e-commerce: Life after the boom
The good news is high-quality companies will still get funded but the irrational exuberance is unlikely to be repeated soon
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Bengaluru: Things were good. India’s largest e-commerce firm had raised as much as $2.6 billion in the 12 months to May 2015. Flipkart’s valuation had soared to $15 billion, five times in the span of a year. The euphoria was unprecedented and the expectations high.
Flipkart’s phenomenal rise generated a mixture of awe and envy. For the company’s backers, it was India’s answer to Alibaba, the Chinese Internet behemoth that went public in 2014 at a record valuation of more than $200 billion. For critics, Flipkart epitomized everything that was wrong with consumer Internet start-ups and the most convincing example of a start-up bubble.
As the events of the past year unfolded, it is now clear that both groups erred somewhat in their assessments.
The funding boom that lasted nearly two years has now ended. Investors have become more demanding. And many of 2015’s superstar start-ups—Grofers, Oyo, Zomato, Flipkart, Snapdeal and Ola—have slowed expansion and cut costs. The focus is back on profitability. Indian Internet’s go-go days are over, at least for now.
To make a bad situation even worse, online retail sales shrank in the first nine months of the year from the levels seen at the end of last year, as Snapdeal and, to a lesser extent, Flipkart, cut back sharply on advertising and discounts.
Flipkart bounced back in the festive month of October and, along with arch-rival Amazon India, reported record sales in that month before the shock move of demonetisation brought the nascent e-commerce recovery to a grinding halt in November.
The weakness in the consumer Internet space highlighted an awkward truth of India’s Internet market: While the number of Internet users is growing rapidly, the number of online shoppers isn’t increasing at the same rate. That has put at risk the rosy projections of investors who have pumped billions of dollars into them.
This unsettling truth has consequently put the brakes on mega investment deals. Flipkart and Ola struggled to raise funds at their preferred valuations. Another unicorn, Snapdeal, had to settle for a relatively small fund raise of $200 million in February this year after raising more than $1.6 billion in 2014-15.
To be sure, while the funding tap has narrowed to a trickle, the slowdown hasn’t been nearly as bad as many had feared. Online grocer BigBasket and digital wallet Paytm raised funds at attractive valuations, and many new start-ups got funded, although very few of them belonged to the consumer Internet space.
Investors shifted their focus to enterprise software start-ups that take up much less cash, generate revenues and can show healthy margins.
So far this year, venture capital firms have invested around $4 billion in start-ups, compared with $7.7 billion last year. While that is a sharp decline, the number of deals largely stayed flat this year—996 so far, compared with 1,027 last year, according to Tracxn. This indicates that early-stage funding remains healthy, even though the number of mid-stage and late-stage deals dropped significantly.
“The year (2016) brought a lot of rationalization in the (Indian) start-up ecosystem. Investments are now more focused on companies that have stronger fundamentals—product market fit and sound unit economics. So, 2017 is expected to cut the noise and bring the best out of the ecosystem,” said Abhishek Goyal, co-founder at Tracxn, which provides data on start-ups and VCs globally.
The stars of the year
2016 was the year of the underdogs of the start-up ecosystem—enterprise software start-ups.
There are several business factors that make enterprise software start-ups attractive. As firms become increasingly comfortable buying software on the Internet, Indian enterprise start-ups are rapidly expanding into overseas markets without necessarily building large, costly sales teams. The domestic market for these firms, too, is looking up, with small businesses as well as consumer Internet firms spending more money on digital solutions provided by enterprise start-ups.
Enterprise software start-ups are also perceived to be low-risk, compared with money-losing consumer Internet start-ups. They have a relatively lower cash burn, start making revenues from day one, and some are even profitable.
Firms such as Freshdesk, which operate on the software-as-a-service (SaaS) business model in India, and Druva both raised more than $50 million in late-stage rounds this year—a big vote of confidence for SaaS start-ups.
