A growing tribe of private equity and venture capital investors is heading to India’s hinterland amid a rise in local tech talent coupled with improving infrastructure, increasing Internet penetration and lower operational expenses.

According to data available from research firm Tracxn, startup funding in third-tier cities has been steadily rising and in 2023 stood at $59.7 million despite a slowdown in overall funding amid macroeconomic uncertainties.

For the whole of 2023, funding contracted by more than half to touch $11.8 billion, down from $26.6 billion for the previous year, according to proprietary data compiled by DealStreetAsia. Deal volume was down 40% from the 1,562 transactions in 2022, per the data.

While metros like Bangalore, Delhi-NCR (National Capital Region) and Mumbai have traditionally led the way in job creation and technological advancements, investors are now increasingly recognizing the potential of emerging startup ecosystems in third-tier cities as well.

“Enhanced digital connectivity, supportive government initiatives like the Startup India campaign, and untapped market opportunities have all played pivotal roles,” said Abhilash Sethi, investment director at Omnivore. “Additionally, the cost-effectiveness of operating in these regions, rising consumer wealth, and a shift towards digital services have created a fertile ground for innovation and entrepreneurship.”

Besides investments, these cities have also experienced rising employment. According to Primus Partners, the number of jobs created by startups in second and third-tier cities has gone up from 5 million in 2021 to 10 million in 2022 and 15 million in 2023.

Consequently, various state governments have launched programs supporting the growth of startups such as iStart Rajasthan, Startup Odisha and Startup Haryana, among others.

“Several initiatives and policies by the central and state governments and a conducive regulatory environment have helped transform these cities into attractive startup hubs. With enhanced infrastructure and increasing internet penetration, tier-2 and tier-3 cities will attract even greater investor interest in the coming years,” said Ankur Bansal, co-founder and director of Blacksoil Capital.

Rising employment and disposable incomes are also driving e-commerce growth in these cities. According to a BCG report, 50% of online urban shoppers lived in these cities in 2021, and the figure is projected to rise to 60% by 2030.

“The growing middle class and consuming class in emerging cities represent an underserved market ripe for disruption by agile startups,” said Arjun Malhotra, general partner at Good Capital. “With rising incomes and mobile Internet penetration enabling access to products and services earlier restricted to tier-1 cities, we foresee strong growth potential, particularly in sectors like retail, agritech, fintech and SaaS (software as a service).”

These smaller cities have a long way to go before becoming bustling startup hubs like Bangalore or Gurgaon, and their journey will unfold over time, said Omnivore’s Sethi. “In contemporary India, a pressing issue facing all major cities is the strain of overpopulation,” he said. “To solve this, there is a concerted effort to divert investments towards tier-2 cities, to upgrade them to metro standards.

“Cities like Ahmedabad, Bhubaneswar and Jaipur are already witnessing such transformative developments. Enhancing the quality of urban centers will lead to the development of surrounding ecosystems and a more balanced national development.”