Collateral Damage Of Anti-China Sentiments: the Indian Startup Ecosystem Indian investors may not have enough dry powder to replenish the Chinese investment, if disrupted

The year 2020 was supposed to mark the 70th anniversary of the establishment of diplomatic relations between India and the People's Republic of China. Various activities were planned to celebrate this historic milestone, but the coronavirus pandemic put a damper. Then came the grisly clash between the troops of the two nations in eastern Ladakh's Galwan Valley, due to a border row that escalated quickly. Twenty Indian soldiers were martyred in this confrontation with the Chinese PLA at the Line of Actual Control (LAC).

The alleged initial mishandling of the COVID-19 outbreak in the city of Wuhan by the Chinese government, coupled with the border clashes in Galwan has invoked anti-China sentiments across India. Angry street protests erupted across the country, with people breaking Chinese televisions and smartphones, burning Chinese goods and effigies of Chinese President Xi Jinping, and calling for a boycott of Chinese products, even Chinese food.

The Great Wall Against China

Citing national security concerns, the Indian government recently banned 59 apps developed by Chinese firms, including Bytedance's immensely popular TikTok. Later, 47 more apps were banned and 250 have been put under scanner including the hugely popular gaming app PubG. According to reports, a few days ago, the government notified new rules for the e-commerce companies, including the mandatory display of 'country of origin' on all products sold on their platforms. Failure to do so will attract penal action.

This move will allow consumers to identify and boycott Chinese goods and choose "Make in India' products. Although the Indian government hasn't explicitly announced or outlined any "boycott China' policies, many state governments and PSUs are planning to refrain from awarding tenders and contracts to Chinese firms and some are even canceling the contracts that have been previously awarded to Chinese companies.

Prior to all these moves, the Indian government had also tweaked its extant FDI policy, thereby requiring government's approval for all FDI proposals coming from any country that shares a land border with India. According to the government, this step was taken to curb opportunistic takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic. This rising anti-China rhetoric, however, could result in deep-rooted consequences for the thriving Indian startup ecosystem, as much of its accelerated growth has been fuelled by massive Chinese investments.

The Deep Impact Of Chinese Investment On Indian Startups

India is home to one of the largest startup ecosystems in the world, which has grown exponentially over the year. According to a Tracxn report, "The decade has seen an impressive 25 times growth from a tiny $550 million in 2010 to $14.5 billion in 2019 in terms of the total funding raised by startups."

But, the ecosystem owes a major chunk of this growth to Chinese investments, which not only helped the startups to scale exponentially but also helped them create an impact on a global level.

According to a February report by foreign policy think tank Gateway House-Indian Council on Global Relations, Chinese tech investors have put an estimated $4 billion into Indian start-ups. Out of the 30 unicorns in India, 18 are backed by Chinese investors. Fintech giant Paytm, online grocery retailer BigBasket, food delivery startups Zomato and Swiggy, ride-sharing platform Ola, and Walmart-owned Flipkart have thus far received billions of dollars in Chinese investment.

A recent report by data analytics and consulting company, GlobalData also suggests that there has been a 12 times growth of Chinese investments in Indian startups over the last four years—$381 million in 2016 to $4.6 billion in 2019. According to the report, both corporates, as well as pure-play investment firms from China have invested in Indian unicorns.

During the pre-COVID era, access to funds has been relatively easy for Indian startups due to Chinese investors with deep pockets being eager to invest in India. "Chinese investors are highly motivated to invest in the Internet startups of India, which is the second-most populous country with more than 500 million Internet users. Moreover, the lack of tech giants to invest huge amounts of money in the country's startups at a desirable speed is often driving young Indian entrepreneurs to look out to China for quick capital," said Kiran Raj, principal disruptive tech analyst at GlobalData.

But, the pandemic and the current geo-political scenario have deeply altered the fundraising demand-supply equation for the Indian startup ecosystem.

The Collateral Damage

Although 2019 was an exemplary year for the Indian startup ecosystem in terms of fundraising, things aren't going that well in 2020. According to Tracxn, in the first six months of 2020, startup funding dipped to $4.2 billion—a 29 per cent decrease from $5.9 billion in the same period last year.

