Investment Outlook for India’s Startup Ecosystem in 2023

Posted by Written by Manah Popli Reading Time: 8 minutes

India’s startup ecosystem, ranking third globally, boasts over 99,000 recognized startups and 108 unicorns valued at US$340.80 billion, with a bright future ahead. The 2019 update to DPIIT’s startup definition ensures eligibility based on incorporation, turnover, innovation, and scalability. Factors like global inflation, HQ relocation taxes, and valuation complexities have led to a recent funding dip. However, India’s startup appeal remains strong, with over US$20 billion in dedicated funds ready for deployment, as projected by industry experts.

Startups have become key contributors to innovation and job creation in the Indian economy.They are responsible for creating around one million direct jobs, which increased by 64 percent in 2022. However, Indian startups appear to be experiencing a funding winter, which officials date to the end of 2022. Concerned with this decline in investments, the Department for Promotion of Industry and Internal Trade (DPIIT) has been taking active measures to come up with need-based solutions.

What is a funding winter?

Funding winter refers to an extended time period where there is a scarcity of funds raised as private equity firms and venture capitalists hold back on making new investments, back out of existing deals, or hold off releasing the promised funds to their target startup ventures.

Investment outlook for India in 2023

In the Indian investment landscape, the first half of 2023 marked a notable decline in both deal volume and funding amounts. Venture Intelligence, a trusted PE-VC data provider, reported that there were 332 deals valued at US$17.6 billion during this period, compared to the previous year’s US$21.7 billion. This dip was even more pronounced when compared to the peak funding cycle of September 2022, where investments reached a staggering US$37 billion.

Concurrently, India’s foreign direct investment (FDI) inflows for the fiscal year ending on March 31, 2023 amounted to US$70.97 billion, encompassing equity inflows, reinvested earnings, and other capital sources. This figure reflected a decline from the prior year’s US$84.83 billion, emphasizing the shifting dynamics within the Indian investment landscape.

The Indian startup ecosystem also witnessed a downturn in H1 2023, as indicated by the ‘Tracxn Geo Semi-Annual Report: India Tech- H1 2023.’ The number of funding rounds dwindled to 536 during this period, a substantial decrease from the 946 rounds recorded in H2 2022 and the over 1,500 rounds in H1 2022. In parallel, the total funding in H1 2023 amounted to US$5.5 billion, marking a 24 percent decline compared to H2 2022 and a staggering 72 percent drop compared to H1 2022.

This decline was not confined to a particular stage, as late-stage rounds, early-stage rounds, and seed-stage rounds all experienced significant decreases in funding, reflecting the evolving landscape of investment in India. Furthermore, the emergence of new unicorns in H1 2023 was scarce, indicating a shift in the dynamics of the startup ecosystem. Notably, IPV, Accel, and 100X.VC emerged as the top investors of the year, signifying their continued influence in shaping India’s investment landscape.

Introduction to India’s startup ecosystem

The Indian startup ecosystem has evolved into the third-largest in the world, standing shoulder-to-shoulder with economic giants—the United States and China. Its origins can be traced back to the 1980s when seven visionary engineers pooled a modest capital of US$250 to establish the tech giant Infosys. These passionate individuals, driven by their coding expertise and global ambitions, scripted India’s maiden and iconic startup success story. In the footsteps of Infosys, companies like TCS and Wipro followed suit, solidifying the nation’s standing in the global economy. Today, this burgeoning industry employs 4.8 million individuals and is poised to reach a remarkable valuation of US$19.93 billion by 2025.

As of May 2023, the Indian startup landscape boasts a staggering count of over 99,000 startups officially recognized by the government, with nearly half of them headquartered in Tier 2 and Tier 3 cities. These startups are spread across 669 districts, spanning 36 states and union territories.

India currently hosts 108 unicorns, collectively valued at US$340.80 billion as of March 31, 2023. Among this unicorn cohort, 44 achieved this status in 2021, amassing a cumulative valuation of US$93.00 billion, while 21 new unicorns emerged in 2022, commanding a total valuation of US$26.99 billion.

