Funding innovative technologies

ANIRUDH SURI

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OVER the last five years, the Indian startup ecosystem has seemingly come of age. The spurt in the number of venture capital firms – across stages and sectors – and the associated high level of funding received by startups has been a double-edged sword. On one hand, it has provided an unprecedented fillip to the spirit of entrepreneurship in the country, much like the significant role venture capital has played in fostering entrepreneurial communities and growth across various regions of the world. On the other, the various stakeholders of the startup ecosystem, especially regulators and policy makers, have often found themselves ill-equipped to handle the associated changes and myriad complexities that have arisen as a result. This article seeks to examine the nature and reasons for the exponential growth of funding in technological innovation in India in recent years, and specifically address the policy issues and debates that have accompanied this spurt in funding.

Venture capitalists play a critical role in driving innovation and growth by providing high-risk capital to various new and innovative ventures at the early stages of growth. Many professional investors, especially public market investors, are skeptical of VCs and often question the logic behind their investment decisions and valuations of privately held companies. At the same time, VCs around the world embody a certain mystique mainly due to the fact that they have often funded such innovative startups, generating extraordinary returns for their investors. As investors in and incubators of ideas and entrepreneurs, venture capitalists are often considered the feeders to a dynamic private equity market as well as a lively public capital market.

Countries such as the United States and Israel have proven that a well developed venture capital system provides the fuel for innovation and long-term competitiveness. That Silicon Valley continues to be the driver of the United States’ continued global competitiveness is well known and widely accepted. As a result, countries such as India that seek to remain competitive and establish themselves as leaders of the knowledge and technology revolutions require a healthy and well established venture capital ecosystem.

 

The 1990s marked the emergence of VC investors in India. Venture capitalism is still at a nascent stage in India. India’s first professional VC firms surfaced right around the Internet boom and bust in 1999-2000, though there was a sprinkling of VC firms in the late 1990s as well. The early venture investors in India largely included subsidiaries of institutions such as ICICI, UTI and IDBI. This phase saw the emergence of companies such as Naukri.com, Baazee.com and MakeMyTrip.com.

After the Internet bust of 2000, it took a few years for startups around the world to regain their place in the mainstream, as their unviable business models had seemingly proven the skeptics right. While India was far away from the action, it was not until 2005-06 that a new set of venture capitalists surfaced again as Silicon Valley re-emerged stronger with a new set of business models. The next couple of years saw the establishment of consumer internet companies such as BookMyShow, Flipkart, Quikr, Zomato, and Myntra as well as enterprise software/ B2B companies such as Practo, Druva Software and InMobi, though their pre-eminence would take a few more years to be established. Between 2006 and 2008, several prominent global venture capital firms such as SAIF Partners (2004), Sequoia Capital (2006), Matrix Partners (2006), Helion Ventures (2006), Nexus Venture Partners (2006) and Accel Partners (2008), entered the Indian market.

 

The next big wave in the Indian venture capital space started in 2010-12. During this period several new venture capital funds, notably several early or seed stage focused funds such as India Internet Fund (2011), Blume Ventures (2011) and Kae Capital (2012) set up shop alongside the more established global names in the venture capital space. Firms such as Snapdeal, PayTM, BigBasket, PepperFry, Free-Charge, Urban Ladder, ShopClues, Delhivery, and Ola Cabs which were established during this timeframe, also started to mature and raise significant rounds of funding. Notably, global investors such as Tiger Global that had first entered India in 2005 and shut office in 2009, returned and started to commit serious amounts of money to the Indian startup ecosystem in 2011.

 

The most recent, and presumably the biggest, wave began in 2014-15 when several large global investors such as Softbank, Alibaba, DST Global, Tiger Global, Sofina, Foxconn, Singapore’s GIC, Hong Kong’s Stead view Capital, Falcon Edge Capital, Tencent and others led unprecedented and extremely large funding rounds in Indian startups. PayTM, founded in 2010, notably raised a $575 million round from Alibaba and Ant Financial in 2015; Flipkart raised $550 million largely from existing investors in 2015, after raising $1 billion in 2014; and Ola Cabs raised a total of almost $900 million in 2015. By August 2015, Flipkart had already raised a total of $3 billion over 12 rounds and 16 major investors. Existing venture capital firms also raised new funds on the back of such extreme optimism and flurry of activity in the sector.

