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Lead Story

Bubbling over
Amid the flurry of investments in start-ups, failures are rising too. will this lead to more realistic valuations?

Kripa Mahalingam

British economist John Maynard Keynes once famously said, “The market can stay irrational longer than you can stay solvent.” Indian start-ups are learning this adage the hard way, with some paying the price for the irrational exuberance of investors. Making a beeline for start-ups, investors have pumped in $7.4 billion in 2015, up 57% compared to last year, according to Tracxn, a start-up intelligence platform. Start-ups such as OYO Rooms and Grofers raised more than $100 million in a year from investors like Softbank and Tiger Global, barely two years after starting operations. Amidst this barrage of money, people seem to have forgotten to check the inner mechanics, especially the core that businesses can’t sustain on bad unit economics.  The fall, thus, is going to be severe, says Ashish Gupta, senior MD, Helion Ventures, an early to mid-stage, India-focused venture fund. “Valuations are going to be reset in India because we have priced ourselves ridiculously ahead of the market size.”

Arguing that the valuations based on gross merchandise value (GMV) don’t work, as the metric doesn’t include discounts, returns or cancellations, Gupta adds, “There is no arithmetic involved in valuing private companies. It’s only a function of how much the investors are willing to pay and how many investors you are able to line up.” In fact, he says, many of the businesses being funded make no sense, including a string of Indian start-ups cloned after US-based on-demand grocery delivery start-up, Instacart. The start-up allows customers to shop from stores like Whole Foods, Target and Costco online and then delivers the products within hours. Similar ventures have been floated by Indian companies over the past one year, with more than 55 companies attracting investments, including Grofers. The question though is how many firms do we really need to deliver a loaf of bread and milk, especially when there is hardly any differentiation. Moreover, the local kirana store does the same job, with the assistant doubling up as the delivery guy. “Instacart is not even a success in the US. That is the risk of extrapolating from the US and China. While we can learn from these markets, copying them blindly doesn’t work. I don’t know how many of these copycat businesses are viable in India,” says Gupta.

Bad economics
It isn’t smart economics either. In the hyperlocal delivery business, where even the most efficient player could lose up to 50 per order and the least efficient thrice that amount, you are just guzzling money no matter the scale. If it doesn’t work on a unit level, it won’t work when you scale up operations, says Avnish Bajaj, managing director, Matrix Partners. “Firms, who don’t have the right unit economics, espouse this theory about scale,” he adds. Usually when the business grows, economies of scale kick-in and help the firm spread its fixed costs. But when you have a negative contribution (sales-variable costs), not only do you lose on every transaction, you can never recover fixed costs, making scale irrelevant. Bajaj explains: “Everyone knows that Ola and Uber are burning cash to win market share. But if you remove the incentives and cashbacks, they are making money on every ride. In the case of hyperlocal delivery businesses, they have inherently flawed unit economics and scale doesn’t really help,” he explains.

Ashish Gupta, managing director, Helion VenturesThe taxi aggregation business is not capital intensive as players don’t own taxis or employ drivers. They merely connect customers with drivers through a platform, for which they charge commission. Still, Ola and Uber have been burning through cash by doling out discounts and incentives to draw users and drivers, respectively, amid intense competition, losing 400-500 per ride initially. But once the pricing war abates, their unit economics may work given surge pricing allows them to control prices to some extent, barring regulatory pressures. But, for now, with Uber and Ola undercutting each other, there are little signs of that happening soon.

In the case of hyperlocal businesses, there are no levers. According to a report by Kotak Institutional Equities, for inventory-less hyperlocal firms, unit economics starts to work only when they hit around 100,000 orders a day per city. Grofers, the largest player in the segment, delivers around 35,000 orders a day across 10 cities. That’s not just a huge gap to fill, Grofers also needs to fund the huge cash burn in the interim. It did raise $120 million from Softbank in its last funding round in November 2015 and $165 million in a year, expanding its presence to 17 more cities (mostly tier I and tier II cities). But Grofers soon shut operations in nine of the 17 cities as it discovered that people still preferred the local kirana shop to technology. “It is a hard business to execute. It’s always going to be. After managing all the complexities, if the firm eventually gets it right, they would make about 100-120 per transaction. There are better businesses that entrepreneurs can build and investors can fund,” opines Parag Dhol, managing director, Inventus Capital.

Avnish Bajaj, managing director, Matrix PartnersOn the other hand, BigBasket, which follows the inventory-led model, has expanded to 20 cities, and plans to launch operations in five more cities by end-April, 2016. The company had recently raised $150 million from investors, taking its total funds raised to $180 million. Started in 2011 in Bengaluru, the company’s gross margins are higher because it procures goods directly from manufacturers and farmers. Abhinay Choudhari, co-founder, BigBasket, puts the gross margin around 20%, with the average ticket size at 1,500. In the case of hyperlocal firms, the margin is 5-7%, with the average ticket at 500-600. “We are profitable at the transactional level and hope to break even in 2017-18. While we can hope to break even, hyperlocal businesses will find it very difficult given their cost structure and wafer-thin margins,” says Choudhari. Considering an average order size of 500, at 7%, a hyperlocal business can make 35 per order. But delivery costs at 70 mean they end up losing 35 on every transaction at the operating level even before fixed costs come in.

