine war and a spike in crude oil prices. Nearly a dozen startups had started their IPO process as of last year, and five of them have already filed their draft red-herring prospectus (DRHP) with the regulator. They will now need to rethink.

According to a senior executive of one of the largest PE players in the country’s startup space, with stakes in a few of them, “we have made it clear to our companies not to think of an IPO in the next six months. The market is too volatile, and FIIs (foreign institutional investors) are taking out their money from India in droves. No one knows how bad an impact the Russia-Ukraine war will have on oil prices.”

THE LIC factor and other challenges

And then, there is the impending IPO of Life Insurance Corporation (LIC), the country’s largest public issue, which will suck out a substantial amount of liquidity from the markets. A senior executive of a startup that has filed its DHRP told Business Standard that merchant bankers were advising them first, not to launch an IPO close to LIC’s; and second, to rethink the valuation and size of the IPO, since markets have now become very selective.

Some, like Oyo Rooms, are understood to be considering trimming their IPO size (Oyo has refused to comment on the matter). Some others, like Delhivery, which has got Sebi’s clearance and has time until August to hit the public market, are now saying publicly that nobody wants to go public amid such strong headwinds.

Yet others say they will look at how the PharmEasy IPO will do. And those, like InMobi, which wants to list in the US and is profitable, are believed to be going slow, as the US stock market is in a tizzy, and the mobile advertising market is getting consolidated with Big Tech companies (Google, Facebook).

Some companies are trimming their IPO size. Others which have got Sebi clearance are now saying that nobody wants to go public amid such strong headwinds. Yet others say they will look at how the PharmEasy share issue will do

Getting follow-up funding is also going to be a challenge. SoftBank executives, for instance, have admitted in their public interviews that private capital will be limited, especially for startups looking at big-ticket fundraising (of over $250 million or so). It will be difficult for them to get lead investors. In fact, PE funds are already asking founders to put their own money on the table and join the upcoming rounds as substantial partners, if not lead partners, to boost investor confidence.

Ed-tech giant Byju’s is one example of such an arrangement. Its founder, Byju Raveendran, has committed himself to investing $400 million in the company’s funding round to raise $800 million. This will increase Raveendran’s personal stake in Byju’s from 22 per cent to 25 per cent, according to a source, and send out a positive message to investors.

At present, promoter commitment in startups is quite low: The median promoter stake in India’s top 20 unicorns stands at 12.5 per cent. PE investors would prefer this to be higher. They are willing to give money for growth — not through pure equity play but through convertible instruments like loans pegged on future revenue or valuation targets. If these are not achieved, the PE funds get a larger chunk of shares in the company.

Some see such a move as risky for promoters. “To raise such a large amount, you will need to pledge your shares. And that will be a risky strategy to shore up valuations; if something goes wrong, you might just lose control over your company,” warns an investor in startups.     

Another concern is that many US-based PE players, including the hedge funds that pushed up the valuation game last year, are drawing down the net asset values (NAVs) of their respective funds by 10-15 per cent in view of the Russia-Ukraine war. “This will mean less liquidity to invest in follow-up funding. It is not going to be easy to repeat 2021,” says a top executive at a home-grown PE fund. 

 

Many PE/VC players also see this moderation as an opportunity to pick bargain buys, as many startups are willing to correct their future valuation expectations. SoftBank said it had the capital but was waiting for more realistic valuations before taking the plunge. A home-grown PE fund has already started talks with potential companies for investment, even as it finalises its startup fund. It said the response was positive, with companies talking of more reasonable premiums.

An East Asia-headquartered fund, meanwhile, is looking at bargain deals among SaaS startups. It expects their private valuations to mirror those of listed SaaS entities which have fallen from 20 times their price-to-earnings ratios to 10-12 times.

Crystal-ball gazing

Despite short-term challenges, many analysts see startups playing a key role in transforming India’s equity landscape in the near future. Goldman Sachs assumes that half the unicorns (data for a total of 67 were studied) and firms with $100 million in revenues will list over the next two to three years.

Based on a conservative listing premium of 15 per cent over the issue price (the long-term average since 2004), they will add $440 billion to market cap from new listings. It also projects that the weight of the new economy sector in the MSCI index will go up from the present 5 per cent to 12 per cent.

The year 2022 will also test many of the new online business models that emerged last year.  For instance, quick commerce, which delivers products in just 15 minutes, has already caught the fancy of big players. Reliance is backing Dunzo, while Zomato is funding Blinkit and is in merger talks with it. Swiggy, Flipkart and Amazon are also joining the bandwagon.

While quick commerce promises to be the next big thing in e-commerce, Jefferies has projected that the market size will grow from a mere $300 million currently to $5.3 billion by 2025. Kabeer Mitra, the founder of Dunzo, which is raising $200-300 million in the next three to six months to expand to more cities, reckons that next-day deliveries will soon become history.

But there also are some sceptical investors who are asking if the model can ever make money. Despite a large addressable market, convenience without discounting of products might have only limited consumer traction.

Roll-up e-commerce players are also disrupting the market. PE players invested over $600 million in five such startups last year. Two of them have already become unicorns — first, Mensa in a record six months, and then Global Bees. These startups buy small but potentially attractive consumer brands that sell on Amazon and other e-commerce platforms and help them scale up quickly.     

What’s more, with new-age startups increasingly buying or building offline businesses, the hybrid business model could just get bigger. Many are adding an offline play to complement their online business and also hedge their bets. For instance, Nykaa is not just an online mall anymore; it recently opened its 100th retail outlet in the country.

Likewise, Byju’s is no longer just an online ed-tech company for K-12 students; with the acquisition of Aakash Educational Services, it now has over 200 offline coaching centres preparing students for entrance and board exams.

And, three-year-old fintech startup BharatPe has partnered Centrum Finance, which has a small finance bank licence, and also acquired the business of PMC Bank. The real test for the hybrid strategy will be if it can help secure better valuations or a quicker run to profitability.

Will 2022 be a big game-changer for online startups? Perhaps, but only if the great Indian valuation run gets corrected.