A year of reality checks for start-up valuations amid fall in funding

With a dramatic fall in venture capital and private equity funding, Indian start-ups are pulling up their socks, cutting losses, and trying to turn profitable

Sanjeev Bikhchandani, founder of Info Edge, predicts that 2023 will be the year “which will separate the wheat from the chaff” among start-ups.

Bikhchandani should know. The entrepreneur who founded naukri.com, and who now runs a venture capital (VC) firm that has invested in companies like Zomato and PolicyBazaar, points out that “the excess liquidity in the market with funds has now gone due to high interest rates globally and fears of inflation. The fear of missing out (FOMO) among VC investors in India, which pushed valuations to new highs, is now over. And we are being more careful, and taking more time in making investment decisions.”

Bikhchandani says the focus will now be on companies which can promise positive unit economies in their business until they turn profitable.  

It’s also a year for start-ups to get real on valuations. A select group of start-up founders who are steering their companies in that direction or are already there, agree. Says Bhavish Aggarwal, founder of Ola’s mobility business, which has been profitable for a year and plans to go in for an initial public offering (IPO): “Only good companies on the way to profitability will get higher valuations. Investors in this environment are looking for quality companies.”     

The truth is, a majority of start-ups are still deep in the red as they build scale. Funded by the free flow of VC or private equity (PE) cash in 2021, which helped them bump up valuations to stratospheric levels, they hope that eventually they will make money. But the party ended last year as VCs shut the money tap.    

The extent of red ink across start-up balance sheets is reflected in the fact that five well-known ones — Swiggy, ShareChat, Udaan, Unacademy, and Meesho — collectively lost Rs 15,713 crore on revenues of Rs 22,138 crore in 2021-22 (FY22). Note that the bulk of these revenues came from a single start-up — Udaan (Rs 9,900 crore). Yet their combined valuation currently is more than $26 billion, or 13 times their revenue.

Even so, many unicorns believe that the valuation winter, which kicked off in 2022, should be over by the middle of this year, and valuations will get reset — especially since they have taken tough measures to trim their cash burn and are moving towards positive unit economies.

As many as 78 start-ups cut 23,000 jobs, some reworked their business models (Meesho pivoted from social e-commerce to normal e-commerce), while others rationalised their infrastructure costs (like Udaan did with its warehouses). And there are those who are also looking at newer sources of revenues.

Says the CEO of a start-up looking to raise fresh funds, “We are expecting a recovery of valuations in the middle of this year. After all, the fundamentals in India are better than any other country in the world, as we are seeing reasonable GDP growth and inflation is under RBI’s watch. And we have made deep cost cuts to move towards profitability.”

Start-ups argue that most global VCs, PEs, and sovereign funds have enough dry powder which has to be invested to provide returns to their investors, and that they cannot wait and watch indefinitely. They have a point. Despite the funding winter in 2022, data from Inc42 — an information platform — show that in 2022, 126 funds raised a pool of over $18 billion for investing in Indian start-ups, three times more than in 2021. This includes a mega $2.8-billion fund from Sequoia India and Southeast Asia.

Most start-ups which received late-stage funding avoided raising capital at a discounted valuation last year, hoping that things will get better and they could push up valuations, especially before an IPO.

But most VCs and PEs privately argue that there are no discernible signs of any change. They reason that global challenges on liquidity owing to high interest and inflation persist, and will continue at least until the end of the year.

Investors in many highly over-valued companies are pushing the founders to undertake some serious surgery to be in the game. For instance, a leading edtech company has been told to focus on what its investors consider to be its core business, and sell others, such as its US business and study centres for competitive exams, and pay investors’ dues. Some of its investors are also looking to sell their stake as a block to a strategic investor, fearing that valuations could fall further.

“Everyone is waiting to see who will blink first — the VCs or the start-ups. We estimate that most start-ups have funds to continue for the next 12-18 months. After that, they will see their growth impacted if they don’t raise money. They will get money, but don’t expect any hefty valuation increases,” says a senior executive of a global VC fund.

Most agree that it is time to get real on valuations. Says Parth Gandhi, founder and chief investment officer of Bombay Capital, “While there is plenty of dry powder, the slowdown is driven by the fact that companies are adapting to a new investment thesis (concentrate on cash conservation and cash flow) and after that, we should see investments happening, but at expected lower valuations.”

He adds that even funds have to adjust to the fact that valuation multiples are expected to be lower, resulting in lower returns for funds as well as their investors.

The numbers tell the same story. According to Venture Intelligence, which tracks start-up funding, the total value of deals made by VCs and PEs between April 2022 and January 2023 in Indian start-ups has plummeted by a staggering 60 per cent to just $13.45 billion. The average deal size has fallen by 45 per cent, while the actual number of deals has dropped by 43 per cent in the same period.

