Why Indian Startup Ecosystem Is Starved Of Domestic Capital?

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Digital wallet payment giant Paytm is majorly owned by Chinese conglomerate Alibaba.  Domestic e-commerce unicorn Flipkart, as well as local cab hailing leader Ola, have secured a majority of its investments from Japanese investment fund SoftBank or US-based Tiger global. Another inline unicorn, Zomato has recently raised $200Mn from Ant Financials which is again connected with China’s largest e-commerce firm Alibaba.

Do these cold facts ring a bell? Aren’t the homegrown unicorn’s ownership structures are dominated by the foreign capital? But why?

India has successfully gauged a position as a global startup hub that is becoming attractive to investors, startups and corporates and emerged as the 3rd fastest growing market for technology startups globally. The Indian technology landscape has witnessed a tremendous growth towards the creation of innovative startups. But the domestic capital has been conspicuously lagging behind its competitors abroad, if not absent, in making these entrepreneurial stories successful.

Why Not Just Foreign Capital? 

As per some of the statistics, about 9o percent of the funds that flow into Indian VCs are of foreign origin. And, about five years ago that used to be as high as 98%. These numbers are reliable enough to implicate two trends in the investment ecosystem of Indian startups.

First is that there is an apparent domination of foreign capital in fuelling the growth of Indian startups ecosystem and the other is the domestic investment, though at a slow pace, has started picking up.

The problem with foreign capital is two-pronged. One is it comes in the growth stages of the startups leaving the early birds starved of funds and the other is despite it being a helping hand in supporting entrepreneurial activities and creating employment opportunities, the long-term benefits of domestic growth are harnessed abroad.

Domestic Funds: Under Sized But Over Cautious!

However, it would be utterly naïve to hold domestic liquidity crunch responsible for lacklustre interest of local investors as indicated by some analysts due to the ongoing TBS challenge. As the data itself suggests that domestic share of investment has gone on an upward trajectory in a time period when average liquidity headed southwards.

However, the fund sizes of domestic venture capital (VC) funds or private equity (PE) funds have been comparatively too small. For example, local funds face capacity crunch to support individual deals worth more than $100Mn which is almost negligible in comparison to the $100Bn plus aggregate investments made by Japanese or Chinese giants.

However, it would be unrealistic and unfair to expect a domestic VC of comparable size as of its Chinese or American competitor especially when their GDP is five to seven times bigger than the Indian GDP. Put simply, it would be foolish to compare apples and oranges! Naturally, with smaller fund size comes lower risk appetite.

Indian VCs and PEs have remained too cautious in making their investment decisions and it would be no exaggeration if we term Indian funds more of a follower than a trend setter in making appropriate investment calls.

Further, small fund size, lower risk appetite and an ultra-conservative approach make Indian VCs grossly uncomfortable with sky-high valuations of emerging startups. The recent acquisition war between Walmart and Amazon to acquire local e-commerce player Flipkart at a rocket high valuation of $20Bn plus rules out any possibility of any Indian VC getting into the race.

The Foreign Capital Advantage!

It has been also observed that startups prefer to go for foreign VCs as they boost the brand image and come with the technical and managerial expertise of global standards, international network and more importantly much higher valuations! They also provide easier terms to utilize the capital comparatively and have lesser interference in the boardroom busy in making strategic decisions.

The other obvious advantages that a venture capital fund from abroad enjoys in comparison to domestic fund house are the lower cost of capital, higher fund sizes, lower return expectations and higher ability to go for long-term maturity.

The Enabler Government: Needs To Become Risk Sharer!

To the credit of the government, it has played its role near to perfect in creating an enabling environment to foster Indian startup ecosystem by taking initiatives like Startup India, Standup India, improving ease of doing business, simplifying rules for startup registration and regulatory clearances, promoting innovation and technology and creating a digital techno interface to support the budding startups.

Indian entrepreneurial community is much more enthusiast, hopeful and ambitious in the era of current dispensation due to these favourable policies. Even the state governments have been competing to attract investment and facilitate entrepreneurial activities in their regions by framing favourable startup policies which is a classic example of competitive federalism.

However, the government needs to upgrade its role from just an enabler to a risk sharer not just to sustain the ongoing momentum but also to enough confidence in the domestic capital and investors. One needs to recognize that despite reaching impressive milestones on the journey of Indian startup ecosystem, most of them especially the ones which are in a nascent stage are still capital starved.

As per a Tie report, still, a low proportion of startups gets funded in India. Since the market is starved of domestic capital and foreign investments come only in the growth phase of the venture, the budding startups face the fund crunch.

Globally the venture capital money has also come from sovereign wealth funds, pension funds and other such large-sized funds. India has no such source of funds despite public sector enterprises likes of LIC have been sitting on huge cash piles. The government needs to come with necessary regulatory changes to enable the capital inflow from such PSEs to unlock the potential promised by the growing startup ecosystem along with securing the possibility of high capital returns.

In order to attract more private capital in the startup ecosystem, Government of India came with a Rs.10,000Cr, Fund of Fund plan executed by SIDBI which is a very welcome step. This was launched to motivate Alternative Investment Funds (AIFs) to float schemes that will invest exclusively in startups; however, the disbursement of funds has remained sluggish and conservative making the initiative inefficient. This has been a pattern across the state funds created to support startups. There is a dire need to cut down the bureaucratic hurdles.

If one digs deep into this problem, the over-cautious attitude of bureaucrats sitting over state funds is not because of traditional red-tapism but due to the excessive fear of being seen in wrong light if the investment goes south.  The government, therefore, needs to ensure much bigger participation of private professionals in making swift decisions to ensure efficiency of the policy initiative. 

Listing in India has remained another humungous task faced by startup community to access market capital. Most of the startups have preferred to be listed abroad than to go through the complex procedure in India. Government and SEBI must come together to simplify the listing process to have smoother access to capital market.

Ideas such as establishing an Exchange Traded Fund (ETF) if paid due diligence can turnout to be a brilliant possibility and create a win-win situation for startups, VCs as well as retail investors. Further, the government can always amend the tax laws to incentivize venture capital investments especially when the imposition of  taxes such as angel tax has been causing tax terrorism!

There is no doubt that Indian startup ecosystem requires much more domestic capital infusion. If the government is willing to take a step forward to become a risk sharer party, if It can successfully mobilize enough confidence from the private sector, there is nothing that can stop the Indian startup ecosystem to become the brightest star of global entrepreneurial paradigm.

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