Apart from established VCs such as Accel Partners and Sequoia Capital that increased their SaaS investments, new funds such as Ideaspring Capital and Utilis Capital set up shop with a sharp focus on enterprise software companies.
“The percentage of entrepreneurs interested in enterprise software has definitely increased this year, with entrepreneurs inspired by the success of firms such as Zoho. I think VCs also recognized the need to have a good balance of technology and consumer start-ups in their portfolios. But for a stellar year, we need to see exits happen in this space,” said Naganand Doraswamy, managing director, Ideaspring Capital.
Tough times for consumer Internet start-ups also meant that enterprise software start-ups, which had earlier lost out top talent to the likes of Flipkart, had become attractive for those looking for stable jobs.
Among consumer Internet companies, Paytm was by far the best performer, extending its lead over rivals such as Snapdeal-owned Freecharge and Mobikwik. Paytm’s valuation more than doubled to roughly $5 billion in August when it raised funds from Taiwanese chip designer MediaTek Inc.
Digital payments were given a boost by the introduction of the unified payment interface (UPI) platform in August. The National Payments Corp. of India (NPCI) started working on UPI in February 2015 and announced its launch in April this year. Many analysts expect UPI to transform India’s payments business. Unlike a digital wallet that needs to be refilled with money frequently, UPI does away with this step by connecting payments directly with the bank accounts of a user. Hence, a UPI-based product can be more convenient than a digital wallet. UPI has the same infrastructure as the Immediate Payment Service (IMPS), which is used by banks for real-time transfer of cash. IMPS has a limit of Rs200,000 per transaction, while UPI allows transfers of up to Rs100,000.
The biggest push to digital payments, however, came from India’s move announced on 8 November to withdraw denominations of Rs500 and Rs1,000 banknotes. The so-called demonetisation exercise, which has hit economic activity in the country, drove millions of consumers to digital payment methods. Paytm was the biggest beneficiary of the move, adding over 10 million new users in November and expanding its offline merchant network to over one million. The company claims its user base has grown to over 160 million. Also, despite being a low-key sector as compared with consumer Internet, healthcare technology was another sector where investors received a fair amount of bang for their buck.
Practo was easily the breakout start-up in this sector, with no meaningful competition in sight—according to experts tracking the start-up ecosystem, Practo has the potential to bag a multi-billion dollar valuation over the next few years and join the ranks of the Flipkarts and the Olas.
And last, but not the least, another sector that fared well in 2016 and is poised for a massive take-off next year, is fintech, where UPI-based start-ups and digital wallets may witness explosive growth, especially in light of the government target to encourage digital transactions.
The key battles
In 2016, the key market-share battles—one among Flipkart, Snapdeal and Amazon and the other between Ola and Uber—decidedly went in favour of the American firms. By most accounts, Flipkart is still slightly ahead of Amazon, while Ola is ahead of Uber. But most analysts now do not consider Snapdeal as serious competition to the market leaders and while Flipkart and Ola are still ahead, Amazon and Uber made rapid strides in 2016, in a continuation of their rapid expansion in the previous year.
These two market-share battles have huge ramifications for the start-up and VC scene in India.
Together, Flipkart (valued at $15 billion) and Ola (valued at $5 billion), along with online marketplace Snapdeal (valued at $6.5 billion), accounted for a mammoth 55% of the cash raised by all Indian start-ups in 2014 and 2015. Their combined valuations constitute 65-70% of the valuations of all Indian Internet start-ups, according to Mint research.
The three unicorns are backed by practically all the best-known VC firms operating in India: Accel Partners, Kalaari Capital, Sequoia Capital, Matrix Partners and Nexus Venture Partners.
Apart from traditional VCs, three of the most influential start-up investors in India—Tiger Global Management, SoftBank Group and DST Global—have poured huge amounts of money into Flipkart, Snapdeal and Ola.
