Cockroaches in demand as unicorns catch a cold this funding winter

Illustration: Suneesh K

In November, Priyanka Bansal (name changed), founder of an edtech company, was looking to raise about $12 million in Series A funding. Bansal was confident about getting more than one term sheet and the valuation she was demanding.

Her thesis was simple: early-stage funding was still not hit by the much-talked-about funding winter, and her startup was catering to higher education and upskilling, a niche among edtechs that was hot even this year, when startups confronted a funding winter.

As central banks globally raised interest rates to stem inflation that accelerated amid the Russia-Ukraine war in Europe, throwing financial markets into turmoil, funding to startups dried up.

Startups in India raised close to $41 billion in equity rounds in 2021, which meant that companies had a lot of cash on their books. But funding slowed down consistently since the first quarter of this year amid the macroeconomic headwinds.

In 2022, Private Equity (PE) and Venture Capital funding dropped to $25.9 billion, according to data collated by private market intelligence platform Tracxn Technologies. In the last three quarters of 2022 in fact, funding halved to $18.1 billion over the same period of 2021, the data showed.

“Series A and early-stage rounds were active even this year, and investors were looking for sectors that were growing,” said an advisor to Bansal’s company, requesting anonymity.

“She (Bansal) was very confident about cracking it. Their TAM (Total Addressable Market) was large, so naturally, their revenue potential was large and that’s the story they were planning to sell. Honestly, in my opinion, it’s a very good story to tell for an early-stage company in a booming market,” the advisor added.

How funding conversations changed

But much to Bansal’s surprise, when she met investors in November, very few questions were asked about her startup’s projected revenue growth and its TAM. Investors also asked very little about the outlook on the sector the startup was catering to. Rather, more questions were asked on profitability, the startup’s unit economics, how it plans to optimise its expenses and by when it planned to list. These are not usual questions asked by investors during Series A funding rounds.

“Even last year, the startup was in the market to raise funds. They got good investor interest. But they didn’t raise money, thinking if they work on their revenue metrics, they might stand a chance to get a better deal,” the person quoted above said.

“Investors were obsessed about TAM and revenue projections last year. But this year, thanks to the funding winter, things have changed. For instance, revenue multiple was discussed a lot last year, it has now changed to EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) multiple. Investors are getting a bit choosy about startups with not-so-good unit economics,” the person added.

Bansal isn’t alone. Many founders had a similar experience while raising funds this year as investors were looking beyond TAM, and revenue projections before investing even at early stages.

The much-talked-about funding winter that has rocked the world’s third-largest startup ecosystem has also made investors conscientious about investment decisions. Naturally, many are seen shifting their bets on more immune cockroaches, which are expected to pip unicorns to become the most-sought after startup species in 2023.

The term cockroach is used to describe a startup that has the ability to survive during periods of funding slowdowns, by tighter cost controls

“Companies have raised a lot of money in 2021 so they have some cushion until at least till a quarter or two in 2023. But these are the companies that have a high burn rate too. So these may die a slow death in the near-term,” said Anand Lunia, founding partner, India Quotient.

“Investors might come back next year. But they will come selectively and will prefer to invest in companies, which might have shrunk burn and kept growing, and have the ability to survive perpetually without additional capital,” he added.

Profitability in focus

With investors asking more about unit economics, startups had to shift their focus from ‘growth at any cost’ to sustainable growth. Naturally, ‘profitability’ was among the most-discussed topics in the startup world this year.

In May, Moneycontrol reported that only a fifth or about 23 of India’s then 100 unicorns were profitable. In fact, during the year, edtech platform Byju’s came under fire for reporting a loss of more than Rs 4,500 crore for FY21 (2020-21), making it the biggest loss-making startup of India in FY21.

Moreover, public shareholders’ response to companies like Zomato, Paytm and Policybazaar, highlighted the low appetite for shares of high-growth, loss-making companies in India. Since the start of 2022, shares of PB Fintech (parent of Policybazaar), Zomato and One97 Communications (parent of Paytm) have fallen 51-60 percent.

The three companies are trading well below their listing prices too. This further compelled private market investors to push even early-stage startups to focus on stronger unit economics, industry observers said.

The trend may continue even in 2023.

“The problem is going to happen to companies that once started becoming profitable but stopped growing. If your company's growing 10 percent year-on-year, you will not get the same kind of valuation that you used to because people pay valuation for growth. If it's a reasonable profit characteristic at high growth, only then people are ready to pay high premium valuations,” said Pankaj Naik, executive director, and co-head of digital and technology investment banking at Avendus.

