[The Outline By Inc42 Plus] Funding Boom Before The Bubble?

Dear reader,

Three years, 36 months and 1096 days — 2018, 2019, 2020. These were some of the most critical years for Indian tech, but 2021 eclipsed them in less than 365 days and under 12 months.

When people talk about inflection points, this is what they mean. Not hockey stick growth, this is The Great Wave off Kanagawa, dwarfing the ones that came before it. And to think, this year has a couple of more weeks to go, to really drive home this record-breaking run.

Here’s the headline: Indian startups have raised more than $39.3 Bn in 11-and-a-half months of 2021 over nearly 1,500 deals. We have seen 40 new unicorns this year, and through IPOs, over $7.3 Bn was raised by tech startups through the public markets.

When we started this year, little did we imagine that things would be this way. For instance, our annual projection in January for funding in 2021 was just $13.2 Bn. Even investors that I spoke to are taken aback, since no one saw this coming. Not after 2020, when startups went through personal and business turmoil.

If the pandemic was called a black swan event, then this unprecedented surge is another instance of a once-in-a-generation catalyst.

While the year began with private confidence among investors that the tide will turn in 2021, the second wave in March gave them pause. Since then it has been all upbeat for the startup ecosystem. Now investors believe it is the time to be cautious but also to capitalise.

How 2021 Changed Startups

In 2021, besides funding, the other big stimulus has been the massive growth in the user base across consumer and B2B tech startups. As we said in The Outline a few weeks ago, India is the world’s largest internet market today, thanks to a major shift in consumer behaviour and greater acceptability for tech solutions.

This is backed by over 833 Mn active internet subscribers and more than 24 Bn app downloads in 2021. While tapping India’s massive addressable base has always been a big challenge for startups, 2021 has more or less solved that. Now, startups are looking to evolve into profit machines rather than growth monsters.

This has become a global phenomenon and is not just restricted to India — everyone has realised that traditional businesses have a role to play, but everything that is relevant for the world today is digital.

Uncertainty in the market has given way to liquidity and optimism, and resulted in the IPO wave that is set to continue in 2022. In our opinion, the biggest testament to this optimism is the way Indian startups and the economy bounced back from the second wave. It was devastating and brought in a lot of turmoil for people. But in a matter of 8 weeks, India was back to doing business again.

“2020 had already eroded a lot of myths about investing and what we have seen in 2021 is just a result of this change in thinking.  We have all got very comfortable doing business differently, our ways of working were changing and the way everyone looked at tech was different,” says Alka Goel, founding partner of a growth-stage VC firm, Alkemi Growth Capital.

Goel adds that the changes over 2020 and 2021 have also fortified founders. The feeling today is that no matter what external market forces are in play, startups can overcome it — even if something goes dramatically wrong with the economy or if there are other external geopolitical factors or indeed another wave like we are seeing currently with the Omicron variant. Having survived what many consider to be the worst of the pandemic has given startups the confidence to take on more and overcome the inherent challenges.

Are Funding Bubble Fears Valid?

But history is witness to cycles of ups and downs in the world of business. It’s not only about the 21st century where we have seen two major depressive periods. Even going back hundreds of years, we can see economic booms followed by slowdowns since the dawn of modern capitalism.

While there’s a definite sunny disposition among investors, there have been more than a few alarms raised about the long-term implications of this funding boom. We have seen funding peaks followed by troughs in the past. Do investors feel the next such trough will have a more severe impact on tech startups? Or will the greater acceptance for tech products be a safeguard against such temporary depressions?

“While there is continual maturing of the Indian startup ecosystem with each cycle, the 2021 funding boom has far more to do with the global capital liquidity in a zero yield world. There is inflationary growth across all assets. In fact, from an investment point of view, the 2021 vintage may not produce great returns. Some new generational companies will emerge, but a lot of people and funds will also lose money,” adds Nitin Sharma, cofounder of early-stage investor Antler India.

In other words, there is such a thing as too much funding.

The Short-Term Trap 

Like other investors, Sharma too believes that while it’s easier for startups to raise a lot of capital now, founders can come dangerously close to succumbing to short-term thinking. “With the pressure of chasing growth at all costs, the noise in the market can distort good product thinking and culture building.”

As we have seen in a market where funds are coming in easily, startups are struggling with the implications. For instance, the talent crunch is by far the biggest challenge right now, particularly in buzzy sectors such as quick commerce, blockchain, Web3, crypto and deeptech.

“Given the amount of capital flowing into India, founders, today, are rushing to scale teams and their business. But the focus needs to be on the right processes or culture building for the long-term to avoid the pitfalls that may come in 2022 and beyond,” warns the founding partner of one of the most active venture capital investors in 2021.

While funding has grown, the talent pool lags a lot. We have seen startups that have raised millions rush for mid-to-senior level hiring, without looking at the culture fit. The fact that they can afford their high salaries is another matter altogether, the risk of culture erosion is too big to ignore.

The frenzied pace of funding and potential indiscipline by startups in spending towards growth in 2021 could mean a lot of startups don’t end up justifying their high valuations, or lose their culture, which will only be exacerbated in moments of crisis in the future. Investors are quick to point out that sound unit economics and sustainable scaling are the only weapons that startups can use in a potential funding bubble.

We have seen these cycles before in India, and globally. We don’t even have to go far back in history to see this. VCs are wary of big investments going south, particularly for early stage bets. Just think about the crash of 2016, where nearly two dozen startups shut down in six months, after a funding boom in the preceding year.

There was a phase where Indian startups espoused the philosophy of growth at any cost. In 2020, this gave way to a bigger focus on unit economics and profitability. Now, again we are back to a phase where the spotlight is on growth, but only meaningful growth.

The need to balance these two seemingly opposing forces is higher than ever at the end of a record-breaking 2021.

Till next week,
Nikhil Subramaniam