It wouldn’t be a stretch to say that the future of the country’s nascent venture capital scene, in its current form, hinges on the outcomes of the market-share battles between Flipkart and Amazon, and Ola and Uber, according to VCs and entrepreneurs. “There’s a lot riding on Flipkart and Ola,” said Sharad Sharma, an angel investor and co-founder of iSPIRT, a software products think tank. “If these two companies can deliver returns above the watermark, then we will have a soft landing for B2C (business-to-consumer) sector. If, however, in the worst-case scenario, they don’t deliver basic returns, the investor sentiment towards Indian consumer start-ups will turn bad.”
To stay ahead, Flipkart and Ola will need massive infusions of funds. Most investors expect both companies will need to accept the so-called down rounds in order to attract new investors. Snapdeal is regularly mooted as an acquisition target, but the company denies it and says it plans to remain independent.
The road ahead
2016 proved to be a tough year for consumer Internet start-ups in general, with the number of transacting users—a key metric used to track the health of India’s largest Internet start-ups—not growing at the pace at which investors anticipated.
The country’s e-commerce business, in particular, took a big hit, with the market staying largely stagnant over the past 12 months—a development that has spooked investors in Internet start-ups and forced them to mark down the valuations of large unicorns such as Flipkart and Ola.
However, investors are also betting that the consumer Internet space should witness an upswing over the next 6-12 months as Internet penetration and purchasing power increases in tier-II and tier-III cities.
With billions of investment dollars riding on India’s largest Internet start-ups, VCs are for now playing the waiting game and betting that consumer Internet will deliver big-bang exits over the next 3-5 years.
Like consumer Internet firms, it remains to be seen if the new investor darling, SaaS start-ups, can provide profitable exits to investors. VCs are betting that bigger technology companies, especially in the US, will be the most active buyers of Indian SaaS start-ups. That investment thesis will be tested next year.
Young SaaS start-ups that raised funds this year will have to expand their client base in markets such as the US, while relatively older ones such as Freshdesk and Druva will have to justify their rich valuations by maintaining their flying sales growth.
“In the next year, we should see more deals, more momentum in the B2B space overall. Three things—availability of data, data scientists, and the willingness of businesses to buy from Indian start-ups—will give a significant push to enterprise software start-ups. The differentiating factor will be in how they use artificial intelligence and machine-learning to build superior products,” said Manish Singhal, founding partner, pi Ventures.
For investors, securing exits from past bets next year is possibly even more important than making new investments.
Already, VC firms have been forced to seek more time from investors to return their money as start-up exits continue to be elusive.
Most VC firms in India started out in 2006 and 2007. Many VCs, including Nexus Venture Partners, Kalaari Capital, Matrix Partners and IDG Ventures India, have already extended or will extend the timeline of their first funds by two years to return cash to their investors, according to a dozen VC firms and limited partners (LPs) familiar with the matter. LPs are firms that invest in VC firms.
These two factors, together with other smaller ones, have shown that many of the investments made by VC firms in 2015 are simply unviable, and the future of the VC scene in its current form hangs in the balance.
Most investors are still sanguine about India’s Internet economy. The mobile Internet boom that has been turbocharged by the entry of Reliance Jio Infocomm Ltd will attract hundreds of millions of potential new customers for start-ups. Plus, among the too-big-to-fail unicorns, Flipkart and Ola, are getting their act together and Paytm seems to be on a tear.
Most importantly, VCs have billions of dollars sitting in the bank, waiting to be invested. A top VC, Accel Partners, raised a new fund of $450 million last month. These sectors are expected to find favour with investors next year: SaaS; digital payments and financial technology; healthcare; education; and, selective consumer Internet start-ups.
“I think 2017 could end up being a watershed year for Indian start-ups, given the serious amount of digital consumption that we are witnessing and will continue to witness. Good companies will continue to get funded. But it will be unrealistic to expect a repeat of 2015, which was a serious year of aberration. All kinds of random companies with random business models were getting funded at random valuations—thankfully, in 2016, that randomness came to an end,” said Amit Somani, managing partner at Prime Venture Partners.