India’s Seed Stage Startup Ecosystem Growth Hampered By Policy, Tax Uncertainty

This election year was no different than the previous ones, the promises made by the political parties in the context of Indian startups were highly lucrative. The ruling BJP boasted about setting up an INR 20K Cr seed fund, besides eyeing 50K new startups along with 500 new accelerators/incubators by 2024. The Congress party, in its efforts to guarantee the “startup vote bank”, promised fantasies such as the abolition of angel tax and creating a red tape free experience for the first three years of operations for startups.

But from the government’s point of view, the sustainable development of the startup ecosystem seems to be a priority only in manifestos, election speeches and parliament discussions.

Despite such aggressive marketing of startup-related schemes by government representatives, the intervention into the Indian startup economy has typically been disastrous to a certain extent. The best example to justify this is the adverse impact caused by policy uncertainty from decisions such as the much-maligned angel tax. All these have led to negative investor sentiment towards specific sectors, which in turn has impacted the funding ecosystem. This is especially true at the seed stage startups, which will make up the bulk of the startup ecosystem a few years down the line. With angel investment in seed stage startups slowing down, the government’s ambitious plan of 50K startups by 2024 looks unsustainable and could well be a pipe dream.

If we look at the data around startup launches, India has seen over 49K startups founded till date, of which, 10K shut shop (as of September 2018), with a majority of these shutdowns taking place at the seed stage, often called the most crucial stage of the startup lifecycle. With issues such as angel tax, this number is expected to rise, which can be asserted from the funding data of the last few years.

DataLabs data shows that the total capital inflow into Indian startups between 2014 till the first half of 2019 was more than $51 Bn across 4,554 deals which are growing YoY.

However, the number of startups funded at the seed stage plunged by 39.74% to 329 in 2018, when compared to the pre angel tax era of 2017, where around 546 seed stage startups were funded. And 2019 was no different than last year. According to DataLabs by Inc42 the count of startups funded at seed stage in H1-2019 was 38.92% lower than the half-yearly average of 219 from 2014-2018.

Before we delve further, let’s take a look at the seed stage funding ecosystem in India:

Seed Stage Startup Ecosystem In India

From 2014 to H1 2019, a total of $1.26 Bn was poured into seed stage startups across 2,419 deals. The funding amount is growing at 23.44% (2015-2018), but the deal count has a negative growth at 14.43% — showcasing that the opportunity for new ventures to get capital infusion at seed stage is shrinking.

In the same period, a number of prominent startups were funded at seed stage which later on turned out to be successful businesses — ShareChat (2015) and Grofers (2014) being examples that are on track to become unicorns.

From 2014 to H1 2019, the contribution of seed stage funding to the total funding amount ($51 Bn+) was a mere 2.47% or $1.26 Bn. On the other hand, in the case of the deal, seed stage startups accounted for 53.12% or 2,419 deals in the Indian startup ecosystem, with the total deals recorded being 4,554. The smaller share of funding amount can be attributed to the lower average ticket size for funding amounts in seed rounds, but the fact that more than 50% of the total deal count is for seed stage investments, indicates that investors are still very much interested in this segment.

Impact of Angel tax Fiasco On Seed Stage Ecosystem

The issue regarding the tax on angel investments in Indian startups has definitely scared away from investors in the past few quarters. It was a product of the lack of understanding of startup-related concepts (in this case, the Discounted Cash Flow valuation model) on the government’s part.

The adverse impact of the prolonged angel tax issue can best explain the downward trend evident in the recorded funding deal count after H2 2017, which is 305.

Going by the half-yearly trend between 2015 to 2018, the only time when seed stage deal count in the Indian startup ecosystem slipped below the half-yearly average (2014 to 2018) was after the emergence of the angel tax controversy in the first half of 2018. The total deal count in H1 2018 (207) fell by 9.21%, while H2 2018, with just 157 deals was 31.14% lower than the half yearly average of 228.

The negative impact of angel tax dilemma on India’s seed stage ecosystem is apparent from the slide in the overall percentage share of startups funded at the seed stage to the total startups funded in India on an annual basis.

As evident from the exhibit, the share of startups funded at seed stage was highest between 2015 and 2017, which is the period before the angel tax made its way into the Indian startup ecosystem. The recorded growth rate of startups funded at seed stage between 2014 to 2017 was 85.89%. After the angel tax introduction in 2018, the share of seed stage startups to the total startups funded in 2018 was around 46% in comparison to the average of 52% (2014 to 2018).

Although, during the Union Budget 2019, finance minister Nirmala Sitharaman assured the ecosystem that startups and investors who have filed requisite declaration will not be bothered by tax notices. An official clarification on this issue is still pending, while for many startups who have already received notices will still have to go through the rigmarole of proving the investor’s capability, authenticity and wherewithal.

Overall the Indian startup ecosystem had a moderate first half in terms of capital inflow in the startups — the total recorded funding in H1 2019 ($5.85 Bn) was 16.64% higher than the median half yearly funding amount of $5.01 Bn (2014-H1 2019). In the context of the seed stage, the contribution of seed stage startups in both funding deal count and the number of startups funded was the highest, which could indicate a revival for the overall seed funding growth in the Indian startup ecosystem. More details about the state of seed stage ecosystem in India for H1 2019 can be found in the latest DataLabs by Inc42 report titled “ Indian Tech Startup Funding Report H1 2019”.

In many ways, the seed stage ecosystem is the foundation of the overall Indian startup ecosystem, so a revival of seed stage funding in H1 2019 would have a big positive impact and be a shot in the arm for the overall startup ecosystem. At the same time, a further delay in this context can impact the overall spirit of entrepreneurship in the country, pushing back the Indian startup ecosystem’s progress.