VCs and Entrepreneurs Must Understand Each Other

The economic crisis is affecting most segments of the IT industry here in India, and I will specifically talk about start-up companies and the VC funding scenario.

Impact on Startups
The crisis is affecting start-ups in broadly three different ways: Firstly, fundraising has become harder, in India as well as the U.S. In accordance, start-ups that were looking at going in for Series B or Series C round of funding in the next 12-18 months must now look at what are the realistic chances of them being able to raise money and also consider ways to extend the runway of current funds.

Secondly, there is a business-specific impact of the crisis, which varies by startup. In the case of IT companies, it is feared that as clients cut spends, it will affect the revenues of the IT firm negatively. Similarly, start-ups relying on consumer and ad spend may be affected adversely.

Third, the economic crisis has marred the exit scenario. Public markets are likely to remain out of bounds for at least the next two years, and start-ups having plans of going public must postpone their plans. The M&A markets are also expected to be buyers’ markets.

In addition to these, there has been some talk about a drop in valuation, and it is real. As regards to Series A funding, valuations have dropped by around 20-30 percent. However, VCs are not thrilled at being able to buy at 20 percent lesser costs at an early stage; rather, they are more concerned about the outcome of the start-up they invest in.

Late-stage financing of companies without much traction is off as well. This, despite the figures that show that VC funding in the July-September quarter is up year-on-year. The trend will start reflecting in figures over the next two quarters.

So, in a sense, entrepreneurs are taking a hit on both ends. Late stage funding is hard to come by and customer spends are reduced; those start-ups currently looking for money need to undertake some constructive action.

Impact on VCs
On the VC front, it has become difficult to raise new money. Of course, VCs with pedigree still manage to do so, but a lesser amount is raised. While existing VCs are likely to see a 15-20 percent reduction in funds they raise, new VCs will find it very hard to close fundraising.

Secondly, VCs raise money from institutional investors. There is a fear that as some of the investors’ public and late stage private equity investments come under pressure, in spite of having committed money, they might not be able to provide it to the VCs. This has not been observed in the market thus far, but remains a key apprehension in the industry.

The exit issue is as potent for VCs as it is for start-ups. A long dry spell in this regard is expected.

The silver lining is that India will still grow at 7 percent or so over this downturn, and remains an attractive destination. The long term story of India remains intact, and investors remain optimistic about building large businesses here.

What should startup entrepreneurs do?
In this difficult scenario, entrepreneurs must understand why VCs are behaving the way they are. Contrary to the portrayal of unavailability of capital, what has happened is that capital has become harder to get and more expensive. VCs have raised the bar, and are looking for substantial traction in companies they fund. Those start-ups that offer value proposition will continue to get funding, despite the downturn.

One should note that a boom scenario is always accompanied by companies accumulating a lot of fat. This is the ideal time for start-ups to shed that fat. In some cases, they should be able to cut up to 30-50 percent of their costs without compromising on the revenue. Extending their current runway, and if possible, reaching a cash breakeven point on current cash, would help startups survive and thrive in this environment.

Also, the tight situation is a perfect chance to focus on the core business and customers and build traction minus boom scenario distractions. Competitive intensity is likely to go down, and new leaders will emerge from this downturn.

The author is Managing Partner, Canaan Partners India