“There are companies that continue to grow, and at the same time manage to cut costs and show profitability. These will get a very good valuation because they have been growing. But the companies that are either not growing or are not going towards profitability will have a problem,” Naik added.

Funding winter to last longer

The funding winter was bad this year and is seen getting worse in 2023, investors reckon. Just as Lunia said, investors are expected to come only selectively next year. While many Venture Capital and Private Equity fund) are sitting on tons of cash they raised during the year from their limited partners despite a funding slowdown, capital deployment will be slower.

To be sure, PE/VC firms, including some of the most aggressive investors in the country such as Sequoia Capital, Accel, Matrix, have dry powder of as much as $9 billion, Moneycontrol has reported. However, most investors feel that funding would last at least till the end of 2023.

“Founders have been waiting for 2023 as if a new year would turn everything for their funding needs. I agree that funding might revive a little next year and even more in 2024, but will it ever go back to what we saw in 2021? That was an unprecedented year. So companies will have to prepare themselves for a prolonged realistic funding era,” Lunia said.

“From what I have seen, founders are very smart in scaling upwards. But the question is, will these founders be able to scale down also smoothly? In 2022 they were still sitting on funds that they raised in the previous year so one couldn’t tell if they were ‘cockroaches,’ but next year it will be different.,” Lunia added.

Lunia has a point. Startups in the country raised close to $41 billion in equity rounds in 2021, which meant that companies had a lot of cash on their books. But funding slowed down consistently since the first quarter of this year amid macroeconomic headwinds.

In 2022, PE/VC funding dropped to $25.9 billion and in fact, in the last three quarters, funding halved to $18.1 billion over the same period of 2021, data by Tracxn Technologies showed.

With funding slowing, startups in the country have had to take harsh calls like layoffs and vertical shutdowns, but these corrections were gradual.

Sample this. Edtech platforms Unacademy and Vedantu undertook three rounds of layoffs, sacking over 1,000 employees each. In fact, Unacademy fired over 300 employees in November after its co-founder and CEO Gaurav Munjal officially told employees that the company would not exercise any more layoffs after it had sacked more than 700 till July.

“That’s (gradual correction) the problem. Now these companies had raised tons of money last year. So they were sitting on cash and were hopeful of things getting better. So they might have thought instead of taking radical decisions and later regretting, let’s see how it goes,” said an investor requesting anonymity.

“Firstly, they shouldn’t have hired so aggressively last year. But even after that, if they had downsized teams significantly in one go, employees would have been free and the company would have been free to take their decisions. So startups should learn from this and prepare for the worst next year,” the investor added.

Strengthening core business

With the funding winter seen getting worse in 2023, startups will have to focus a lot on their core businesses. To be sure, many startups have already reduced spending on their non-core businesses in 2022.

For instance, SoftBank-backed social commerce platform Meesho shut down its grocery business in 90 percent of the cities in India. Edtech unicorn Erudtius, too, scaled down investments into its newer initiatives anticipating a longer funding winter, its co-founder Ashwin Damera told Moneycontrol in May.

“Companies would do bare minimum next year. They will go into a shell. The main focus will be on core business to make sure it continues operations,” said Lunia.

“What most companies raised last year, would have easily given them a runway of about five to six years in a normal scenario. They wouldn’t have had to raise another round even until IPO. But the burn was so high that a lot of it has already been burnt. But having said that, many of them may have enough to do the bare minimum to survive,” Lunia added.

Lunia also advised founders to not be ashamed of saving their companies by reducing the team sizes, changing office spaces, taking salary cuts or even by doing a funding round at a lower valuation.

"Media and your peers will not respect you. your family also may have to suffer. but everyone will understand in the end if you survive and thrive eventually," he said in advice to founders.

Vamsi Krishna of edtech unicorn Vedantu said the company would focus more on strengthening its core business in the coming few quarters while focusing less on expansion and growth. Krishna said while the layoffs were hard for Vedantu and its co-founders, it was a step in the right direction to make the company ‘IPOable’ in the next two years.

“Mid-year we have further taken a stronger call and said building a runway is not enough. Now we have to create a structure in such a way that no matter what happens externally, we are not dependent on any funding. We aim to create Vedantu which can do an IPO with the existing capital,” Krishna told Moneycontrol in a virtual interaction.

After a tumultuous 2022, as investors and founders gear up for an uncertain 2023, it will be interesting to see who wins the race--mythical unicorn beasts or grounded immune cockroaches.