Why Indian e-commerce has hit the fork in the road

Indian e-commerce is entering a critical phase, as founders and venture capitalists give way to strategic investors. And that’s why 2017 will be a defining year. The first in a two-part series

“The past can't hurt you anymore. Not unless you let it. They made you into a victim, Evey. They made you into a statistic. But, that's not the real you. That's not who you are inside.”

- Alan Moore, V for Vendetta

2014, 2015 and 2016. 

Two steps forward, and one bloodied step back.

A decade later, we’ll perhaps recall these three years as the ones that defined India’s startup ecosystem. Some may even say these were the years of its birth, except for the fact that the labour pains have just started.

Starting with the first ever billion dollar fund raise by Flipkart, to the $100 million early stage rounds of funding in startups that had barely begun business—the pace and scale of burn stupefied every entrepreneur who knew how hard it is to turn a profit in an Indian business. Here were firms with business models that had only been test-run on PowerPoint, spending capital unashamedly. The more they raised and they spent, the more they were celebrated by our newly formed tech-media. Funding was confused with success. Burn with growth.

Let’s put the biggest story of the last three years in perspective: the meteoric rise of Flipkart and its steep decline. From $15 billion to $5 billion—from a bellwether that could do no wrong to a company under siege.  

"What’s being seen as a study in chaos—three CEOs in one year and all the other noise—may turn out to be a coup de ma?tre by Tiger Global"

Yet what’s being seen as a study in chaos—three chief executives in one year and all the other noise around it—may actually turn out to be a coup de ma?tre by Tiger Global. Tiger is executing a turnaround, while taking complete control of the company without any friction and bad blood with the founders. The clean-up is on, the management decks have been tightened and Flipkart is ready for a strategic sale to a buyer who is likely to find a price tag of $6-8 billion attractive.

"Sometimes what’s best for a company may not be the best for its founders. And vice versa"

Here’s the upshot: capital cannot afford to be emotional—it needs to find a return.

After all, sometimes what’s best for a company may not be the best for its founders. And vice versa.

Yet, in this case, the founders have found roles that will help grow the Flipkart eco-system—payments, private labels, logistics—and substantially reduce the overheads. And for Tiger, executing a strategic sale at Flipkart and recovering its investment will be nothing short of historic. It may actually end well for everyone involved.

I expect a similar story will play out at several other firms in 2017. After all, building aircrafts requires a different set of skills than flying them.

That is why I reckon 2017 will be a defining year for Indian e-commerce. We’ve reached an important crossroads. And the only way we’d be able to see the big shifts that are quietly underway is by separating the signal from the noise.

The question of burn

Ever since it has become easy to access financial data at the Registrar of Companies (ROC) online database, it has become a bounty for headline writing. Our tech media screams out that ABC startup lost XX hundred crores. Sometimes in their generosity the headlines talk about how a company’s revenue grew by 3X and losses grew by only 2X—a misleading statement since for most startups the base of revenues is much smaller than the base of losses.  

The analysis is meaningless unless you figure what that burn is doing. Few delve into the configuration of the business—why and how the costs are the way they are. Putting out burn numbers without context doesn’t make for sensible analysis. It’s just retransmission of raw data.

The fact is: if a firm is creating new habits, creating a new category of consumption or winning market share from incumbents, burn is inevitable.

In India, even more so, due to our inherent high cost structures and friction (by some estimates on an adjusted basis the cost of logistics in India is 3-4X of that in the USA. Our fuel is more expensive, our trucks cost more and carry smaller loads, our roads are worse, our trucks wear and tear faster—the only place we save is the driver’s cost which is a fraction of the whole chain).

"Two companies having the same Rs 1,000 crore burn may achieve very different objectives with it"

You can’t have an opinion about burn unless you see where it is going.

Two companies having the same Rs 1,000 crore burn may achieve very different objectives with it. One could invest it to strengthen foundations for the future—while the other might simply allow that cash to vaporise.

More specifically, one may gain huge market share, add suppliers and stock keeping units (SKUs), set up warehouses all over the country, improve customer experience and create a programme for customers that keeps them coming back for more.

Another may burn the same money and lose market share, spend it on huge overheads, burn it up to gain temporary gross merchandise value (GMV) growth, or spend on a new campaign which leaves no sustainable value.

I am sure you will be able to recognise the firms that I refer to above across the two buckets.

The question to ask: Is the money being burnt to just fuel huge overheads “inside” the company? Or is the money being spent “outside”, to carve out markets and categories and to deepen consumer engagement? Are your expenses aligned to the inherent promise of the internet model—that at some point your “inside” expenses become fixed in nature and every incremental rupee of sale generates a huge margin catapulting you into a virtuous cycle which allows you to plough that back into growing even more? Investors bet their billions on this—that at some point you’ll break the stranglehold of fixed costs and start throwing up huge marginal profits. 

Break-even is not an end in itself

Some of our unicorns haven’t reached this point of leverage because their fundamentals are flawed. In the internet business, it isn’t just enough to achieve break-even. What is more important is, the trajectory with which you hit break-even.