While this drop can be largely attributed to the coronavirus pandemic and the economic uncertainty it brought upon the world, the new FDI policy that regulates Chinese investments in India has not helped the situation. Although the new policy has been put in place to prevent opportunistic takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic, the collateral damage is faced by the Indian entrepreneurial ecosystem.

Talking about the impact of tweaked FDI policy on the influx of Chinese investments in the Indian startup ecosystem, Abhishek Goyal, founder, Tracxn, told Entrepreneur India, "The new FDI policy should have a significant impact on the investment inflow. Investors do not like geo-political uncertainty while making investments and most believe that relations between the two countries will remain difficult in the coming days. Relations may see a new low if India is able to attract a meaningful number of manufacturing outfits from China. Largely, border issues cannot be seen only with an economic impact of one segment."

Nitin Sharma, founder of FirstPrinciples, said, "In the short-to-medium term, it will have a drastic impact. Through our own portfolio, we are learning that many smaller funds and corporates are understandably wary and even if the non-automatic route is feasible, they may tread cautiously for 9-12 months. In the long-term, and with respect to larger funds or strategics like Tencent or Alibaba, I am sure they will continue to explore the growth opportunities in the Indian market actively and wait for the environment to evolve."

According to Ben Mathias, managing partner, Vertex Ventures, several startups were in the process of raising financing rounds from Chinese investors and these have been delayed or called-off due to the new FDI policy. This will impact unicorns more than early-stage startups because there are fewer players who can write larger checks.

The current version of the new FDI policy is quite ambiguous as there are plenty of details that still need to be ironed out and loopholes left to be plugged. Transparency is an integral factor in international fundraising. Therefore, the ambiguity, coupled with the added red-tapism, might create apprehensions in the minds of potential and existing Chinese investors.

"In the absence of any clarifications from the government on whether there is any threshold up to which investments will be automatically permitted or sectors that will be exempted from prior approval, it seems like all new and existing investors from China (and other entities which are incorporated in a country which shares its land borders with India, or where the beneficial owner of an investment into India is situated in or is a citizen of any such country) will need to obtain prior government approval before they can invest new money into Indian companies or fund more equity into existing investments for growth purposes," explained Delano Furtado, a partner with law firm Trilegal.

"There is also no timeline prescribed on how long it would take to acquire government approval, but if you were to compare with previous timelines taken to obtain government approval for FDI, we could be looking at anything between 4-6 weeks for FDI investments to be approved. If border tensions between China and India continue, the time taken for obtaining government approvals could be impacted even more in some of the more sensitive sectors," he added.

The Moral Quandary

The rising anti-China sentiments in India have even made certain Indian startups increasingly morally apprehensive about raising Chinese investments. Rakesh Mohan Joshi, professor and chairperson, International Collaborations & Research, IIFT, believes that the rising sentiments of self-reliance among Indians, combined with other protectionist measures that have been established, could not only potentially hamper Chinese investment in India but also make Indian startups more apprehensive of sourcing Chinese capital.

"When you combine increased regulatory scrutiny, longer timelines for investment, and in some cases, optics with respect to their own customer base, I think it's fair to say Indian startups will tread more cautiously for some time," opined Sharma of FirstPrinciples.

Goyal believes that it would be difficult for a startup to turn its back on a potential funding source, given the sizable mindshare startups have to spend on raising capital. Although, according to him, announcing it publicly or even internally would prove to be the difficult part as some employees might question if it was right to take capital from Chinese investors.

What If The Chinese Investments Dry Up?

Rising anti-China sentiments, protectionist policies and regulations, and continued tensions between China and India could potentially cause the funding from Chinese investors for Indian startups to dry up.

A number of stakeholders in the ecosystem believe that Indian startups are resilient enough to absorb the impact of the Chinese funds drying up. The startups will have to acclimatize to the new normal.

