Strategise on ways to mop up domestic sources with foreign funds drying up for startups

At present, more than 85 percent of the investments into the Indian startup ecosystem are from foreign sources, making the Indian startup ecosystem excessively dependent on foreign capital.

India is now the third biggest startup ecosystem in the world, with over 95,000   startups, up from 350 in 2014, and 115 now grown into unicorns. Foreign investments have so far played a significant role in shaping the Indian start-up landscape.

At present, more than 85 percent of the investments into the Indian startup ecosystem are from foreign sources, making the Indian startup ecosystem excessively dependent on foreign capital. In the first quarter of this calendar year, no new unicorns emerged in contrast to the previous year's 14. It is imperative for India to harness its domestic resources to keep the momentum alive.

The pace of startup growth has slowed down due to various factors arising from geopolitical tensions, economic uncertainties and changing regulatory environments. This foregrounds the importance of a larger pool of domestic capital, wherein domestic investors could play a greater role, which will help make the  Indian startup ecosystem more resilient and/or less vulnerable to external factors amidst the funding winter.

What Parliament Noticed

In September 2020, the Jayant Sinha-led Standing Committee on Finance had presented a report on “Financing the Startup Ecosystem” highlighting how unicorns are heavily dependent on foreign funding.

Furthermore, the report underscored the underutilisation of domestic institutional funds in non-traditional investment sectors. It recommended loosening restrictions on pension funds' investments in unlisted AIFs (Alternative Investment Funds), granting major banks the ability to invest in Category-III AIFs, and increasing investment limits for insurance companies.

Subsequently, it proposed the expansion of the Small Industries Development Bank of India’s Fund-of-Funds.

Untapped Potential, Government’s Response

Alternative Investment Funds (AIFs) require access to broader capital pools such as pension and insurance funds. Pension and endowment funds play a critical role in the US, the Netherlands, Canada, and Norway.

Both on a national and global scale, insurance companies and pension funds have achieved noteworthy accomplishments through their investments in non-traditional asset categories.

Similarly, Indian institutions should be allowed to diversify their investment portfolio across various asset classes, aiming to amplify their returns. These measures may be aimed at expanding the investment horizon for these institutions to encompass SEBI-regulated entities like AIF, REIT, and InvIT, in addition to the presently allowed investments.

In March 2021, the Ministry of Finance issued a directive allowing privately managed provident, superannuation, and gratuity funds to invest up to 5 percent of their resources in alternative investment funds such as SME funds, venture capital funds, social venture capital funds, and infrastructure funds.

This change permitted major Indian conglomerate-associated pension funds to allocate a portion of their funds to AIFs and was positively received by the investor community.

Incentives For Domestic Resources

To mitigate the effects of the foreign funding slowdown, India must look inward and tap into its domestic resources.

By diversifying their portfolios to include venture capital investments, financial instruments like pension funds and insurance funds can contribute to the growth of the startup ecosystem while enjoying potentially high returns.

High-net-worth individuals and family offices are increasingly recognising the potential of startups as an asset class. These entities can not only support innovation but also benefit from the potential financial rewards.

But to encourage these domestic sources to invest in startups, a range of incentives and tax breaks are needed:

Reduced Capital Gains Tax: Lowering the capital gains tax on investments in startups can attract more capital from domestic investors, stimulating greater participation.

Angel Tax Exemptions: Ensuring that investments made by angel investors, family offices, and HNIs in startups are exempt from the angel tax can boost investor confidence and facilitate investment.

Investor-Friendly Regulatory Reforms: Regulatory processes and bureaucratic hurdles that are deterring domestic investors from investing in startups must be reviewed and overhauled.

Power Of Domestic Investments

While foreign investments undoubtedly play a crucial role, a healthy balance of domestic investments can bring stability and sustainability to the startup ecosystem. Domestic investors often have a better understanding of the local market dynamics and can provide valuable mentorship and industry expertise to startups.

By tapping into pension funds, insurance funds, family offices, and HNIs, government can facilitate much-needed capital but also foster a culture of entrepreneurship and innovation. Such access to institutional capital could be achieved through mechanisms like Mother Funds, through which such incentives and tax breaks may be provided.

According to a report by StrideOne in 2022, the Indian startup landscape holds the capacity to make a 4-5 percent addition to the nation’s GDP within the upcoming three to five years. A well formulated strategy for mobilisation of domestic funding for Indian startups is needed. It can help quicken our race to become the third biggest economy by this decade’s end.

Dhanendra Kumar has been India’s Executive Director in World Bank & first Chairman of Competition Commission of India. He is currently Chairman of Competition Advisory Services. Views are personal, and do not represent the stand of this publication.