What’s the “marginal profit” you can generate on a transaction, and is it likely to create a virtuous cycle—that’s really your only moat.

In India, if your marginal profit is not large enough, then by the time you scale again, your cost structure will rise as complexity of doing business goes up and your fixed costs inflate.

Thus, some startups which are aiming to break-even by cutting discretionary costs, but not re-visiting their fundamental premise, may discover to their shock that arriving at break-even with a very low “marginal profit” is a recipe that won’t excite investors for your next round.

Existential problems

Humans have two responses when faced with a crisis—look at the mirror or point a finger at their circumstances. We should put the recent stories about Flipkart and Ola’s plea for protectionism and trying to take the high ground on innovation to a momentary lapse of reason—there is no way they could have wanted India to become like China, nor could they actually be serious about Amazon and Uber not being innovative companies.

My perspective is different—they’ve arrived at this juncture by the force of circumstances. To call them protectionists or lalas undermines the work they’ve done, and the constraints they have to deal with.

The contract

When you raise venture capital, you take on an obligation (there is a reason the equity sits on the liability side of the balance sheet!). Essentially you sign on to the following promise: “We (the founders) have used your capital to grow this business, and we are obliged to arrange to make this equity fungible (convertible into cash) after a reasonable period of time.”

It’s their moral responsibility to give an exit to investors. It’s neither good nor bad. It is just the way things are.

After a period of time (usually five to eight years), the company and its founders take an obligation to arrange an exit for the investor via any of the following means:

• via an IPO, or
• via a sale to a third party

Failure to do so triggers a whole host of rights in favour of the investor essentially designed to create liquidity (i.e., cash for his stake or any other mode of fungibility that they desire), and founders can be “dragged” along in any such sale. Usually these contracts protect investors if the company doesn’t perform well—they have the first right to recover their invested capital from the proceeds of the sale, ahead of the founders. These rights are called liquidation preferences. This “time bound” fungibility is sacred because it mirrors the fiduciary obligation that the VC fund has taken on when it raised money from its investors.

Now once you get this, you just need to look behind the rhetoric of protectionism, the idea of capital dumping and realise that these companies are essentially obligated to create an exit for their investors in some form or shape. And that is the pressure founders are beholden to.

"If a unicorn's investors get a strategic offer, the founders will be obliged to sell their businesses to a foreigner"

The discussion about foreign capital is moot because very simply if a unicorn's investors get a strategic offer, the founders will be obliged to sell their businesses to a foreigner faster than you can say “Uber”. 

The country of origin issue

"It’s not Flipkart versus Amazon—it has never been. It was always Flipkart versus Flipkart"

It’s not Flipkart versus Amazon—it has never been. It was always Flipkart versus Flipkart. And Ola versus Ola, Quikr versus Quikr. These firms have done more damage to themselves than their so-called foreign competitors.

To people who have seen the legendary battles between Coke and Pepsi and Kingfisher and new beer entrants, these startups have had mere skirmishes. Simply put, it is case of bad cloning.

"The Indian unicorns reverse-engineered what was visible from the outside, but missed how the businesses were modelled from the inside"

These “Indian” unicorns cloned everything about their American counterparts. They cloned the business idea, the organisation structures, and every aspect of the business—but they forgot to clone the cost structures, the sheer focus on managing a low-margin business, and the relentless pursuit of quality and customer retention. And that’s where we tend to miss the wood for the trees. So I’d describe this as a failure to clone the harder aspects of the business. The Indian unicorns reverse-engineered what was visible from the outside, but missed how the businesses were modelled from the inside.

On top of this, the unit economics or the market size haven’t supported them. They thought they were running a road race, but discovered they were on a treadmill— the market did not grow as expected (more in this earlier piece). And they never expected that a downturn would hit them mid-stride. Their moats are made of money. 

And money is a game Amazon and Uber can play. What I disagree with is that they are not about innovation. If anything, they are innovating harder than our local players. Imagine setting up business in a market which you have no knowledge of and setting up a successful business there—(by the way, both Uber and Amazon are registered in India; the two Indian players are not!), hiring local management and creating an environment for them to succeed. In my book, that’s what constitutes innovation in management.

I would go so far as to say that the foreigners haven’t really hurt our Indian companies by doing anything nasty—they’ve simply copied or matched their “burn” rates. Our companies have made self-goals by getting distracted—by launching too many initiatives and also creating cost structures that are simply unsustainable in our market. While they are crying out for protectionism, they need protection against their own bad decisions. They forced the capital war to begin with—routing out other “Indian” startups in the same space with smaller balance sheets—and now when the heat is turned on them, it’s a cry for help.

"Amazon and Flipkart are not even running the same race anymore"

What will become increasingly apparent to everyone is that Amazon and Flipkart are not even running the same race anymore.

Amazon has settled into the confident, energy conservation gait of a long distance marathoner, and will just put its head down and execute its 10 year blueprint for India, while Flipkart is running a 1,000 meter relay—in a hurry to get to the next milestone—whether it’s GMV, break-even or the next funding round.

