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Silicon Valley Bank Crisis: How India Can Save Its Fledgling Startup Ecosystem

Proactive steps towards creating a new-age policy architecture can help build thousands of vibrant & big startups.

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Silicon Valley Bank (SVB), a licenced bank, based in California USA, was a bank focussed on startup financing. Celebrated venture funds like Y-Combinator made the start-ups funded by them bank with SVB, keeping their liquidity as deposits. Many of India’s startups also banked with SVB.

Last week, SVB collapsed, on account of the bank’s traditional ill of asset-liability mismatch and imprudent investment in low-yielding bonds. When depositors wanted to withdraw their deposits and SVB sold part of its bonds at big losses, Bank’s capital got wiped out. Regulators shuttered SVB.

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To calm the nerves of depositors, including those with non-FIDC-insured deposits of more than USD 250,000, the regulators made a major regulatory concession. They assured that all deposits would be made whole and taxpayers would also not bear the burden. Instead, the cost would be spread over all the depositors.

The startups are not in the business of keeping deposits in any bank. They do so when they have not spent the funds raised. While Indian startup firms with deposits in SVB are comforted that their deposits are not lost, the real question is whether the Indian startup ecosystem, already in the throes of a long funding winter, can survive this big blow.
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Indian Startup Ecosystem Has Thrived on US Legs

With more than 5,000 funded start-ups having raised over USD 135 billion in capital investment, India boasts of the third largest startup ecosystem in the world, which has also spawned more than 100 unicorns.

While e-commerce and fintech have received more than half of the total investment, enterprise tech, Edutech, health-tech, and other sectors have seen many startups growing into big businesses. Some startups could list on Indian bourses as well in 2021-22 at eye-popping valuations.

Startups have always needed massive amounts of capital to burn (burning capital as distinguished from working capital in normal businesses) to acquire customers in domestic markets and markets abroad. US venture capital and private equity (VC & PE) firms provided the burning capital in big doses, along with Japanese and Chinese investors, to Indian e-commerce, fintech, and other domestic-market focussed startups.

Many US companies also provided the markets for software as a service (SAAS) and other Indian internet companies. Most estimates suggest that more than 50% of startup capital in India has come from US firms and more than 50% of the market for many startup firms is in the US.

Indian startup ecosystem is, thus, massively integrated with the US (VC & PE) firms, larger financial systems, and markets. The collapse of SVB and two others and also perceptible weakness in many other smaller/regional US banks are understandably causing enormous worry for the Indian startup system.
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US Venture Capital Support System Is Likely To Withdraw Into a Shell for Sometime

Indian start-ups received about half of their total capital (about USD 65 billion) in the last two calendar years, especially in the Covid-19 year of 2020-21. More than 60% of it reportedly came from US investors. Though, there has been a thaw for the last six months.

Covid had made the US government open its purse to shower grants on US consumers and businesses. The Fed also turned on the spigot of virtually free money. The US venture capital and private equity firms lapped up this virtually costless money to pump investments in crypto-currencies, capital-burning and loss-making startups, Special Purpose Acquisition Companies (SPACs), and many other risky ventures.

Indian startups were quite happy to lap up these investments. Indian startups embarked on burning capital to acquire customers; without caring about keeping profitability in sight. Oodles of capital infusion at still greater valuations in each round made them believe that their valuation was directly proportional to the customers they acquired, irrespective of losses they made. Some startups resorted to fooling people into investing their hard-earned money at their artificial and crazy valuations. Very soon super-bloated valuations came down and they rued, with their investments falling by more than half in most cases.

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Inflation has returned in the US after 40 years and with a vengeance. Fed had to reverse its stance and is currently on the other side in trying to contain inflation by raising interest rates. In a year’s time, US fed-fund rates are about 500% higher than in the closing months of 2021.

Consequently, the cost of capital for VC & PE firms has also risen with cheaper money evaporating and their investors demanding higher returns. With their profitability and valuations dropping, many VC & PE firms have started turning off the funding pipeline and have been demanding better profitability in place of more customers. The startups have been forced to look at the bottom line in place of the topline.
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Funding slowed down in 2022 and a funding winter set in about nine months back. India could mint only 20 unicorns in the first half of 2022 after seeing 46 unicorns in 2021. Only two unicorns got created in July-September 2022. There have not been any unicorns in the last six months. On the contrary, the valuations of many startups have come down significantly.