"Startups and founders are very resilient and they will learn to adapt to the changed environment. Business practices that seemed right when the capital was available, will now be put to the test. Growth will slow down, but then this is really relative as even competition will be facing the same challenges and slowing down will not be at the cost of loss of market share. Some may not survive; which is Darwin's theory playing out in the startup world. Customers may feel less pampered—and will have to learn to pay for services that were hitherto free—which is also a development in the right direction," Verma said.

He believes that between the unicorns and early-stage startups, the unicorns—being bigger—are more likely to face the challenges associated with the freezing of Chinese funds.

"The unicorns and other large tech startups are adjusting to the new reality by rapidly reducing their cash burn, extending their runways and boosting their chances of profitability and subsequent IPO listings. The double-whammy is of course because of the economic impact of COVID-19 in parallel," believes Sharma of FirstPrinciples.

In the case of early-stage startups, he is of the opinion that the slowdown is primarily because of COVID-19 and the recession. "As later-stage valuations correct because of the absence of China's capital, it will have a lagging effect on early-stage as well, but that will be clearer in a few months."

According to Goyal, startups in the pre-unicorn phase have a lot less dependence on Chinese capital. "Quality startups have access to capital in most scenarios; price may get slightly impacted or it may take longer. Recent Jio fundraise has clearly demonstrated that assets with a good hope story will have enough and more capital coming their way."

"In the current pandemic and global environment in which consumer demand is subdued and liquidity remains a concern, most startups whether unicorns or early-stage companies will be faced with a huge level of uncertainty on whether they can count on future investments from their Chinese shareholders to tide over the current crisis," Furtado opines.

He believes that for the early-stage companies, it may be a question of survival if clarifications do not come from the government soon enough. "As for the unicorns, given that they already have achieved some amount of recognition globally and domestically, they may find it easier to find alternative backers from new investors in other countries. However, this will be an uphill task and could also impact future outlook and growth for these unicorns."

Home Is Where the Money Is

The current geo-political scenario and the dearth of Chinese investment have created a fund-raising vacuum in the Indian startup ecosystem that could potentially be filled by alternative funding sources and open up investment-centric avenues from other countries. But, the first and the most obvious alternative source of funding would be Indian investors.

However, according to a recent IVCA-EY report, the last three years witnessed approximately $111.7 billion worth of long-term capital being invested into Indian companies, more than 80 per cent of which was from foreign capital.

Is it time for Indian investors to step up and invest more in homegrown startups so that the ecosystem's reliance on foreign money can be mitigated?

Verma believes it is. "The strongest and most resilient is the domestic market and what has been very positive in the last few years is the emergence of alternative investment funds (AIF), which have raised capital from the domestic market. They have largely been in the early stages – angel funds, Series A funds, and there is a need to encourage later stage capital funds also."

"Only in the last 4-5 years, we have seen domestic capital entering the startup ecosystem. This is after the massive success of Flipkart and the rise of startups like Ola, Byju's and OYO. Domestic capital will increase as there is more wealth creation among existing investors. Investors will follow the returns," Goyal opines.

During a recent webinar, Union commerce and industry minister Piyush Goyal called upon Indian investors to come forward and play a greater role in supporting the Indian startups and invest more in them.

He also highlighted the fact that the Indian government has also been playing its part in strengthening the startup ecosystem and that there are more steps that need to be taken to further enhance the ease of doing business quotient for the startups.

Government & Policy-makers: The Domestic Investment Catalysts

The government does play a crucial role when it comes to promoting the flow of domestic capital into the Indian startup ecosystem; favorable policies can certainly help in doing so. "As most of the Indian unicorns are funded by foreign capitals, induction of indigenous capital would always be a welcome step as it would reduce their dependence on foreign capital. This requires both India's institutional structure as well as a policy framework to support Indian investments in the startups," says Prof. Joshi.

According to Goyal of Traxcn, "Policy can play a huge role in it - they can bring capital gains on private market returns (20 per cent) in line with public equity returns (10 per cent) and reduce the overhead of paperwork when selling shares in private companies."

He believes that initiatives such as allowing the offsetting of capital gains in startups against investing in other startups or offering tax breaks on capital gains against investment in venture and private equity will definitely instigate Indian investors to invest more in Indian startups.

