Wary VCs go slow on startup deals, step up diligence

Aggregate venture funding fell to $2.19 billion during January-March 2023 dropping from the $11.34 billion invested in the same quarter last year according to data sourced from Venture Intelligence. The inflow was higher even in the final quarter of 2022 when startups received total funding of about $3.17 billion.

“I think we have simply reverted to the mean – so the time spent is sort of what used to happen in 2018 or 2019. This much diligence or negotiation is not something we haven’t seen before. It vanished when global money was being parachuted into India. It’s a little slow but because decision making is slow,” said Anand Lunia, founding partner at IndiaQuotient, which has invested in companies like ShareChat and Koo.

In addition, investors who are deploying capital are picking the clear winners in a category.

No quick-fix deals anymore

Nearly a fourth of the money invested in the sector in the Jan- March 2023 quarter is attributed to the $500 million raise announced by Asia’s largest eyewear retailer Lenskart. Walmart-owned PhonePe also raised a cumulative $650 million in three tranches as a part of its $1 billion fundraise round.

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While for other deals, they are taking more time to run deeper due-diligence. Deal closures are also being affected by the mismatch in valuation expectations between founders and potential investors. These elongated timelines are similar to what was witnessed in the pre-pandemic years of 2018-2019. Led by an exponential rise in demand for digital services and heightened money supply globally, Indians startups had seen a massive funding boom in 2021.

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Pointing to the macro-economic changes in the market in the aftermath of the pandemic, Lunia said “ if a firm is raising one fund every six months, they cannot afford to spend six months on one deal.”

“Earlier, people used to have diligence ready, and that would be accepted by the incoming investor – all of this is not happening now. Lawyers, third-party firms would be paid to do due-diligence quickly but that’s not there now. Internal teams doing due diligence are also more cautious now about being caught on the wrong foot, so they might be spending a little extra time,” he added.

In the boom years, investors were engaged in quick-fix deal making to prevent losing out on good assets. This year, with VC firms taking their foot off the gas pedal, some funds are asking for more data and negotiations are also taking more time.

“Till last year, every good asset was being chased by several funds, this year that’s not the case. Till last year, there was fear of losing out on the deal. Now, they are doing pre DDs and demanding exclusivity,” according to Madhur Singhal, managing partner, financial investors group at Praxis Global Alliance, a management consulting and advisory firm that works with venture investors for commercial due diligence, mergers and acquisitions.

“The fundamental equation itself has changed,” he said.

A recent spate of governance issues across the startup industry including in firms such as payment major Bharat Pe and Go Mechanic, has also spooked investors who are putting in extra effort into due diligence.

Early-stage troubles

Even for early-stage startups that were earlier deemed immune from questions of profitability, they are now tough questions to answer on path to profitability. While not as bad as the decline in late-stage funding, early-stage investments have also been hit by the funding winter.

According to Venture Intelligence data, during January-March, Seed and Series A investment rounds saw $712 million in funding, less than half of the $1.92 billion recorded in the same quarter last year. The number of deals also fell from 248 to 115 during this period.

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“Early-stage investors do not assess profitable growth when investing but what they do look at is whether the business will appeal to late-stage investors as the business grows. An early-stage investor typically stays for 2-3 rounds before exiting. So, this investor needs to see what the larger investors are ready to underwrite,” said Singhal of Praxis Global.

“Previously, capital was primarily used for customer acquisition and the growth from that. But now even early-stage investors are questioning where the capital will be used – whether on hiring a team, performance marketing,” he added.

A founder of a Gurugram-based health-tech startup backed by angel investors, is finding seed capital difficult to come by, he told ET. With investors demanding that the startup change its business model for fear of bigger rivals in the space while he fears that a pivot can lead to loss of the existing customer base. A second founder who runs a seed-funded social commerce startup said that while the company still has a cash for a year more, early conversations for the next round of Series A capital are stuck around discussions requiring a business model pivot.

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Way forward

A report by Praxis Global Alliance points to sectors such as health-tech, climate-tech and financial services as the breakout sectors in 2023, as far as investments are concerned. “On climate tech, we’re seeing many startups in energy storage, solar cells, biomass, etc, and also renewed interest in waste management and recycling. Further, in the US, we are starting to see ESG-related startups – mostly services companies – getting funded,” Singhal said.

He expects that investments in financial services will mostly be driven by MSME-lending – small ticket financing like supply chain financing, agricultural financing, which typically banks and NBFCs find it difficult to do.

Startups will also continue to be focussed on improving core metrics, investors said, till such a point the funding slowdown subsides.

“I don’t think we’ve seen the bottom of it unless the US Fed’s rate cycle changes – that’s when we would have seen the bottom. It’s anybody’s guess when that will happen,” said Anand Prasanna, managing partner of venture fund Iron Pillar, which has backed startups like FreshToHome, Uniphore, Servify, Curefoods, said.

IndiaQuotient’s Lunia pointed out that alongside companies looking to cut through their cash burn rate, will also be aiming to build for what might be needed for the next fundraise. “The key focus for early stage companies right now is on reducing burn and living through 2023. Along with this they are also looking at what is important to raise in the next round because maybe after two years the cycle will change,” he said.