The venture capital in India has come of age in the last decade. India has emerged as the third-largest startup ecosystem—both in terms of volume of transactions and number of investments—with 114 unicorns. While the last two years have been very tough for startups, the overall investment climate in India has remained vibrant and promising despite a chilling funding winter.

The funding winter has had a profound impact on the way the deals are being closed in India. It changed everything in the life cycle of a transaction, be it the deal flow, deal structures, complexity, and timelines.

In the aftermath of the crash in valuations, investors have become very cautious, which has impacted each stage of a VC transaction—from valuations to diligence, management rights for supervision of the business, and post-closing oversight of operations. All these factors led to the transactions becoming more complex and closure more time-consuming.

With the drop in valuations, there was a huge gap in the expectations of the founders regarding valuation and the VC’s assessments of the valuations of the startups.

A deal cannot be made unless the gap in valuations is bridged. Accordingly, the parties started to negotiate complex methods to determine the valuations and such methods will sometimes mean that the transaction will be closed without fixing the exact valuation and will depend on conditions to be fulfilled in the future. Investors used innovative methods to fix valuations with a significant focus on actual performance and achievement of projected revenues or earnings. Sometimes, the valuations are not only linked to earnings but also to the diversification of markets or customers or the development/registration of intellectual property rights to secure future growth.

It is not easy in India to fill the valuation gaps just by issuing convertible instruments to investors and may involve the issuance of additional ESOPs/MSOPs to founders with complex vesting schedules and conditions. 

Sometimes, even if the valuations are low, startups may raise funding as a matter of survival in tough times. A down-round financing (ie, raising funding at a lower valuation than the previous round) may trigger anti-dilution rights of the existing investors. The anti-dilution provisions provide existing investors an adjustment to their entry price so that they are not impacted by the down-round financing. This requires the shareholding of the existing investors to be realigned before the new funding round. Accordingly, a transaction would not only involve heavy commercial negotiations with new investors, but a commercial agreement with the existing investors as well to align their effective shareholding.

In an uncertain environment, it is not uncommon for investors to push creative and innovative liquidation preference terms. Instead of the conventional provisions, which usually guarantee a return equivalent to their investment or a pro-rata share of liquidation proceeds based on ownership stakes, the investors are now suggesting more complex formulae and conditions for the distribution of liquidation proceeds.

Further, investors are seeking investor protection matters or veto matters that will necessarily require their consent, especially around the protection of the value of the company at the time of exit by the investors. In critical times, investors have been very careful with the information and inspection rights. They are also more focused on compliance and data privacy, and paying closer attention to the fulfillment of conditions that have come to light during diligence. The due diligence process and approach have also become more stringent.   

Despite the funding winter, the financial markets in India have done significantly better than their peers the world over, with Nifty and Sensex soaring to unprecedented heights. This has led to some large and successful IPOs that have provided exit to investors.

The scramble to list in India is so immense that some of the startups that had been held from abroad are trying to reverse their holding structures in India to get listed. While reverse flip involves heavy costs and tax leakages, the Indian markets are offering significant valuation premiums and brand recalls in comparison to other jurisdictions and startups are willing to pay the price. Apart from the costs and taxes, the reverse flip may involve navigating stringent regulatory restrictions. For example, for participation in an offer for sale as part of an IPO, the offering shareholder must hold the shares for a minimum period of one year before the IPO. Any reverse merger through a court with its offshore holding company is a time-consuming process that will require the approval of the Reserve Bank of India.  

Nevertheless, India is expected to continue to provide an excellent ground to the VC ecosystem. India, with its demographic advantage of a young population, provides a vast market that no one can afford to ignore. Also, India is expected to grow rapidly with a stable government and consistent policies. India also hasn’t suffered significantly from the post-pandemic economic and monetary instability and even from the ongoing geo-political tensions. While these issues have impacted economies across the globe, India is expected to benefit from supply-chain disruptions.

Accordingly, investors are cautiously optimistic, focusing on identifying and backing startups that have the potential to navigate the challenging environment and emerge as market leaders. As we look ahead, the venture capital landscape in India is likely to reach even greater heights.

(Manvinder Singh is Partner at JSA Advocates & Solicitors.)