[By Akshat Shukla and Tanvi Agrawal]
The authors are students at the National Law Institute University, Bhopal.
I. Funding Winter: Meaning and Overview
Funding Winter is a phrase used to describe the phenomena of a downturn in the investor’s confidence in the start-ups leading to a more strategic and curtailed approach towards funding. It often leads to investors avoiding firms without a set path chalked out for profitability. This, in turn, prompts a need to correct the value of the start-up. Further, one of the prominent effects of funding winter is that it requires business owners to reset their priorities in terms of profit maximization.
Funding winter is not a new concept but a cyclical effect that happens due to multiple factors which impact the free flow of investments in the market. These factors may either be generically applicable to the entire market such as geopolitical unrests in countries, monetary policies, financial irregularities etc. or may be centric to the relevant sectors. By the way of this article, the authors seek to address the reasons for the funding winter that has descended in the Indian market, its effects and the possible way out for the start-ups to withstand the funding crunch in the coming months.
II. Reasons for the Downturn in Investor Confidence
There are several reasons for funding winter as aforementioned.
A. The Generic Factors
- Geopolitical situations such as the Russia – Ukraine conflict and other acts of hostilities lead to the stipulation of a slow market by the investors. The world is interconnected in more than one aspect. The reliance of countries on one another further augments in the context of development and sustenance of international trade, flow of investments and exchange of services, etc. For this very reason, the occurrence or non-occurrence of any significant geopolitical event in one part of the world has crucial ramifications on the other. For instance, the standard indices in Indian, South Korean, Japanese and several other Asian markets were disrupted as a direct consequence of the announcement of the military operation by Russia on Ukraine.
- Financial irregularities and unscrupulous practices by nascent companies shake investor confidence. The classic case of this would be when the closing date of Sequoia Capital’s $2.8 billion India and Southeast Asia (SEA) Fund was delayed as a result of suspected financial irregularities and corporate governance failures at some of its portfolio companies.
- Monetary policies of the Government and regulators also determine the level of investment inflow of the investors. For instance, the repo rate has been increased by 40 basis points in the latest meeting of the RBI, as it wanted to tighten the policies and curb the relaxations given during the COVID-19 times. It also suggested increments in the Cash Reserve Ratios (CRR) and Statutory Liquidity Ratios (SLR) so as to prevent the banks from lending to the start-ups.
B. The Sectoral Factors
- The product efficiency and viability in the market have a significant impact on the trust of the investors. For instance, the electric vehicles market in India may suffer from a funding crunch owing to the recent explosions that happened in the e-scooters.
- Some sectors are in demand due to a particular event or cause and in case of a dynamic shift from that phase, the particular sector may face a funding winter. An example of this is the loss suffered by Softbank due to the tech sell-off that occurred after the shift from a virtual to a physical setting. These instances make investors cautious about investing heavily in a particular sector.
- The funding winter for some sectors may happen because of the different effects of the policies on that sector. For example, deflation may be a cause for funding winter as inflation may be helpful for mid-cap firms in the hospitality or other B2C sectors as these firms have the dominance to pass over the burden of increased pricing to their customers. In the shorter term, there can be an impact on the balance sheets of such firms but in the longer run, these firms benefit as the increased prices do not tend to go down even when prices of raw materials and primary commodities stabilise. Hindustan Lever, Asian Paints and Pidilite are some companies that have established how inflation proved to be helpful for them in maintaining margins.
Such factors affect not only the expectations but also the decision of the investors altogether in choosing how and where to employ their funds. Thus, they play a significant role in determining investor confidence and investment growth prospects.
III. Effects of the Funding Winter
With the funding winter in place, the start-ups resort to measures which help them save their working capital as the expectations of funding from the investors are minimal. The advertisement expenses, capital expenditure and expansion plans are put to a halt in order to increase the sustainability of the firm. Only the expenditure essential to the survival of the firm is undertaken and all possible steps are put in place to ensure unnecessary expenses.
Lastly, the end goal remains to maximize profit harnessing which keeps the firm steady even without the investment inflow. For instance, the statement of the CEO of Unacademy, Gaurav Munjal, highlighted the need to focus on profitability along with the need to work under restricted resource supply. He urged his employees to, “learn to work under constraints and focus on profitability at all costs.”
From the perspective of the investor, the funding winter does not mean a complete stoppage of investments by the investors. It infers that the investors become less interested in projects that have certain risk elements even though the same would have been pursued in a normal situation by the investor.
IV. The Start-up Market and Need for Regulations
Funding winter can have several effects on the economic enterprises and the economy but it essentially disrupts the start-up market. In the context of developmental reforms in India, it is necessary to have a framework which would help start-ups to overcome such downturns in funding from investors. The Start-up India program, which was launched in 2016, is an instrumental step in providing entrepreneurs with a platform to seek opportunities in the forefront.
As of now, there are schemes such as the SIDBI Funds of Funds Scheme and Start-up India Fund Scheme have been launched by the Government to support start-ups in garnering funds, however, it is not enough to capacitate the booming start-up market in the country. In the coming years, the focus of the Government should be to relax the FDI Policy for governmental route sectors to increase the funding inflow. Further, new policies must be introduced for new enterprises to flourish even without the support of investors.
V. Recourse under Extant Laws
An important consideration for investors is the protection of their investment in the companies where they invest. With the requisite reforms suggested, it is relevant to note the few methods which can be used in order to ensure the investors in times of uncertainty. The protective rights or anti-dilution rights are helpful instruments for investors to further their interests. It ensures that the investors do not have to lose out in case the valuation of the enterprise goes low in a down round.
Both the full ratchet and average weighted methods can be used to protect the investors. The full ratchet method can be used in a situation like funding winter where the investor turnout is nil as it favours the investor heavily by compensating the full lowered value of shares. One consideration of which foreign investors are generally wary is the provision for the sale of shares at fair market value as per Rule 21(2)(ii) of the Foreign Exchange Management (Non-debt Instrument Rules) 2019. In such cases, compliance is to be made by issuing the first valuation at a price much above market value to ensure that the down-round valuation is near the fair market value.
In the coming years, it would be pertinent for the regulators to create a better landscape for the investors by allowing for open approaches to foreign investors in the existing anti-dilution regime which is already incomprehensible worldwide due to its complex and mathematical nature.
VI. Conclusion and Way Forward
The duration of a funding winter is unpredictable and it may last for a long time depending on the multiple factors acting upon it. Some solutions for large and mid-size start-ups in order to sustain themselves through this phase of low investments are lowering the capital expenditure, maintaining high levels of working capital, cutting down on expansion ideas and maximizing profitability. While all of these solutions may be helpful for the enterprises that have the resources to sustain without any subsequent funding rounds, they become ineffective for the enterprises that are dependent on the investment rounds for sustenance.
In such cases, the first recourse for the enterprises may be to opt for possible and profitable pooling of resources through mergers and acquisitions which may help in increasing cash flows, product output and market presence without any additional funding. Such mergers and acquisitions can be helpful in increasing efficiencies in the vertical channels as well such as distribution and transportation services. Secondly, the infrastructural regime for start-ups in India would be an important aspect for the Indian Government to expand its quest for optimum utilization of resources. Lastly, it would also be feasible to seek recourse to extant laws and give some cushion to investors in order to lure them even in times of downturn.