Not just hyperlocal businesses, investors are also skeptical about hotel aggregator OYO Rooms’ growth. After raising funds in August 2015, OYO has been adding hotel rooms at a frenetic pace. From just one partner in 2013, the venture has developed partnerships with 4,500 hotels in 2015, and claims to do a million bookings per month. There are questions about how the company will be able to sustain its discount-fuelled growth. The model would have been simple if OYO would have stuck to getting a commission for bookings generated through its site/app and a fee for maintenance, but its minimum revenue assurance complicated matters. “I don’t know if the money is being used prudently. You can’t build a business by paying hotels full price and offering the rooms on discount. That is not just negative unit economics but bad business practice. It just doesn’t make sense,” says an investor, who has invested in the space. On the face of it, with all transactions happening through its app, the business might seem asset-light. But to entice customers, considering OYO offers rooms at 999 when the rack rate is 1,999, it ends up funding the 1,000 shortfall. In such a scenario, both the consumers and hotel owners are a happy lot, but for OYO, it means increasing cash burn and growth that will most likely peter down when the discounts stop.

Abhinay Choudhari, co-founder, BigBasketPulling the plug
With the euphoria around start-ups fading and questions being raised, investors have started to pull the plug on some investments or are orchestrating mergers. For instance, after raising an initial round of $1 million from SAIF Partners in May 2015, SpoonJoy was forced to shut operations in Delhi and Bengaluru, and was eventually acquired by Grofers. Townrush, which connected merchants with logistics, faced a similar fate. The list of casualties is long and not limited to hyperlocal businesses. Food delivery firm Dazo, women-only fashion brand Done by None, online recruitment firm TalentPad, food tech firms Eatlo, Langhar, OrderSnack, online grocer Localbanya, jewellery portal Jewelskart and sister concerns Bagskart, Watchkart are among start-ups that had to shut down operations after failing to find investors.

Mumbai-based food ordering app, TinyOwl too has been in the news for the wrong reasons. The firm, which was struggling to find investors, got a lease of life after securing a bridge round of 52 crore from existing investors Nexus, Sequoia and Matrix Partners in October 2015. TinyOwl, founded in 2014, had raised 6 crore from angel investors in August 2014. Thereafter, it had raised 127 crore in two rounds from Nexus Ventures, Sequoia and Matrix Partners till Feburary 2015. But things went awry when the company fired 300 employees. In the standoff between the management and employees and its bid to raise more funds, the company lost sight of the business, and ended up losing ground to competitors such as Swiggy and Zomato. Still hanging by a thin thread, there is now talk of merging it with Roadrunnr — both have common investors in Sequoia and Nexus — before it runs out of funds.

Mohan Kumar, executive director,  Norwest Venture Partners IndiaThe TinyOwl story is symptomatic of the pressure start-ups face after an easy influx of money. “It is the fault of the investors, who think money can buy customers, build a business and scare competition,” says Mohan Kumar, executive director, Norwest Venture Partners India. “When you give a $100 million valuation to an early-stage company, there is a huge pressure on them to grow revenues to justify the valuation for the next round. Soon, you want to expand to 20 cities but you don’t have the management bandwidth and even if you do, the market isn’t ready and you have no choice but to scale back and send people home.” TinyOwl is not alone, big names like Housing.com and Zomato faced similar issues. Housing.com, which was in the news for the fracas between its founder and former CEO Rahul Yadav and investors, let go of 800 employees after raking in losses of 279 crore in FY15. Zomato too fired 300 employees (about 10% of its workforce) after it fell short of achieving some of the milestones it had promised investors and losses grew nearly four-fold to 147 crore.

In the case of Zo Rooms, the writing was on the wall after it failed to raise more money. The company had raised $47 million in two rounds from Tiger Global and Orios Venture Partners. Thus, its acquisition by OYO Rooms was the most opportune. According to the deal, Zo Room founders and investors got 7% in OYO Rooms. The split though was such that the seven founders got 2.5% and the investors 4.5%. For OYO, which had just raised $100 million from Softbank and existing investors, the acquisition brought access to Zo’s network of 11,000 rooms in 1,000 hotels across 50 cities and towns in India besides technology.

Patch work
Not everyone is lucky to find suitors though as German firm Rocket Internet learnt the hard way. Known for cloning successful US businesses in Europe and Latin America, the firm would typically exit within four years of making an investment. India though has been a different story. While they entered with a big bang in 2012, incubating nearly half-a-dozen companies, they have struggled with all their investments here.