The quality of the capital on its balance sheet forces this behaviour. So you’ll probably see Flipkart run faster than Amazon for now—using all its energy to prove it can grow out of the problem. The pilot is jettisoning the cargo and at the same time adjusting the jet-fuel mixture and trying to achieve take off. 

Demand for regulatory intervention

Let’s understand two things:

1. All the capital in this sector is foreign for a reason: These are low entry-barrier, high-risk businesses which have to activate both ends of the marketplace simultaneously—change consumer habits and create supply ecosystems. Indian balance sheets neither have the depth of capital, nor the mindset or the mandate. There is a certain kind of capital that has this appetite—it’s dollar capital and it’s primarily found in Silicon Valley. And venture capital needs exit—either to strategic investors or to other VC firms who can extend the holding period to a potential IPO.

2. Lobbying for a regulatory “lock-down” is natural in such a situation. It can essentially freeze market share, and force the competitive intensity to come down. The bet is that this lock down will make room for next-round VCs to come in, as it gives them visibility on the competitive landscape. Any new player, whether VC funded or foreign, will be at a disadvantage, since network effects would have kicked in for the incumbents.

What happens next?

Our unicorns are caught between a rock and hard place. They’ve run as fast as their investors asked them to, they’ve used capital to buy out competitors and companies they probably did not need to or wish to—and they’ve done admirable jobs of scaling companies. And with funding drying up, things look bleak. But things will work out for most of them. Why?

The beauty and the beast

Why do I think the Flipkart situation will work itself out?

Suspend your judgement for a moment—and think about Flipkart as two entities.

Flipkart, the brand. And Flipkart, the business.

The moment you can make this separation you can see that the former is the beauty, the latter a beast. As a brand, Flipkart commands top notch mindshare, it has loyal followers and leads several categories. As a business, its overheads, its cost structure, are out of whack with market realities.

"Flipkart, the brand. And Flipkart, the business. You can see that the former is the beauty, the latter a beast"

But if you are in the market to invest in a company, you care only about its future, not its past—so the day Flipkart’s business is leaned up, it will be the single most attractive investment opportunity for a strategic investor. (We’ll discuss the possible candidates in the sequel to this piece).

It is the same for Zomato’s brand—and its business. You can extend this argument across every unicorn under siege. OYO Rooms, Ola, Quickr. Look around and you’ll find several brands in superb shape (Jabong is a case in point), but the business debilitated.

Urban Ladder is another example of a great brand, but a poor business model. It has decided to sell on other platforms like Amazon and Flipkart. Its customer acquisition cost combined with low frequency and high churn make it unviable to run an online-only business.

Many vertical e-commerce players set their sights on building traffic and eventually becoming a brand or a destination. That thesis is coming apart at the seams. That’s why players like Urban Ladder are looking to expand offline as well. This will compel them to invest in a very different kind of imagery. And make the internet one more channel as opposed to being their core, as they had originally set out to do. It is possible that some might succeed in making this transition. After all, India is starved of good quality national brands in several markets like furniture, lingerie and home furnishings, to name a few.

Yet, these players will face a fork in the road. They will need to choose between being an online business with an offline strategy or the other way round. The trouble is that their valuations will have to correct precipitously because they no longer deserve the heady revenue multiples that pure-play internet forms command. And instead, they will start to be valued as any other offline business with an online merchandising arm.

"The day the chasm between the brand, the business and the valuation closes, these will be fine businesses to acquire"

Coming back to the unicorns: The sheer scale of spend on branding has ensured that these unicorns command unprecedented mind-space in a market where consumerism has suddenly taken root and is hungry for brands. The day the chasm between the brand, the business and the valuation closes, these will be fine businesses to acquire.

Closing this chasm will require deep culling—of people, of processes. It is easier said than done, and we’ll find several will lose their will along the way. As long as the firms take the hard calls to repair themselves, recalibrate their aspirations and valuations (including possible haircuts), we will emerge with great businesses. They may not give 50X returns but can turn out pretty decent outcomes over longer periods of time. These firms will have to dig in for a long haul—and investors who are patient and want to see businesses built versus find the next round investor will win. 

Imagine Walmart’s shock when it does a due diligence on one of our e-commerce operations. It will baulk when it sees the cost structures. After all, the one thing that Walmart knows is that costs have to be down to the bone. It won’t invest unless these things are fixed. 

In my piece Saving Private Flipkart, I had predicted that investors will come under pressure and make management changes, given that e-commerce is a game of ruthless efficiencies. It’s very difficult to sustain your business and make deep cuts at the same time, but it appears that the Flipkart team is treading that thin line and it’s working. At a $6-8 billion valuation, it will be a brilliant buy for someone who has the muscle to take on Amazon. And at that valuation, no one loses.

Clearly, once this gaping chasm of losses between the business and the brand is bridged, the elusive exits will begin.

The exits will set off another war—where VCs and the unicorns will give way to the strategic investors and the war to dominate the Indian internet landscape will be played out between the Americans and Chinese. 

Cheers, Happy Reading

Gagan Malhotra