Moving on from the funding winter narrative

Sun, 01 Oct 2023

Earlier this weekend, I was at the HSX Headstart Summit and was asked a few questions about the startup ecosystem prevalent in India. Headstart is an annual event that aims to bring together entrepreneurs from various parts of the country to share stories and interact with each other. It was amazing to meet several startups from non-metro cities, who were all working on building excellent companies. Undoubtedly, this will help us do better as a country and an economy, having more entrepreneurs build localised solutions for various parts of the country. I don’t think we would have imagined this happening in India a few years ago. But kudos to us as a country for achieving this.

But since the dawn of 2023, there has been a lot of chatter about how the venture funding world does not seem as rosy as in the past couple of years. And I was asked to speak about this topic on a Headstart panel. I realised it would be nice to also write down my thoughts on this topic as a blog, with detailed context. Rest assured, I did not reference or regurgitate the Zero-Interest Rate Phenomenon (ZIRP) phenomenon at Headstart. I won’t go into it too much in this blog as well. But since ZIRP gets quoted quite often for the troubles facing the Indian VC ecosystem, here is a quick explainer.

ZIRP is quoted often placing the blame for all economic turbulence, in this case, specifically the venture capital bubble of the yesteryears, at the doorstep of the Federal Reserve (Fed). It all started after the 2008 financial crisis when the Fed started reducing interest rates to stimulate the US economy. While it was easy to get this going, the rate cuts meant interest rates reached zero and negative at times when adjusted for inflation, and it stayed there for far longer than anybody had planned. The pandemic then further inhibited the interest rate hikes in favour of economic stimulus and fear of economic downturns.

But while it lasted, everyone lapped it up. While the US treasury rates remained low, capital piles from the US started finding ways to earn more yields or returns since the fixed-income returns were unattractive. This is where it gets interesting - the US is the largest financial services market in the world. That means, all the excess money from the US would eventually flow to other markets. That brings the Indian VC asset class into the picture given how India was one of the promising emerging markets for several reasons - young working population, shiny consumption story, govt and policy pushes and the emergence of talented VC funds and entrepreneurs. Since most VC funds from India promise an annual 25% IRR in dollar terms, no less, foreign money found its way into the country. All this has been written at length, and the ZIRP era ended with headlines like ‘End of the Free Money’. Given all the macroeconomic difficulties, the Fed initiated the steep hike of interest rates for 4 decades, amounting to about 4.5%! Staggering. But anyway, now that ZIRP has ended, all the money floating around emerging economies like India has been repatriated briskly. For now, this is all you need to know, and the rest of the blog is more about what else has been troubling the VC ecosystem in India. Here is a graph of the Fed rates if you are curious to check the historical Fed interest rates since 2000.


Here is the interest set by RBI in India, which tracks the Fed rate hikes,


Okay, getting back to the VC troubles I spoke about at Headstart. So now that VC funding in India has dropped from $35 bil in 2021 to $10-12 bil (projected) for 2023, it is quite natural for everyone to speak about the major concerns of lack of funding, primarily referencing the ZIRP phenomenon. That is quite a neat trick, and probably an attempt at brushing all the other challenges under the rug. And boy, have challenges festered over the past couple of years.


For some context, VC funding that found its way onto Indian startup balance sheets between 2021 and 2022, just two years, was almost $65 bil! And the amount of VC funding between 2012 and 2021? Nearly $50 bil. You see the problem - a classic bubble ripe for the harvest. The bubble burst sometime in mid-2022 but also exposed the underlying malaise that had festered for quite some time.

So, the question must be asked, though, how did it all come to this? We certainly dont have anyone else to blame but ourselves—a collective failure to apply common sense when we most needed it.

And yeah, in hindsight, it is easy to dissect the situation today and suggest what could have been better. The argument is that if we knew the consequences of our actions, we would have avoided them at all costs. Well, it was evident from the get-go what would happen. We didn’t pay attention.

It does not take anyone too long to identify how cyclical the VC industry is - while it might look like the good times will never end, it always does. Stories of the dot com bust and the global financial crisis come to mind. Yet, nobody behaved rationally.

Here is what the last decade of VC funding availability looked like,


And where have we seen a similar peak and dip? Yep, 2000. And if you look closely also in 2008.


So, yep, this is quite similar to the lull of the post-dot-com crash. Uncannily similar.

Also, check out this excerpt,

Over the past few days, two venture capitalists have expressed their worries about the current state of the US startup community. In essence, both are saying that startups are burning through too much cash and that the overall risk currently taken in Silicon Valley is excessive. It’s not the first time people have warned about a new tech bubble. The period of prudence that followed the financial crisis of 2009 is officially over.

While this excerpt is from an article in 2014, it could also describe what happened last year. The point being - what’s happening today is not new. This has happened before; as I said, it will happen again. But could we all resist the urge not to play along next time? Time will tell. And if I was to guess, I dont think we can help ourselves.

So why are we talking of the end of the world? And with that, here are my thoughts on what went on in the past two years and how to navigate the next few years.