The global love story with Indian startups had officially begun. These couple of years also saw the founding and heavy funding of another wave of startups such as Grofers ($120 million), UrbanClap ($25 million), Oyo Rooms ($100 million), LendingKart ($45 million), Capital Float ($38 million), and Byju ($75 million). With almost $9 billion pumped into Indian enterprises, 2015 was widely touted as the ‘golden year’ for Indian startups.

 

There were several reasons that led to the 2014-15 boom in investments in Indian startups. One, the ecosystem had been steadily growing and maturing. An increasing number of funds and investors, as well as entrepreneurs (often with work experience in Silicon Valley startups), emerged to serve the fastest growing market of mobile and internet users in the world. As the charts show, India is poised to overtake the U.S. in internet users, while it might have already exceeded the U.S. in terms of mobile internet users. The fact that almost all of the new internet users in India are coming online through smartphones has driven the consumer and mobile internet revolution in India.

Two, global investors very quickly realized that India was the next big internet frontier after China. Mary Meeker’s widely respected State of the Internet reports highlighted the potential of the Indian market year after year, with the 2016 report concluding that India had outshone the U.S. and China in the mobile internet space and outpaced growth in both these markets.1 Many of these global investors had benefited from several profitable investments in the Chinese internet space (Softbank, Alibaba, etc.) while others, who had missed the Chinese internet boat, were keen, almost desperate, to not miss the Indian one. In addition, there seemed to be almost an undeclared war among Chinese and U.S./European investors to win the uncharted territory that was the Indian internet market. If Amazon had won in the U.S., and Alibaba in China, the question now was which one would win the Indian market. This was largely the driver of the unprecedented investment activity by global investors in 2014-15.

 

Three, a change in government in 2014 that brought Narendra Modi, a self-proclaimed believer in the power of technology and startups, to power also helped highlight India as a potential internet and startup giant among the global tech behemoths and large global investors including pension funds, university endowments and sovereign funds. While it can be argued that the startup ecosystem in India was maturing despite the government, there can be no doubt that a proactive supporter in the form of the Indian prime minister and the Indian government only helped in creating further hype around the potential.

Four, a not-so-subtle cultural, economic and societal change had been underway since 2009-10. In the aftermath of the global recession in 2007-08, the banking and consulting sectors – that usually held sway when it came to recruiting the best talent across the world – had started to lose their sheen quickly. In their stead emerged the new, cool tech companies – Facebook, Google, Apple, Twitter, Amazon, WhatsApp, etc. – that became the employers of choice for many of the smartest engineering and management graduates across the world. India was no exception. A quick analysis of the background of the entrepreneurs in India in the 2008-2015 timeframe would show that most, though by no means all, of the founders were graduates of the premier management and engineering universities in India who would otherwise have been recruited by the likes of Goldman Sachs and McKinsey and Co.

 

As the smartest and brightest graduates began to launch startups and raise large sums of funding, the mainstream media – specifically newspapers such as the Economic Times, Mint and others – started to hail these startup founders as the new age heroes of the Indian economy. As Bhavish Agarwal and Sachin Bansal started to be compared to Narayan Murthy and Nandan Nilekani, impressionable students and their even more impressionable parents started to rapidly adopt entrepreneurship or ‘starting-up’ as a legitimate career option. Co-working spaces were starting to emerge and pop up all over in cities such as Delhi, Bangalore, Hyderabad, Mumbai and Chennai, and universities were rushing to set up incubators and accelerators to showcase their credentials as supporters of this new startup movement.