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Our Policy Environment Has Been Less Than Conducive & Is Taking a Wrong Turn

While producing and delivering goods and services, largely digitally, is the foremost identity of a startup, the Indian government has a highly diluted definition of startup.

Department of Promotion of Industry and Internal Trade (DPIIT), the nodal department for startups, recognises any ‘original entity’ of less than 10 years in existence, incorporated as a private limited company or a registered or limited liability partnership, with a turnover of less than Rs 100 crore in a year as a startup in any sector of the economy.

This loose definition has resulted in more than six lakh firms becoming part of the Startup India Hub with over 93,000 getting officially recognised as startups by DPIIT. In the process, nurturing of digital economy startups has got wholly diluted.

The government made profits of start-ups, registered by the CBDT before 31 March 2023, tax-free for any period of three years within a period of 10 years under section 80-IAC of the Income Tax Act. The VC/PE industry recognises over 50,000 digital/internet startups; of which more than 5000 have received funding from angel investors, PEs, and VCs.

However, for tax exemption purposes, there are only 1,162 startups in the country, that too not necessarily digital startups. These startups get no real benefits. The government does not provide the number of taxes foregone under this section in the Budget Papers.

Budget 2023-24 is pushing the Indian startup system into a still worse policy blind spot. Section 56 (2)(viib) of the Income Tax Act, effectively provides, in the context of startups, that capital infusion in any new round at price higher than the price of the previous round, will be taxed as a capital gain. This tax is also termed as angel tax. Despite the fact that most startups make losses in the growth phase and burn their capital, the tax officers have gleefully assessed such higher valuation of shares in the subsequent round as capital gains and raised tax demands. This has been a major heartburn in start-ups.

Until the financial year 2022-23, foreign investors in startups were exempt from this angel tax. The Finance Minister has proposed in the Budget 2023-24 that this exemption would no longer be available to foreign investors and there would be a tax on such higher valuations.

So far, this mindless provision was not affecting startup funding for the simple reason that most of their capital was coming from abroad. It should be quite clear to everyone who cares that this amendment will sound the death knell of foreign VC/PEs funding in Indian startups in the future.

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What Can Possibly Save and Sustain Indian Startup Ecosystem?

Startups bring enormous efficiencies to industrial-age businesses by making extensive use of digital technology and data sets. The startups require a policy and regulatory environment in which they can innovate and experiment liberally using foreign funding, technology, and Indian data sets. They don’t need government tax incentives and small funding support.

To build such a vibrant startup ecosystem, the current policy environment needs to be drastically changed. Some specific policy changes required are:

First, the angel tax for startups needs to be abolished by repealing section 56(2)(viib) of the Income Tax Act or exempting all startups from its application.

Second, no one seems to be really availing of the tax exemption available under section 80-IAC as it is highly restrictive. The government rubs it further by increasing the eligibility period every year by one year. This Budget also raises it to 31 March 2024. The exemption may be extended to all digital startups and the eligibility time limit be increased in one go to 2030.

Third, the government established a Fund of Fund (FoF) for providing equity capital to startups. In the last 8 years of its existence, it has not even disbursed half a billion dollars. This is pittance. This little funding seems to have also gone to non-genuine non-digital startups. This FoF should be simply disbanded. The government may, if it still wants to do something, establish a professionally run majority private VCs/PEs/Sovereign Fund-owned alternate investment fund (AIF) on the lines of NIIF, with a large capital base of, say, about USD 5 billion.

Fourth, access to personal data, of course with willing consent, is the basic building block of digital-age startups.

India has unfortunately, been toying with the idea of bringing in a very restrictive personal data protection law. India has also made rules which impact e-commerce and other start-up businesses quite adversely. As a result, we don’t have even a single global-level internet business platform. India must bring data facilitation and freedom of doing digital business law, with appropriate provisions for the protection of involuntarily accessed critical privacy data, to become a pioneer in laying the foundation of big startups.
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Fifth, the Indian financial system, including banks and long-term institutions, does not provide finance to startups. Neither are Indian industrial-age businessmen quite keen to invest in startups. Regulatory, tax, and fiscal architecture need to be changed to nudge these institutions to provide finance to startups.

SVB collapse has shocked the Indian startup ecosystem. Funding winter is likely to worsen. By taking proactive steps to create a new-age policy architecture, we can build thousands of vibrant and big startups.

(The Author is the Chief Policy Advisor, SUBHANJALI, Author: The $10 Trillion Dream and Former Finance and Economic Affairs Secretary, Government of India. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for the same.)

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