Tiger Capital, a hedge fund, has seen its deal numbers fall by more than half — to a mere 28 between April 2022 and January 2023, compared with 62 between April 2021 and January 2022. Sequoia’s deal number fell by nearly a third — to just 44 between April 2022 and January 2023 over the same period of the previous year. In fact, Tiger Global’s partner, Scott Shleifer, has stated that their returns on capital in India have been far below average.

To be sure, Tiger Global has had a bad year globally. It admitted last year that it had underestimated inflation and its portfolio composition and exposure levels were not well-suited to the volatility that followed.

As for SoftBank, the really big player in start-up investing, which has pumped in $15 billion in India, it has not made a single investment in the country in the past six months.

The withdrawal of the most prolific investor in this space can be seen from the fact that SoftBank invested only $510 million in CY 2022, a sixth of the $3.1 billion it invested the previous year. SoftBank’s two global vision funds, which have a corpus of $150 billion, and from where they invested in India, have lost over 60 per cent of their value. CEO Masayoshi Son did not even attend the earnings call held in February. 

It is not that VCs have stopped investing in Indian start-ups. But they are tweaking their strategy. They have dramatically reduced their investments in late-stage start-up funding, and instead, are putting their money in early-stage start-ups that are looking to take the next growth steps. Of course, if these companies do well, the returns to investors will be many multiples of what late-stage companies can provide.

Data for CY 2022 from Tracxn, which tracks start-up funding, shows that while the amount raised from VCs in growth and late-stage funding in India fell by 37 per cent over the previous year, their exposure in early-stage funding went up by 20 per over the same period.

At what levels will valuations settle? There is no doubt that most start-ups are overvalued compared with global benchmarks. Also, there is a huge gap between the unreal private valuation of companies and what the market is ready to offer, which is discernible in the case of companies that have already gone public.

Start-ups that went public in 2021 are trading at hefty discounts to their IPO listings, giving no comfort to investors. For instance, on March 20 the Paytm share closed at a discount of 74 per cent on its listing price; Zomato closed at a discount of 29.5 per cent. 

And while Zomato, the leader in the food delivery business, had a market capitalisation of Rs 45,804 crore on March 20, its competitor in the same space, Swiggy, has garnered a private valuation nearly double that — $10.2 billion — based on its last funding round.

The same trend is evident in other sectors too. “SaaS start-ups in India have a valuation which is 27-28 times their forward earnings. It has no relation to, say, Freshworks, which is listed and which is at eight times its forward earnings. So why should VCs pay such a hefty premium for them?” asks a top executive of a global VC fund.

Even compared with global valuations, India is expensive. A study by moneycontrol of 107 unicorns which filed their financial reports for FY22 shows that their average revenue multiple of 12 months is at around 30, whereas global averages are in the range of 15-20.

VC funds are both watching as well as prodding and even helping start-ups to get on the road to profit. Meesho, for instance, has claimed that it has been able to reduce its cash burn by 90 per cent between January and December 2022, to under $5 million. Its attempts to raise money since its last fund-raise in 2021, at valuations of around $5-7 billion, did not fructify.

But one of its investors points out that what they are now watching closely is whether the reduction in Meesho’s cash burn will have any impact on its heady growth of around 90 per cent a year.

Ola Cabs has been able to do what many start-ups are trying now. It has become profitable by making a combination of changes, which includes doing away with discounts on fares — a key area of cash burn. A spokesperson for the company says: “Our focus has been to build core technologies and increase capital and operational efficiencies. In ride-hailing we are building leaner and consolidated teams, capabilities and scale in such a manner that they keep profitability intact.”

Others are strengthening their corporate governance structure, especially after concerns that investors have taken even their board presence lightly when the going is good, and provided too much power to promoters. Sequoia’s problems in two companies, BharatPe and Zilingo, highlighted the conflict between the two.

Swiggy, for instance, recently roped in three independent directors on its board, including the managing director of TAFE, Mallika Srinivasan, chartered accountant Shailesh Haribhakti, and Sahil Barua, CEO of Delhivery.

Some have also got professionals at the helm. ShareChat founders Bhanu Pratap Singh and Farid Ahsan have stepped down from running daily operations and have allowed the next rung of managers to take leadership roles.

Start-ups that have investments from SoftBank have been advised that their focus should be to move towards profitability by December this year, so that they are ready when the tide turns.   

Start-ups like Oyo, Udaan and Ola Cabs, which have been planning an IPO, are still looking at the right time to go public. The volatility in the stock market has compelled many of them to wait and watch; many may postpone their IPO once again and look at one only next year. In 2022 there were only two start-up IPOs, compared with 11 the preceding year.

Clearly, the heady days of the start-up revolution are undergoing a much-needed readjustment.