A virtuous cycle was emerging in India – as more global investors invested in Indian startups, and more smart students and young professionals took the plunge to launch startups, which in turn encouraged more investors to come and invest in India. The result was a clear change in mindset and a much needed validation of entrepreneurship in the country.

 

If the picture seemed rosy in 2015, by early 2016, behind closed doors, investors based in India had already started to worry. This level and kind of investment activity could not be sustained, many believed. But no one was willing to really come out and stop the party. For first time investors, specifically the new age angel investor in India, the startup space provided a thrill that was clearly lacking in their primary domain of business or profession. Lawyers, industrialists, scions of business families, doctors, bankers, PE professionals, stock brokers were all partaking in the fun. But for investors who had seen several cycles, the euphoria was extremely worrying.

As global markets began to slow, global investors started to take a back seat and retreat into their comfort zones. Many startups began to fail and falter. The media, after almost two years of sustained hype, was more than happy to do a complete about turn on the sector. Startups and their business models began to be questioned and challenged. Bolstered by this reality check, many leaders of traditional industries whose businesses had begun to be disrupted were emboldened again. The fight clearly was not over.

Tech startups across the world are considered to bring along with them disruption or, at the very least, the threat of disruption of traditional industries. Startups, by definition, want to change the way things work and render established players to irrelevance and obscurity, resulting in declining stock prices and falling profits.

But as we have started to see in 2016, incumbents tend not to give up easily or without a fight. They might be slow to wake up from their slumber, but once they do, they resort to using all the tools and tactics at their disposal to halt the progress of the new challengers. At the same time, such disruption often catches the regulators unaware, as new business models are often less understood by them and fall outside the ambit of their mental and regulatory frameworks. This is as much applicable to business venture capital, as it is in the case of disruptive ventures like Ola or Uber.

 

A booming and fast evolving tech startup ecosystem, therefore, almost necessarily implies a period of regulatory and competitive battles. India is currently in the midst of some of these battles which are likely to continue over the next several years. Whilst these battles are clearly a necessary evil for the much needed evolution of the Indian private sector (the ‘survival of the fittest’ theory clearly still holds true), the key question is whether the Indian public sector is equipped to facilitate and manage this evolutionary phase of the Indian economy.

The role of the public sector in seeding, enabling and scaling startup ecosystems has been a matter of great debate. A report by McKinsey on this concludes that ‘while an enabling policy context might not be a precondition for seeding entrepreneurial activity, it may become more critical when taking a cluster to scale’ and that ‘when doing so, their [the governments’] focus could be on tackling the bottlenecks and constraints that might otherwise inhibit a vibrant startup ecosystem rather than picking winners by supporting investment in particular sectors or business models.’2

 

The Indian government has chosen to use policy instruments to seed entrepreneurial and investment activity while also explicitly working towards removing bottlenecks and constraints that exist in the Indian startup ecosystem, as embodied in the Startup India campaign launched earlier this year. The role governments can play is twofold: one, to help ‘set the table’ by enabling all the requisite players in the ecosystem to set up base; and two, by intervening directly by forming publicly funded venture capital funds or even promoting domestic capital to flow into venture capital funds through various incentives and actively removing all bottlenecks and constraints for startups to launch and then grow and scale.

On the former front, boosting investment activity in startups is as critical a prerequisite for the sustained success of the ecosystem as any other. A unique feature of venture capital firms and startups, however, is that they tend to cluster together geographically. As Josh Lerner argues, early successes of some VC firms led to a ‘virtuous cycle’ as entrepreneurs choose to locate their new ventures close to the sources of funding. This ‘virtuous cycle’ has played out most evidently in Bangalore, and to some extent in Delhi/Gurgaon and Mumbai.

At the same time, Lerner argues, this also becomes a ‘vicious cycle’ for other regions of a country as they are unable to attract VC firms. As a result, the central government and possibly the state governments, need to make an effort to attract venture capital firms and promote VC investments outside of the startup hubs of Delhi, Bangalore and Mumbai where they are likely to happen naturally.

