“`html

India’s Startup Ecosystem: Evaluating Growth versus Profitability

India’s startup ecosystem is currently navigating a critical juncture. Record levels of venture capital are being injected into the system, and another wave of companies aiming for IPOs is emerging. This raises a significant question: does the Indian startup landscape reward authentic business success or savvy financial strategies? As valuations escalate and profitability becomes secondary, an increasing number of founders and investors are questioning whether this boom is sustainable or merely geared towards quick exits.

The foundation of the startup surge is based on a controversial tax framework, one that favours growth at the cost of profitability. The current climate is such that inflated valuations often take precedence over substantial value, with the pathway to wealth increasingly reliant not on dividends or consistent accumulation but rather on lucrative exits.

Tax Implications on Startup Behaviour

Zerodha’s founder, Nithin Kamath, has ignited a discussion regarding the influence of India’s tax regulations on startup behaviours. He clarified how a tax disparity of 37 percentage points between capital gains and dividends has altered the incentives within India’s venture ecosystem. If a business profits and chooses to share dividends, it faces approximately a 25% corporate tax complemented by a 35.5% individual income tax, resulting in an effective tax burden of around 52%. Conversely, a rapidly growing company that demonstrates losses can later sell at a higher valuation with only about a 15% capital gains tax. This stark difference, 52% versus 15%, is significantly reshaping India’s startup economy.

Impacts on Founders and Investors

The repercussions are fairly foreseeable. Founders are now prioritised for their valuations rather than their profits. Venture capitalists encourage growth in revenue rather than net income since their returns arise from capital gains rather than steady dividend payments. As such, a company’s rapid expansion leads to higher valuations, consequently resulting in larger exit payouts. This has led to a scenario where high cash burn rates are regarded as normal, with startups investing heavily in marketing and user acquisition to create the impression of relentless growth.

In response to Nithin Kamath’s observations, Ixigo co-founder Aloke Bajpai contended that the choice to reinvest earnings for market development and long-term value generation lies with the companies, rather than with the venture capitalists. He suggested that when the total addressable market (TAM) is expansive and grows, reinvesting profits to stimulate growth is a sound strategic decision. Bajpai pointed to global examples, highlighting that Google and Meta did not issue dividends until 2024, and that Steve Jobs was famously against dividends, believing that capital should be directed towards innovation and growth until all opportunities were maximised.

Drawbacks of the Current Model

This approach, however, presents significant disadvantages. It tends to encourage financially unstable companies that depend heavily on external funding and find it challenging to survive during prolonged rifts in investment. Additionally, it fosters capital misallocation, where hype-driven ventures receive disproportionate investment, while businesses focused on innovation or sustainable growth are largely ignored. This cycle further complicates competition, as smaller startups struggle to compete with well-capitalised incumbents that can afford to burn cash to maintain market share.

The impact is not limited to balance sheets. Employee behaviours are also shifting; managers accustomed to a growth-oriented mindset without regard for expenses may find themselves out of innovative ideas when they encounter obstacles. This results in the company’s ability to navigate crises, such as the pandemic or other unforeseen market challenges, becoming increasingly tenuous. Real innovation becomes difficult to discern until too late, or obvious to all.

It is worth noting that India’s R&D expenditure is currently just 0.7% of GDP, while it stands at 2.4% in China and 3.4% in the U.S. This trend risks elevating marketing prowess over true innovation.

The IPO Landscape in India

With a scarcity of mergers and acquisitions, IPOs have emerged as the default exit strategy for venture-backed startups, many of which aspire to go public within 10 to 12 years of securing initial funding. It is concerning to observe companies manipulating their financials and operational realities to appear marginally profitable or reduce cash burn right before listing, signalling stability while founders and early-stage investors cash out through Offer-for-Sale (OFS) mechanisms, benefiting from a minimal capital gains tax of only 15%. The term ‘offer for sale’ has transitioned into a more widely accepted practice now, despite being largely overlooked until recent years.

According to industry statistics, nearly 68% of private equity and venture capital exits in 2024 were executed through IPOs, amounting to over Rs 68,000 crore since FY22. Although this trend appears beneficial for founders, funds, bankers, and institutional investors, the long-term implications are borne by public shareholders, especially retail investors lured in by the narrative of growth and the fear of missing out. Many have deemed the Indian market as significantly underdeveloped in terms of investor acumen.

The government’s intentions might have aimed to foster investment and spending rather than hoarding cash, but the current balance seems skewed. The system now favours exits over sustainability. Addressing this imbalance will necessitate structural tax reform to lessen the divide between dividend and capital gains tax.

A scenario where inflated valuations overshadow genuine viability was likely not the original aim. Many corporations pursuing immediate growth attain inflated valuations while remaining unprofitable and fragile in the face of tightening market conditions. The failures of growth-at-any-cost models, both internationally (such as WeWork) and domestically (like Byju’s), highlight this vulnerability.

The venture capital framework exacerbates the ongoing cycle. Funds supported by institutional partners are generally expected to yield returns of 5 to 10 times their investment within a decade, placing a higher value on valuation increases than on profitability as true performance indicators. Consequently, growth without profit attracts 3 times higher valuation multiples compared to stable, profit-oriented progression. Suggesting that this is the norm in other markets diminishes the severe capital constraints still faced by the Indian market relative to the U.S. and other developed regions. Efforts to demonstrate profitability for an IPO, while knowing full well it is unsustainable, create market distortions that disadvantage those left behind in the rush. This perpetuates the inequity faced by conservative founders who have built robust, albeit smaller, enterprises.

The current methodology may lead to quicker exits and theoretical wealth accumulation, yet it concurrently breeds businesses that are fundamentally fragile and reliant on continuous external funding and favourable market mood. A combination that is as elusive as clean air in the NCR region for lengthy periods. This raises concerns as to why even a GDP growth rate of 6-7% might be inadequate to support these enterprises, a question that is increasingly resonating within the industry.

“`