Getting in the backdoor

The Indian e-commerce market has seen a true explosion over the past few years. Large players such as Flipkart and Myntra have not only made us ‘click and collect consumers’ but have also raised their company valuation to the billion-dollar mark. However, some of the deals are falling foul of Foreign Direct Investment (FDI) regulations. The consolidated FDI policy announced in October 2011 says that FDI in e-commerce companies are allowed only in companies that are engaged in business-to-business (B2B) and not in retail trading.    

This consequently allows for two models of funding. One, where the website is a marketplace that aggregates customers’ orders, while the actual execution is done by a third-party vendor. In this case, the website holds no inventory and does not issue an invoice. In the second model the website executes the order. 

“What companies do in this case is that they register two entities. One becomes the back-end wholesaler, and the other the front-end retailing website. The funding is channeled to the back-end company, which in letter is operating in the B2B model. But even so, FDI has a further regulation that the back-end company should have more than one customer, but that seems to be ignored in these deals,” says Aparajit Mukherjee, a corporate lawyer familiar with the structuring of venture capital funding in e-commerce sites. 

In fact, the policy clearly states that while wholesale trade of goods would be permitted among companies of the same group, such trade to all group companies should not exceed 25% of the total turnover of the wholesale venture. Myntra, a leading lifestyle e-commerce brand, has raised funding for back-end warehousing from venture capital firms such as Tiger Global and Accel Partners. This company only sells to Myntra, whose founder Mukesh Bansal says, “The structure was audited by the VC’s auditors and they have said it is in order. In the future we may look at the back-end company supplying to others also.” 

Flipkart, which also has a similar model, refused to divulge details of how the company is structured. Others like Naaptol that follow the marketplace model suffer from a major drawback. Alok Mittal, managing director, Canaan Partners that has invested in Naaptol, says, “There is a high percentage of return on orders where the payment is cash-on-delivery. Because goods are shipped by the vendor we have no control at all over packaging or delivery delay.” That is why, to ensure greater control over all its deliveries, Myntra holds and ships its own inventory.

While some companies have sought clarification, the violation of the 25% cap is not restricted to e-commerce sites alone. Even international cash-and-carry retailers may not be in compliance. While they sell to entities who meet the conditions that the policy lays out, their share in the total turnover of the company is likely to be much less than 75%, according to Mukherjee. But until an audit mechanism is set in place, this is likely to continue. In the meantime, it is business as usual.