Why The Funding Winter Might Prove To Be Good News For Startups

In India, as around the world, venture capital funding took off spectacularly after the pandemic and reached its peak in 2021 but has seen a marked decline ever since. However, the ongoing funding winter could be a blessing in disguise for startups. 

It urges them to take time to re-think, re-strategise business and possibly develop new business models and ideas, which help them grow more organically in the market, putting customer centricity at the core. 

While Indian startups raised $42 Bn across 1,500+ deals in 2021, they have only raised $25 Bn in funding this year, a decline of 40% from the amount raised in 2021.

This sharp decline in funding has naturally hurt many startups, precipitating significant scale-downs and mass layoffs on account of organisational restructuring. Indian startups had reportedly fired nearly 18,000 employees this year so far. Most startups have also been advised to brace for an indefinite ‘funding winter’ by their existing investors.

VC Model, Hypergrowth & Profitability Paradox

Contrary to popular sentiment, this onset of funding winter might actually be a gift from heaven for many startups. Even though venture capital has both upsides and downsides, the business press in India has unfortunately not adequately covered the downsides as much as it has celebrated the upside — a continuous stream of funding news over the last several years.

The downsides stem naturally from the VC business model. This model is built around generating phenomenal returns, through exits, from just a handful of their overall bets, all within a typical seven-year horizon for the actual investors (called Limited Partners or LPs. Note that VCs are essentially ‘managing’ capital raised from LPs). 

In other words, the VC business model is geared around generating extraordinary returns from a fraction of their overall investments. The key assumption being that gains from a handful of top performers will easily cover for the losses or inadequate gains from other investments (startups).

This model incentivises the VCs to maximise their returns from promising ‘bets’, which are then flooded with capital so they can scale up unnaturally fast and reach a position of market dominance. A second key assumption here is that a dominant leader will be able to exercise enough market power to generate profits later, paving the way for a large and successful exit for the VC.

The problem begins with the expectation of rapid and somewhat unnatural scaling up. The expected scale of growth is invariably pushing the envelope of what a still-young organisation can handle and control. 

Often, and as we have seen in recent years, this push goes a little too far; creating unforeseen problems for the startups to manage their continually growing scale of business and operations. 

It’s worth noting that this uncontrollable expansion is also typically fuelled by venture capital that effectively works as purchase price subsidies for the startup’s customers. Once the funding tap is turned off, the growth immediately returns to normal or rational levels for most startups as we have seen through 2022. 

Addicted to hypergrowth, startups quickly realise that they are hugely overstaffed (with internal teams already built for future growth) and are then forced to undergo mass layoffs.

Now that the funding winter has turned off the capital tap for all but a few startups, it is time to take stock of the price that startups end up paying for hypergrowth, and also discuss alternative growth strategies for startups that eschew VC-funded hypergrowth.  

Firstly, profitability is never an inevitable outcome of market dominance as the experience of several leading startups in India and elsewhere around the world has shown us in the last year or so. Consider any of the recently listed startups in India for reference. 

Now, if profitability is still a mirage after all the time, money, and effort invested in building up the scale, the whole point of reaching a position of market dominance becomes questionable. 

Second, so much importance has been given to a startup’s ability to raise venture capital that many founders end up spending far more time on the fundraise than on running or optimising their business operations. Unless the founders have built a strong A-team, this can easily lead to operations going off-track, compromising the startup’s success in both the short as well long run.

Third, as we have seen in many recent cases, the unending pressure to continually raise funds can even make founders window-dress their books and adopt other shady accounting practices. Worse still, investors who are otherwise supposed to conduct due diligence have been found to overlook these practices. 

This is why the so-called funding winter might actually work out to be good news for the current as well as future generations of startups. Both VCs and startups are now acutely aware of the profitability paradox – market power does not square off with bottom lines. 

Time To Revaluate & Restrategise

As a result, most VCs are now revisiting the key assumptions guiding their investment strategies. We can surely hope that there will be suitable tweaks and adjustments that deemphasise hypergrowth without a crystal-clear path to profitability. 

Startups in dire need of growth capital are now forced to evaluate other sources of capital. This includes strategic partnerships or direct investments by large and established businesses in their own category or related categories. 

Unlike VC capital which is markedly impatient; large businesses can provide startups with ‘patient capital’, one that does not force them to pursue hypergrowth. Many early-stage startups are also choosing to delay external capital infusion as long as possible with the hope of better valuations. 

The hidden benefit here is that they are likely to spend more time managing their operations or planning and executing frugal growth strategies. All these skills are ignored if there is capital abundance.  

It is difficult to predict how long the funding winter will last, but one can be reasonably optimistic that spring will see the emergence of far more resilient and capable startups and VCs — ready to script new success stories.

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