This thriving startup ecosystem is a testament to India’s innovation, entrepreneurial spirit, and its ascent as a global startup powerhouse.

How does India define startups?

According to the revised definition in 2019 by the DPIIT, an entity qualifies as a startup in India under the following conditions:

  1. Incorporation/registration period: The entity can be recognized as a startup for a duration of up to 10 years from the date of its incorporation or registration. This registration can take the form of a private limited company, as defined in the Companies Act of 2013, or it can be a partnership firm registered under section 59 of the Partnership Act of 1932, or a limited liability partnership established under the Limited Liability Partnership Act of 2008, all within India.
  2. Turnover threshold: To maintain its startup status, the entity’s turnover for any financial year since its incorporation or registration should not surpass INR 1 billion.
  3. Focus on innovation and scalability: The entity should be actively engaged in activities related to innovation, product development, process improvement, or the provision of services. Alternatively, it can operate as a scalable business model with significant potential for generating employment or creating wealth.

However, it’s essential to note that an entity formed through the division or reorganization of an existing business does not qualify as a ‘startup’ under this definition.

Understanding the factors leading to the recent funding slump

  1. Global inflation: The surge in global inflation rates has led to central banks worldwide increasing interest rates to combat rising prices. This has a cascading effect on the cost of borrowing for startups and businesses. In India, this trend is contributing to higher interest rates on loans, impacting the cost of capital for startups.
  2. Tax implications of headquarters shifting or reverse flipping: Many Indian startups are looking to move their operations and headquarters back to India causing anxiety among investors as the cost of this shift is quite high on their purses. Recently, PhonePe, a leading Indian fintech startup, relocated its headquarters from Singapore to India, triggering significant tax implications for its investors. This event, known as reverse flipping, highlights the complexities of tax regulations and their impact on cross-border business decisions.
  3. Startup valuation by the Indian government: Startups often experience rapid growth and valuation increases, which may not always align with revenue generation, thereby raising scrutiny from tax authorities. The government’s challenges in comprehending these valuation dynamics can result in regulatory hurdles and tax-related uncertainties for high-growth startups.
  4. Tax parity demand: Startups and investors are advocating for tax parity between listed and unlisted shares to create a level playing field. The objective is to ensure that startups do not face tax disadvantages compared to established listed companies.
  5. Complex capital flow challenges: Startups often encounter complex capital flow processes due to restrictions on foreign capital inflow and outflow, coupled with ambiguity surrounding the ‘Angel Tax’. Investors are seeking simplified corporate laws and clearer regulations to facilitate smoother investments and exits. India has just recently released the final rules on startup valuation and tax assessment on startup investments after various rounds of feedback and consultation with stakeholders.
  6. Lack of single-window clearance: In syndicated funding rounds, startups face delays as individual investors must make separate filings, leading to operational inefficiencies. A single-window clearance system is needed to streamline the investment process.
  7. Expand convertible notes issuance: Industry executives are urging the government to expand the issuance of convertible notes beyond the top 100 startups recognized by the DPIIT. This move could enhance capital-raising options for startups.
  8. Escrow account duration: Industry participants are calling for an extension of the allowable duration for funds held in escrow accounts from 18 months to 36 months. This would align India with global standards and accommodate startups that raise capital incrementally based on achieving growth milestones.