Sharma also believes that the government can catalyze domestic investment by encouraging the large state entities like LIC or banks to increase exposure to the venture asset class.

He is also of the opinion that traditional Indian corporates will learn from the evolution of the US market and local examples like Jio, and realize that the Indian economy and markets will become more and more dominated by technology. "For them, investments in startups and VC funds, or acquisition of tech startups, can be key to bridging the innovation or talent gaps."

Do Indian Investors Have The Dry Powder To Plug The Funding Gap?

Although the notion of Indian investors stepping up and filling the Chinese funding void may seem like a lucrative and obvious choice, it might not be a feasible option. Over the years, Chinese investors have pumped billions of dollars into the Indian startup ecosystem. So, the crucial question that arises here is whether Indian investors have the required dry powder to fill the funding void that might be created by the lack of Chinese investments in India.

"No, there is not enough domestic capital formation in the venture capital asset class," opines Sharma.

"In China, more than 80 per cent of VC capital is domestically sourced, whereas, in India, that number is probably less than 5 per cent. It will take time for Indian institutions like pension funds, banks or insurance companies, or corporates and family offices, in general, to make significant allocations as limited partners (LPs) in VC funds or to invest directly. This needs to be pushed aggressively by the government," says Sharma.

"China is the world's second-largest VC market with over 3,500 firms compared with less than 100 in India. Moreover, a large number of profit-making Chinese companies invest in other businesses compared to India," Prof. Joshi highlighted.

He believes that although the Indian startup and investment ecosystem have evolved rapidly over the years, the fund requirement of Indian startups, presently, exceeds the funds available for investment indigenously to meet their needs. Therefore, Indian startups invariably need to explore foreign capital.

Looking Beyond The Great Wall

Talking about alternative funding sources for Indian startups, Goyal of Traxcn said, "Fortunately, India has been an investment hotspot among private market investors from a very diverse set of geographies. It is expected that limited partners across the world will continue to back Funds investing in India. Japanese and South Korean investors have been aggressively trying to stay ahead of Chinese investors in India."

According to Mathais, investors from other countries are already compensating for the shortfall in funds. "We have already started seeing this happen with significant investment commitments being made by Google, Facebook, and other major US technology companies in recent weeks. There is also an increased investment activity from Japan."

"I think the gap might be partly met by the likes of Jio (with a $20 billion war chest) or existing Indian investors with dry powder. Next, some US or Middle East investors who have some India exposure may perhaps opportunistically fill in the gap, but it may not match the size and speed of Chinese investors in 2017-19," Sharma opined.

"I don't think any other country will be able to fill up the gap. US funds typically come in later stages and not at early stages—Series D and later. Japan has been investing but typically smaller tickets as Japan does not have a large VC base like the US—behemoths like Softbank are more an aberration. I think the Middle East can be interesting; especially for healthcare and education—two sectors that they like. B2B commerce could also be of interest to them," said Verma.

He believes that there will be a gap that will be filled up over a period of time, largely by new funds that will come up with a combination of domestic and international money from the Middle East and the US.

"The Indian digital story is COVID-resistant, even during these uncertain times we have seen investments from North America, the Middle East come into the digital ecosystem of India," believes Amit Bhandari, fellow, Energy and Environment Studies Programme, Gateway House.

He thinks that the European privately held family funds and European sovereign funds will also be looking at India. "India needs a well-calibrated diplomatic outreach to tap these funds. So the Indian tech and startup systems have ample opportunities to tap the overseas markets. A few Indian entities have also raised capital in the past 6 weeks those funds will also be deployed."

According to Prof. Joshi, in view of an innovative strategic approach, the potential for growth and market size Indian start-ups are getting increasingly attractive for investors from the US, Japan, Singapore, and a number of European countries. Even investors from non-traditional countries such as South Africa have invested in Indian start-ups such as Swiggy and Byju's indicating their growing fascination worldwide.

Goyal of Traxcn believes that India is at a stage where its dependence on Chinese capital is not as high. "The Indian startup ecosystem has found the right impetus in the last 10 years and is producing better companies than ever before. If we continue this momentum and don't do anything counter-productive, capital will be available for worthwhile startups."