Why are we here?

In its truest form, venture capital was meant to be risk capital for high-growth businesses. This, by definition, also means not all businesses are venture-fundable and dont necessarily need to be. But all of this went out of the window the past two years. Every startup raised money, and several of them at unexplainable valuations. Be it a function of capital available or a function of our collective greed, it doesn’t matter. The result was always going to be pain.

In no uncertain terms, what is happening today has more to do with how the larger VC investing community has done business over the past few years. Including the hedge funds, the Corporate VC arms, crossover funds, family offices and everyone else who participated in the madness. I explained all of it here earlier. Competing for deals, egging on founders to raise capital when possible, FOMO, pushing to mark up portfolios, etc. But you get what I am saying.

While I understand that in a capitalistic world like ours, investors certainly need to make returns - it was not fair to have come at the expense of founders and startups. The dereliction of responsibility was quite appalling to see.

The only word in vogue was - valuation.

As the pandemic receded, with all the VC moolah on offer, the market switched from an investor market to a founder market. Founders and startups had multiple offers for the equity rounds they were planning, and guess which ones won. Yep, the termsheets with the highest valuations. However, the implications of agreeing to raise at a valuation that could not be justified with business metrics would only be apparent in 2023, when startups prepare for fresh equity rounds or when secondary transactions happen. And this is when the founders realized that the valuations of 2021 and 2022 are probably never coming back. What does this mean, though? Down rounds in most cases - an equity round with a lower valuation, diluting the founders’ stake in the business. A business that probably took a lot of sweat and blood to build. It did not end there; many others employed at these startups were affected too - with all the layoffs, cost cutting, and pressure to demonstrate profitability. Here is Nithin adding another perspective about valuations. All a function of the valuations ascribed to the startups: pain, pain and more pain.

For a VC investor, though, the name of the game is to not miss out on the winners. So yeah, that’s precisely what they did. Outbid each other, and ensured they invested in startups at any valuation that would get the deal across the line. But not a second was spare to think how the founders would eventually rationalise the valuation. Well, the metaphorical albatross was now around the founder’s neck.

Not only did investors get on to the cap table at ludicrous valuations, but they also sold stakes in companies to other investors at a markup to these already high and unexplainable valuations. All because of information asymmetry.

Cue the short scene from the movie Margin Call - the market was being strangled.

While the repercussions have been playing out, we have seen the army of angel and venture investors retreat and spend time reviewing their portfolios. We have also seen crossover funds call it a day for venture investing and return to public investing - have you heard Tiger Global invest the past few months? Certainly not. We have also seen corporate VC arms quite intriguingly repurpose focus towards managing portfolios rather than look at new investments. It was clear that they were all never here for the long run anyway, but we all celebrated them while they lent us some time.

Sure, startups also played along, though. How else do we explain -

  • Startups raising subsequent venture rounds within 6-8 months
  • Hiring and expanding teams by several magnitudes overnight

While I am all for venture investing, throwing all caution to the wind was not prudent. The growth-at-all-costs mindset had to come to a sad end. And so it did pretty dramatically right before our eyes over the past year in 2023.

While writing this piece, one thing escapes me, though - just how the boards of these startups let this happen. It is unexplainable. Until I heard Mr. Damodaran speak at an event recently about corporate governance, he said, and I quote, “In the dictionary, grief comes only a few pages after greed”. It could not have been aptly summarised. Here is an article from him on why responsibility and accountability are critical for any company - yes, at any stage, right from infancy. So, let’s speak about corporate governance, shall we?

Corporate governance

When I think of corporate governance, I think of Infosys—the poster organisation for top-notch leadership and management in India. While the startup ecosystem keeps talking up Infosys, very few have imbibed the values that made Infosys what it is today. For Infosys, what was corporate governance all about?

Good corporate governance requires diligent adherence to principles that remove the twin perceptions of agency problems and asymmetric information. Source

Here is an excerpt from another article describing the history of corporate governance,

In the early 90s, a string of corporate scandals prompted the government to commission a report – the Cadbury Report – which contained the framework for a new set of rules.

Adrian Cadbury’s report also deals with guidance on conflict of interest and information asymmetry. And that is precisely what was missing on the boards of the startups and continues to be a problem. It is understandable why this might have happened - with investors on boards with short-term views, things were never meant to go well. It was a golden straightjacket at best. And obviously, this played such a big part in the pain we see today. You see, the incentive for the investors was not to stick around for the long run but to ensure the company generates enough yield when exiting the investment. This meant forcing the founders’ hands to do what might not necessarily suit the business - conflict of interest. And we spoke about information asymmetry in the previous section. Yep, it’s pretty sad.

Corporate governance is quite simple - it is all about doing the right things, not because someone is watching, but only because it is the right to do. Did the boards of all struggling startups do the right things? Certainly not. Blame the misalignment of incentives, but there is no escaping the collective responsibility. This should have never happened.