Surviving the startup funding winter: Strategies for resilience

  1. Prioritize profitability: In a challenging economic climate, startup enterprises are advised to refocus on the fundamentals—the need for profitability. While this is a timeless business principle, it becomes especially crucial during economic downturns.
  2. Cost management and customer focus: Craft immediate strategies to trim low-priority expenditures and closely monitor high-priority costs. Simultaneously, adopt a vigilant approach to ongoing operational expenses. The cost-saving efforts should align with a commitment to acquiring and retaining customers.
  3. Optimize customer acquisition costs (CAC): Leverage strategic partnerships to minimize CAC. Develop industry relationships that convert users or consumers with high intent, rather than pursuing broad but less effective marketing campaigns.
  4. Embrace a lean approach: Emphasize a culture of frugality and a lean approach. Being lean involves more than just cost savings; it entails starting small, experimenting, and scaling up only after validating success. Avoid investing significant resources in unproven concepts.
  5. Data-driven decision-making: In times of uncertainty, rely on data-driven approaches for business planning and strategy. However, focus on actionable metrics that facilitate informed decision-making, rather than relying on vanity metrics that may provide a false sense of accomplishment.
  6. Innovate and collaborate: Market downturns should not hinder expansion plans. Learn from success stories like Netflix and Groupon, which thrived during financial slumps. Consider strategic alliances and partnerships with complementary players to scale effectively.
  7. Foster transparency and trust: Build and maintain transparency and trust with employees, customers, and investors. A sustainable business thrives on enhanced customer experiences, engaged employees, and strong investor relationships. This trust-based approach ensures long-term resilience and growth.

Why the Indian startup funding winter is expected to be a short-lived chill

India’s startups remain an attractive investment destination, and concerns over its recent slowdown can be alleviated by the significant dry powder of more than US$20 billion held by India-focused funds, eagerly awaiting opportunities for deployment, as per industry estimates. Moreover, H1 2023 witnessed a noteworthy uptick, with 14 funding rounds exceeding US$100 million, representing a 17 percent increase compared to the preceding H2 2022.

Amid the prevailing challenges, India’s space technology startups reached unprecedented milestones, AI-focused enterprises captured the attention of investors, and electric vehicle (EV) startups took advantage of corporate India’s interest in the clean energy revolution in the transport and auto industries. For example, Google marked its first investment in India’s space-tech sector, leading a US$36 million Series B funding round in Bengaluru-headquartered space-tech startup, Pixxel.

Meanwhile, the Indian government is actively addressing operational impediments through engagements with alternative investment funds, startup founders, and fund managers. Additionally, they are soliciting insights from various sectors, including mutual funds, banks, and other stakeholders, to comprehend the factors contributing to the funding decline, demonstrating a proactive stance in nurturing the startup ecosystem.

How do startups in India secure funds?

Securing funding for startups involves a multi-stage process that unfolds as follows:

  1. Bootstrapping: In the initial stages, startup founders often resort to bootstrapping, which entails investing their own capital, as well as contributions from friends and family, to kickstart the business. This self-funding approach allows them to maintain control over the company’s direction.
  2. Seed funding: Following bootstrapping, startups seek seed funding from ‘angel investors’. These individuals are typically high-net-worth investors who specialize in supporting early-stage companies. Seed funding provides startups with the necessary capital to develop their products or services further and validate their business ideas.
  3. Series A, B, C, and D rounds: As startups progress and demonstrate growth potential, they move on to more substantial funding rounds, such as Series A, B, C, and D. These rounds are primarily facilitated by venture capital firms, which inject substantial amounts of capital—ranging from tens to hundreds of millions of dollars—into the startups. Each subsequent round typically corresponds to a higher valuation of the company and supports its expansion, market penetration, and scaling efforts.
  4. Going public: At a later stage in their development, some startups opt to go public, which involves offering shares of the company to the general public. This can be accomplished through an Initial Public Offering (IPO), where the company’s shares are sold on a public stock exchange. Alternatively, startups may be acquired by a Special Purpose Acquisition Company (SPAC), or they can choose a direct listing on a stock exchange. Going public provides a means for anyone to invest in the company, and it also allows the startup’s founders and early investors to sell their shares, potentially realizing significant returns on their initial investments.

In summary, startups utilize a variety of funding sources and stages to secure the capital needed to develop and grow their businesses. The path they choose often depends on their specific business model, growth trajectory, and long-term objectives.

PE and VC investments in India

PE-VC Investments in India between FY20 & FY24

Data for H1FY24 as of September 2023.
Source: Venture Intelligence

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