Before penning a deal with Future Group for FabFurnish, the firm was almost on the stage of writing off the investment. Despite being an early player, FabFurnish had fallen behind rivals Pepperfry and Urban Ladder. In August 2015, it let go of about a fourth of its workforce and shifted to a marketplace model, vacating its warehouses. The all-cash deal, estimated between 15 crore and 20 crore, though marks Rocket’s first India exit. The search for buyers for its other investments – Printvenue, Jabong and Foodpanda continues after previous failures. 

Vishal Gupta, managing director, Bessemer Venture PartnersFor instance, Rocket’s attempts to get Zomato to acquire Foodpanda failed when reports of serious financial malpractice and operational inefficiencies emerged at the food delivery firm. Paytm and Snapdeal were interested in Jabong once but talks failed due to disagreements over valuation. Where investors put a price tag of $500 million for Jabong, buyers were not willing to put in more than half of the asking price. The fashion portal, which has now merged with other international e-commerce firms to form Global Fashion Group, is off the hook for now as Rocket and Investment AB Kinnevik have pumped in $20 million to help it stay afloat. Jabong has also roped in Sanjeev Mohanty as CEO from Benetton India to turn things around.

The Internet firm’s strategy to focus on execution rather than differentiation hasn’t worked in India, especially in segments that are high on discounts. Not only have they been outdone by overfunded competitors, Rocket’s strategy of holding a significant stake in the company, leaving the promoters with just around 10% stake meant there was very little skin in the game for the founders. 

Rajiv Srivatsa, co-founder and COO, Urban LadderHowever, Rocket is not alone in trying to stitch together partnerships to stave off closures. In the start-up world, investors sometimes merge portfolio companies in a last-ditch effort before writing off investments. Take the case of property search and listings firm CommonFloor. Online classifieds firm, Quikr, acquired the company for $120 million in an all-stock deal. The merger was driven by Tiger Global, which was a common investor, after CommonFloor failed to raise follow-on funding. The property portal had last raised money from Google Capital at a valuation of $150 million in December 2014. But with the real estate market struggling, it couldn’t scale up operations, sealing its fate. 

Quikr, on the other hand, has about 30 million unique users across 12 categories. The company has so far raised about $346 million from Investment AB Kinnevik, Tiger Global, Steadview Capital Management, Matrix Partners India and others since 2008. Its valuation has zoomed from $250 million in March 2014 to $1 billion. At the time of the CommonFloor deal, the company was valued at $1.5 billion. However, its losses widened from 200 crore in FY14 to 440 crore in FY15. In a bid to win consumers over, Quikr’s marketing spends (about 75% of its costs) doubled to 390 crore in FY15, resulting in losses.

Maheshwer Peri, founder, Careers360Besides the huge marketing bill, what could add to Quikr’s woes is the not-so-very rosy outlook for horizontal classifieds companies. “The guys in the horizontal classifieds space are in bigger trouble than the e-commerce players since they still haven’t figured out how to monetise their assets,” says Vishal Gupta, managing director of Bessemer Venture Partners. He adds that vertical-focused players are better placed since they have reached significant scale with better unit economics. The shake-out in this space has also led to emergence of leaders such as BigBasket in groceries, LivSpace in interiors, Urban Ladder in furniture and Bluestone and Carat Lane in jewellery. “Vertical players are better placed compared to horizontal e-commerce players given that the ticket size is higher and cost of acquisition is lower. We have far lower SKUs and that gives us better control over inventory,” says Rajiv Srivatsa, co-founder and COO, Urban Ladder. The company, whose average ticket size is around 50,000, hopes to break even next year at a GMV of $250 million. 

Like Quikr, the most common misstep for online players though is the strategy to chase consumers and vendors. It’s not a flip switch, says Maheshwer Peri, founder, Careers360, talking of the shift from growth to profitability. A data-enabled and technology-driven company, Careers360 integrates millions of student and institutional data points with user generated preferences to build prediction and recommendation products. While most companies are spending on marketing, Peri says, “We are a platform meant to help students make better and informed career choices. Hence, we focused on creating content. The strategy has proved very profitable for us.” For instance, the company is working on content for medical entrance exams in July. With over 2.5 million students and 20,000 colleges on its platform, Peri says the focus on content and credibility has given it a sustainable edge besides helping it earn a margin of around 40%. Apart from revenues generated through advertisements, students have to pay for accessing detailed data on the website. For example, its college predictor product, which helps students find colleges, is free at the base level, but costs 299-499 for more information. Peri’s strategy is far from being an acceptable norm though.