When the boards at these startups should have spent a significant chunk of their time discussing tough questions about the business with the founders and helping them build a long-term vision for the team, the debates ensued were more about valuations and new fundraises—money on the table.

Now that we are here, what happens now?

What now?

Now that I have described the problem in detail let’s look at the way forward for the ecosystem.

  1. Great businesses will never really face funding winters. Yep, you read that right. While I haven’t built a business, I speak from my experience watching and listening to some of the founders I interact with at Rainmatter.

    We must never judge the success of a startup based on its ability to raise venture rounds. Instead, we must applaud startups solving a real problem, having a passionate team to stick through the difficult times, having good governance structures, having a plan for good unit economics, and demonstrating a path to running the business without VC dollars, to name a few. This alone will help several founders reimagine how they want to build businesses. And will have access to something that was taken away - Freedom to run the business how they would like to. After all, the founders and the founding teams are the soul of any startup.

  2. Founding teams must remind themselves that equity is precious, and parting ways with it must need some real convincing. Even if it is a VC fund that has delivered several successful companies, it is always prudent to be careful when anyone offers equity capital.

    While it is easy for an investor to draw up a fundraising plan, more founders should question whether they need to raise the money. This is because once the money is in the bank, the clock starts ticking for the investor. If you are not utilizing the money, questions will be asked, and startups may eventually be nudged as well to do things they dont want to or didn’t mean to—quite a situation to be in for a brief lack of concentration.

    And my view on this is an extension of the saying, more money only brings more problems. Unless, of course, the business plans to spend the money on growing the business sustainably. And, marketing/promotions and other discretionary spending might not qualify as prudent spending. I hope founders will spend time thinking long and hard going forward if they need more money from investors.

  3. There are no free lunches or free refreshes for a startup - as a founder, if you are building a startup, remember that there are no extra takes for the business and no course corrections possible in most cases if things go from bad to worse. This means at every step, care must be taken to consider long-term implications before charting the course.

  4. We will now return to the times when a company reaching the Series B and C stage of VC funding exhibits characteristics of mature organisations. All the euphoria of the past few years helped startups remain private longer, and that meant it was okay not to have essential guardrails in place by the time the company raises more than 3-4 rounds of funding. All of that rightly will now come to an end. Companies will be expected to consider how they can mature faster and grow sustainably. This is undoubtedly a positive and must be the norm for years.

  5. Continue solving for uniqueness and something you are passionate about. Because when things go wrong, the only thing that will keep startups from giving up will be the team’s purpose and passion.

Every worthwhile accomplishment has its stages of drudgery and triumph: a beginning, a struggle and a victory. — Mahatma Gandhi.

  1. Never think of growth at all costs - for founders and investors alike. Period.

  2. Hopefully, VC teams look beyond metro cities and support founders from smaller towns in India. More time must be given to teams solving for sectors like climate and health, which need immediate attention. The metro startups are building for a fraction of our population - 100-200 million at best. What about the rest of the billion+ folks in various parts of India? We need more teams working to help a large section of India’s population facing real challenges. And in the bigger picture scheme of things - this will help the country also do well economically. That is the end goal anyway, right?


Even though this entire piece is about how we have collectively failed as an ecosystem, there are some positive shoots nonetheless.

With all the pervasiveness of funding activity and buzz around the startup ecosystem, being an entrepreneur in India today is a viable career choice - it was not a few years ago. Every household in India may today house an entrepreneur in their capacity. Be it someone working a job, or someone building a company. It is beautiful indeed. What this will do is that more Indians will build for India and know that if they come up with an idea that has a market, they will find support to build out the business. It is no secret that India needs more businesses as I mentioned earlier, and the past few years have helped mainstream this narrative and added tangible value towards a mindset shift.

Further, India today houses investors looking to support almost every sector, which says something. A few years ago, this was restricted to IT or SaaS software. But today, if you are an entrepreneur solving a real problem in any sector, you will find help. India is no longer looking towards the West for answers. This is quite a dramatic shift. Further, a realization has also set in about the need for domestic capital for entrepreneurship in India, which has received considerable push from the Govt. More so, Indian venture investors have figured that domestic capital probably understands the local dynamics better and are speaking more about how they plan to tap into it. A much-needed shift from the yesteryears where 0% of the VC funding flowed in from the US and other countries. Not only does this help diversify the risk, but it also ensures money does not vanish in a downturn. With Indians investing in Indian startups, I am certain there will be more empathy and consideration in behaviour.

While we have seen a crazy fundraising environment and are going through a period of pain, not everything is doom and gloom if you are starting up today. Historically, successful startups have been built in the most challenging of times. So, on a positive note, this might be an opportunity for all the founders and startups out there. Now is an excellent time to get cracking on what they love the most - solving difficult problems, albeit with an eye on things we erred in the past few years.

That being said, none of us should take anything for granted and learn from the experience of a venture slowdown. But I reiterate that the room for error available to a startup is a fraction of what a VC firm has at its disposal. I hope all of us internalize this for the rest of the next few decades.