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Why are Indian Startups headed towards Consolidation?

calendar19 May, 2023
timeReading Time: 7 Minutes
Why are Indian Startups headed towards Consolidation?

In recent months, deals have risen significantly in the Indian startup industry, driven by larger organizations seeking growth opportunities and financially constrained startups searching for support and survival. In recent times, the Indian startup scene has progressed and thrived, resulting in numerous enterprises in related or similar industries coming together and transforming into significant entities within their respective sectors. In the first quarter of 2022, the startup industry witnessed a significant surge in mergers and acquisitions (M&As), with a total of 139 deals taking place. This accounted for 70% of the entire M&A activity in 2021. Several factors have contributed to this trend. Corporate governance issues have played a role as startups face challenges in managing, directing, and controlling their companies. Many startups seek partnerships or acquisitions to mitigate risks and improve operations. Another factor is a reduction in venture spending, with investors becoming more cautious about capital allocation. This cautious approach can lead to a cash crunch in the startup market.

Additionally, inflated private market valuations have created a challenging environment for fundraising and financing activities. Despite these challenges, M&A deals in the startup ecosystem offer several benefits. Firstly, they create a wealth effect, generating positive financial outcomes for the parties involved. This, in turn, stimulates further investment and economic growth in the industry. Furthermore, M&As strengthen the overall startup ecosystem by consolidating resources and expertise. Merged companies can achieve greater market reach, scale their operations, and optimize their business models. This Consolidation often leads to improved competitiveness and increased innovation prospects across the startup space.

What Caused the Consolidation Wave?

The global economy has been characterized by significant economic volatility in the past two years, driven mainly by political unrest and other factors. This instability has put immense pressure on markets worldwide, leading to widespread selling activities. One of the key challenges businesses have faced during this period is inflation, which has dramatically impacted various economies. In particular, both the American and Eurozone countries have experienced an 8% increase in inflation rates, and this upward trend is expected to persist until 2022.

The rise in inflation has necessitated re-evaluating due diligence processes for executives with little experience dealing with an inflationary market. It has become crucial for organizations to carefully assess and predict potential inflation scenarios and utilize data analysis techniques to estimate the effects of inflation on their operations and overall profitability. This proactive approach allows businesses to prepare better and make informed decisions in response to inflationary pressures.

Amidst these circumstances, one notable strategy that has emerged as the most prudent for many organizations is pursuing acquisitions. The M&A boom across numerous industries can largely be attributed to the desire to acquire potential competitors or seize opportunities for new business. Through strategic mergers or acquisitions, companies can capitalize on synergies, enhance their market footprint, and mitigate the risks linked to inflation.

This approach helps organizations navigate the challenges posed by an inflationary market and positions them for growth and increased competitiveness in the long run.

Recent Market Scenario

In the last year, Indian entrepreneurs achieved an extraordinary feat by raising an unprecedented $42 billion through fundraising efforts, underscoring the remarkable growth of the startup ecosystem in the country. This period between 2019 and 2021 witnessed the emergence of an average of two new unicorns every month, indicating the thriving entrepreneurial landscape in India. However, the startup landscape has experienced significant transformations due to several factors.

One key concern that has emerged is governance issues within startups, prompting a renewed focus on implementing robust governance practices. Startups are now prioritizing proper governance to ensure transparency, accountability, and compliance with regulations. This shift highlights the industry’s recognition of the importance of maintaining sound governance frameworks.

Moreover, there has been a noticeable decline in the availability of venture capital, causing investors to adopt a more cautious approach when making investment decisions. This cautious stance has led to a more rigorous due diligence process, with investors scrutinizing potential opportunities more thoroughly. Internal audits, such as those conducted by BharatPe and Zillingo, have surprised investors, emphasizing the need for extensive due diligence to identify any potential risks or shortcomings.

The public markets for technology stocks have experienced a general downturn, as evidenced by the declines in companies like Paytm, Nykaa, and Policy Bazaar. This market trend has had a ripple effect on India’s private markets, where startups have faced inflated valuations. As a result, prominent investment firms like SoftBank and Tiger Global have incurred significant losses in their investments, prompting them to reduce their exposure to large-scale investments. However, these firms have shown renewed interest in smaller seed and series funding rounds, indicating a shift in investment strategies.

Overall, the Indian startup ecosystem[1] has witnessed both successes and challenges. While fundraising records have been broken and new unicorns have emerged, the landscape has also faced governance concerns, reduced availability of venture capital, and inflation in valuations. These factors have prompted a more cautious approach among investors, emphasizing the importance of thorough due diligence.

Navigating Economic Challenges: Exit Strategies and Industry Consolidation for Startups

The current economic conditions, including inflation, tighter monetary policies, and funding challenges, pose risks for high-growth startups. To navigate these challenges, startups are actively seeking exit opportunities through partnerships or acquisitions. However, they also need help with additional hurdles, such as corporate governance issues, reduced availability of venture capital, cash shortages, and overvaluation concerns. The market instability and funding shortfall further limit their ability to access funds and participate in industry consolidation, making them attractive targets for larger companies seeking growth opportunities.

I. The Impact of Inflation and Tighter Monetary Policies

The recent surge in inflation caused by rising commodity prices has led central banks to implement tighter monetary policies and increase interest rates. This inflationary environment and concerns about a potential recession pose significant risks for high-growth startups. As consumers reduce their discretionary spending, these startups may experience greater-than-anticipated losses.