Radhika Aggarwal, chief business officer, ShopcluesInvincible syndrome
The three e-commerce big guns — Flipkart, Snapdeal and Amazon, which form a large chunk of India’s $23-billion (1.5 lakh crore) e-commerce market, have been busy chasing customers, pouring crores into marketing. For them, customers are not just assets but also the metric to justify gravity-defying valuations. 

Blue-eyed boy, Flipkart’s valuation soared from $3 billion in 2014 to $15 billion when it raised $700 million in July 2015. The company, with a reported GMV of $5 billion, has raised around $3.4 billion in 10 rounds and counts GIC, DST Global, Tiger Global, Steadview and Accel as investors. Its fairy-tale, however, came to a halt when Morgan Stanley wrote down its investment by 27%, resulting in a $4-billion market cap loss for Flipkart, an indication that valuation had run ahead of growth. The mark down also means that the next round ($1.4 billion) that Flipkart has been looking to raise for some time would be a down round.

As long as investors dole out a generous valuation, entrepreneurs will continue to believe that their businesses are invincible. But the fact remains that businesses are not sustainable until they generate cash flows. Till that point is reached, you are dependent on the funding cycle, even if you are India’s largest e-commerce player.

If the e-commerce giant has to cut its losses now, it would have to sacrifice sales growth. The same is true for the other big guns — Amazon and Snapdeal. But with the market remaining as competitive as ever, none of them are looking to take their foot off the growth pedal. The big three e-commerce players have about 20-50 million users, of which an average 30% are active and transact about 5-6 times a year. There is no doubt about the scope of e-commerce, but companies have failed to factor in the fact that they are trying to buy loyalty through discounts and marketing. The problem with the argument that they can recover discounts over the lifetime of a customer is that the buyer is fickle-minded and sometimes one or two transactions are all you may get. Extending the argument, there is no need for a mobile wallet to spend 2,000 crore, chasing customers, especially when a dozen other wallets offer a dozen other ways for the customer to get his money back without rewarding you with his patronage. Besides, the Indian market, though growing (thanks to smartphone proliferation), is still a much smaller market compared to the US or China. 

The crux of the matter though is that e-commerce companies are treating cash as an unlimited commodity, in the race to get ahead. Snapdeal, which has Japan’s SoftBank and Alibaba as investors, raised $200 million in February in a funding round led by Ontario Teachers’ Pension Plan at a valuation of about $6.5 billion and a last reported GMV of $4 billion in August 2015. In all, Snapdeal has raised $1.6 billion since 2014. As far as the third major, Amazon, is concerned, CEO Jeff Bezos promised to invest $ 2 billion in India when he visited the country in July 2014. According to RoC records, the Indian arm has received nearly half of that. While some of that has gone in building its supply chain, Amazon raked in a loss of 1,724 crore in FY15 due to discounts and ad spends (estimated at 744 crore). “Amazon was on TV for 350 days last year. They better have a market share of 25% after spending so much money,” says a competitor. Flipkart and Snapdeal also raked in higher losses of 1,932 crore (taking Myntra into account, that’s another 740 crore) and 1,328 crore in FY15 respectively. “Having deeper pockets doesn’t always give you a position of strength. If you have a burn rate of $50-60 million dollars, then half a billion dollars will only last you 10 months but if your burn rate is only $2-3 million even $150 million can last a very long time. But you cannot blame the entrepreneur. Every time there is a bump up in the GMV, investors have been more than willing to reward them with unsustainable valuations,” says Radhika Aggarwal, chief business officer, Shopclues, the lastest e-commerce player to enter the plush club. Shopclues is focused on catering to consumers in Tier II and Tier III towns at lower price points. “Our customers come to us for selection and not to get the cheapest mobile phone. We are running our own race and have proved to our investors that growth and profitability are not mutually exclusive and hope to break even by 2017,” says Aggarwal. According to her, the fact that they are a lean organisation and 80% of the company’s sales come from segments other than electronics gives them a shot at better unit economics.

And if the competition in the e-commerce space wasn’t intense already, Alibaba has decided to enter the Indian market, and not restrict its presence through Snapdeal and Paytm. Also on cue, the government recently allowed 100% FDI in e-commerce where no seller can account for more than 25% of sales. While this puts Amazon and Flipkart in a fix as they have associate companies as vendors, it’s right up Alibaba’s alley. Though the ‘Big Two’ will figure out a way, it is clear that the competition is only heating up and throwing money at the problem won’t make it go away.

Looking back, historically, brick and mortar companies took about 20-30 years to reach valuations that start-ups have gotten in the past 4-5 years. The pace that start-ups have been running at, however, has been at the cost of checks, balances and red flags that investors are willing to ignore. Why wouldn’t they? They don’t need all of their investments to work, one or two would be fine, never mind the casualties. “It’s in the nature of business,” they say. At some level, the current boom feels like the dotcom bubble. “No, it’s different this time,” they argue. No it is isn’t. There are no shortcuts to build a business.

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