Currently, the various states that have awakened to this realization have tended to focus only on building incubators in their state and in some cases, setting up publicly funded venture capital funds. However, they are missing the main areas of potential impact: attracting venture capital firms to set up base in their states and removing bottlenecks and constraints. Setting up publicly funded venture capital funds has often not had the desired impact. Given the track record of the Indian government (whether at the Centre or at the state level), most investors are skeptical of publicly funded venture capital funds.

 

A much better approach for the government would be to focus on encouraging domestic LPs and their participation in domestic venture capital funds through the provision of the right incentives. The key is to avoid both conceptual and implementation failures that are likely with a much touted national scheme such as the Startup India campaign.

Going further, the government must also relax rules for not just accredited investors to invest easily and profitably into startups, but equally to encourage the formation of crowd funding platforms that would enable small retail investors to invest in startups by contributing small amounts. Given the value such online platforms add to both startups looking to raise funding and for small retail investors looking to invest small amounts in startups, removal of the grey areas and creating specific guidelines for crowd funding platforms such as Lets Venture and Traxcn would be more productive than simply banning these platforms or restricting their activities.3

 

Creating a favourable tax environment through the right pass-through structures for investment vehicles will go a long way in further boosting foreign capital in Indian startups. Furthermore, the government should consider bringing the capital gains taxes for startup investments at par with the capital gains taxes that are applicable to investing in the public equity markets. In addition to creating domestic pools of capital, it is also important for the government to promote more onshore fund management. Traditionally, the large venture capital funds, especially the global ones, have set up base in Mauritius or Singapore (instead of India) to invest in Indian startups. This must change. The India operations of these funds should not be treated as ‘permanent establishments’, and the government ought to implement the requisite ‘safe harbour’ norms.

Furthermore, the Alternative Investment Fund (AIF) regulatory regime must be reformed to facilitate and enhance investments by AIFs in Indian startups. By making it easier and equally tax efficient for fund managers to be based onshore, the Indian government can promote the growth in quality of home-grown investment managers at VC firms,4 which in turn is likely to lead to more home-grown VC firms being established by these managers in the coming years.

The government has already taken some positive steps. Specifically, the recent amendments pertaining to FDI in AIFs – namely the exemption from all sectoral FDI caps and conditions for downstream investments by India managed and Indian sponsored AIFs, and permission for foreign direct investment in SEBI registered AIFs – are likely to lead to a significant increase in funds under management on Indian shores.

 

It is evident to most policy makers today that going forward investments into tech startups is a critical pillar of India’s growth and development strategy. However, what is not as evident to all policy makers is how to manage, facilitate and regulate the growth and evolution of the startup ecosystems, including, but not limited to, the investment frameworks for venture capitalists. It is critical, therefore, for policy makers to continue to build strong, clear and consistent communication channels with the various players of the startup ecosystem in India. This will enable them to anticipate potential conflicts as established leaders collide with the challengers and disruptors, put in place incentives and policies for boosting the nascent startup ecosystems across the country, and identify ways in which existing constraints can be removed in order to facilitate greater investment inflow. Innovation and technology are essential to keeping India competitive in the global economy, along with a well thought out policy framework. A timely implementation of key initiatives to remove roadblocks and bottlenecks in the system is equally critical.

 

Footnotes:

1. http://www.kpcb.com/blog/2016-internet-trends-report

2. http://www.mckinsey.com/industries/public-sector/our-insights/creating-growth-clusters-what-role-for-local-government

3. ‘Are online funding platforms for startups breaking the law?’ LiveMint, 23 September 2016. Accessed online at http://www.livemint.com/Opinion/I2TA2BTAK7H1 wZ90xfBMRO/Are-online-funding- platforms-for-start-ups-breaking-the-law.html.

4. The Alternative Investment Policy Advisory Committee Report, January 2016. Accessed at http://www.sebi.gov.in/cms/ sebi_data/attachdocs/1453278327759. pdf

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