II. Startups Exploring Exit Opportunities

In response to the challenging economic conditions, startups are actively exploring exit opportunities by seeking partnerships or acquisitions with established organizations. This strategic move allows them to align themselves with more substantial entities and navigate the challenging market landscape.

III. Challenges Faced by Startups

  1. Corporate Governance Issues: Corporate governance has become a prominent concern for startups, highlighting the need for implementing robust governance practices within these companies. This guarantees openness, responsibility, and efficient decision-making.

b. Reduction in Venture Capital Availability: There has been a reduction in the availability of venture capital, making it more difficult for startups to secure the necessary funding for their operations and growth. This scarcity of capital limits their ability to weather economic uncertainties and invest in innovation.

c. Cash Shortage and Overvaluation: The overvaluation of private market prices has created a cash shortage for startups. This shortage forces them to either cut back on expenses or explore alternative financing options to sustain their operations.

IV. Market Instability and Industry Consolidation

The overall market instability has created obstacles for startups in accessing the funds required for their operations and participating in industry consolidation. Simultaneously, the global funding shortfall has made it particularly challenging for small businesses to raise capital or expand. As a result, these smaller enterprises have become attractive targets for larger companies aiming to accelerate their growth. This trend is especially evident in sectors like Fintech and Edtech, where companies often need a competitive edge and offer similar products or services.

Prime Growth Opportunities Post-Acquisition

Acquisitions offer an exciting avenue for business expansion, enabling companies to quickly broaden their reach, tap into new markets, and access innovative products and technologies. In the current competitive labour market, larger organizations are considering acquisitions as a means to bolster their technical teams and attract highly skilled engineering talent.

The cost reductions resulting from the pandemic have made acquisitions a practical strategy for established firms to strategically consolidate their market position by acquiring businesses that complement their own. Within industries, mergers and acquisitions (M&A) provide benefits to acquiring companies as emerging enterprises evaluate established firms as potential exit options. Such takeovers often enable companies to enhance their market share, generate revenue, access valuable technology or expertise, and streamline costs as the initial gains from the pandemic subside.

A noteworthy example is the education technology company BYJUs, which invested over $2.5 billion in strategic acquisitions, including Aakash Educational, Tynker, and EPIC. Another significant acquisition in 2022 was Sharechat’s takeover of MX Takatak, valued at $700 million. MX Takatak witnessed a surge in popularity following the Indian government’s ban on TikTok in 2020 and boasted more than 150 million active users across ten languages.

Numerous prominent startups across various sectors are actively engaging in negotiations, acquisitions, and strategic investments to propel their growth. Notably, the domains of Ed-tech and e-commerce have attracted significant attention, along with fintech unicorns such as Red and Razorpay, mobility-focused companies like Ola and Spinny, food delivery platform Zomato, and fantasy sports platform Dream11.

Companies with substantial market value, including Unacademy, Pharmeasy, BYJU’s, and Zomato, have undertaken 47 acquisitions to diversify into new segments, expand into new geographical territories, strengthen their offline capabilities, and scale up their existing operations.

Importance of M&A Transactions to Investors

Mergers and acquisitions are vital tools for companies and investors. They enable companies to achieve rapid growth and operational expansion while providing investors with liquidity options. M&A transactions, particularly stock-only acquisitions, offer investors the opportunity to invest in high-growth companies and reinvest their profits. Additionally, M&A activities contribute to the growth and innovation of the startup ecosystem, benefiting all parties involved.

Mergers and acquisitions (M&A) refer to the processes through which companies combine their operations or acquire other companies. While M&A is commonly seen as a strategy for companies to achieve rapid growth and expand their operations, it also serves as a significant liquidity event for investors, allowing them to sell their investments in a company and exit their position.

One alternative to M&A for companies seeking liquidity is an initial public offering (IPO), which is the process of offering shares to the public for the first time. However, an IPO is often a lengthy and complex process influenced by various economic factors. In contrast, M&A can provide a more straightforward and quicker path to liquidity for investors.

In some cases, M&A transactions are structured as stock-only acquisitions. This means that the acquiring company pays for the target company’s shares using its own stock rather than cash. Stock-only acquisitions can be particularly attractive for investors because they allow them to invest in high-growth companies. When the acquiring company’s stock value increases, investors can benefit from the appreciation of their investment. This allows them to reinvest their profits in new deals or become angel investors who support founders and early-stage companies.

Furthermore, M&A activities have a broader impact on the market and the startup ecosystem. Consolidation through M&A helps strengthen startup ecosystems by combining resources, expertise, and networks from different companies. This Consolidation makes the ecosystem more self-sustaining and increases the potential for innovation. As companies grow and innovate, they can create new products, services, and technologies that benefit society as a whole.

Conclusion

Undoubtedly, dealmakers now face elevated expectations for achieving success. However, despite this challenge, we maintain a positive outlook on the continued significance of mergers and acquisitions (M&A) as a strategic priority. M&A transactions play a crucial role in enabling companies to undergo a transformation, drive growth, and establish a solid foundation for future success. In the face of a new business landscape characterized by prolonged trends rather than short-term volatility, dealmakers are adapting their strategies accordingly. It is imperative to strategically realign M&A priorities and approaches in order to unlock future growth opportunities. This is an opportune moment to take bold steps and set the stage for the next five years. In a challenging economic environment, M&A serves as a means to pursue valuable opportunities that can contribute to the overall value of their business or portfolio.

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