It amuses me no end when I walk into a room full of senior corporate-types discussing “excesses" by start-ups in the dot-com business. What’s with freebies offered by food-tech guys, cashback schemes from online wallets and the general splattering of money to fund ads on front pages of newspapers and hoardings across cities, they ask?
The inevitable question then follows: “Haresh, do you think this is sustainable? Will investors ever make money? Can these companies ever debut on the stock market with an initial public offering (IPO)?"
My answer? It is not whether they will create value, but how much.
To explain that, I must first embed two thoughts in your mind.
1. The tech bubble will not burst—India has huge headroom for growth—but it is certainly shrinking.
2. The tech bubble shrinkage can be a good thing and a bad thing: Indian e-tailers are worth more if the tech bubble shrinks—since it is unlikely anyone will get funded and the winners are visible. Indian e-tailers are worth less if the tech bubble shrinks—due to the collapse of multiples all over the world, and lower risk appetite.
I think Indian unicorns (start-ups with valuations exceeding $1 billion) will create huge value over the next two decades. We are just at the beginning of the shift—the 50 million “real and habitual" online consumers will swell to over 300 million. We are about eight years behind China on most metrics, but will play catch-up in the next five. In several segments, mega-funding has crowded out competitors.
That said, the only goal of every venture capitalist (VC), hedge fund or celebrity investor is an exit—a public one (via an IPO) or a private one (by a sale of shares to the next incoming investor). I believe as we start valuing these companies at stratospheric valuations, their options get narrower.
Is an IPO feasible?
Most listed unicorns in the West eventually trade at earnings multiples of 40-60 times their earnings. Listed Indian Internet companies like Naukri, Justdial and MakeMyTrip trade at similar multiples.
My submission here is to exclude SAAS (software as a service), software, cloud and subscription-led firms. They are “pure play" Internet businesses. For instance, those in the communication, social or media space, companies like Facebook, Google, Netflix, Pandora or even Airbnb.
These companies’ businesses have a minor offline component, and enjoy almost infinite leverage and network effects. So they deserve higher multiples.
I’ll also ignore the gross merchandise value (GMV) multiple. GMV is the sale price charged to a consumer multiplied by the number of units sold. So, if a company sells 10 books at $100, its GMV is $1,000.
You can use GMV to value early-stage firms growing at 200-300% in the absence of any other relevant metric. But I don’t think it is a sensible yardstick for an eight-year-old mature company—like Flipkart for instance. Especially when investors know these companies can “buy" GMV by spending more money.
Leave Amazon out of it as well. Every investor presentation proclaims I-am-building-the-next-Amazon.
To assume an Indian unicorn will get valued like Amazon is plain silly. Amazon is an outlier. It has been one for 20 years now. It is a perpetual innovation machine with several high-growth businesses.
To put that into perspective, I’m going to take a close look at our poster boys Flipkart and Snapdeal. In doing that, I’m going to make some generous assumptions:
• They will attempt to get leaner, and demonstrate better unit metrics and show a path to profitability.
• They will try to balance the growth-versus-profit dilemma over the next three-five years.
• Competitive intensity in the market will reduce and sense will prevail. Currently, most of these companies earn almost nothing on every incremental transaction.
Let’s do the math at a 50x earnings multiple at IPO (assuming they will leave some upside for public investors!) I’m being generous here. For perspective, Apple Inc. trades at a multiple of 13x today (it hasn’t crossed 50x in the last 10 years).
Flipkart, now eight years old, to justify its $15 billion valuation should have generated about $300 million after tax this year. Clearly, that’s too soon. So let’s give it three more years and assume modestly it will then be valued at $20 billion. At that valuation, it ought to throw up earnings of $400 million.
Let’s be as conservative for Snapdeal. Assume it’s valued at $10 billion in three years. It must then generate $200 million in profits by 2018.
If that is the case, a few questions come up:
• What is the probability that either company will generate such profits three years down the line? I think it pertinent in Flipkart’s case given its overheads and part-inventory model.
• Are they sitting on some hidden Big-Bang innovations that could be orbit-changers? And why are they still called start-ups? These are enterprises. With thousands of employees, they are now large and unwieldy cruise liners slow to manoeuvre. What we ought to ask is how much innovation have they ever really done? They just ran harder and faster than anyone else using the money they had.
And logistics infrastructure is no longer a source of competitive advantage. The acute pressure to innovate starts now.
• Equally important, are their financial accounts and governance practices ready for a listing on the American markets? I don’t think so. The hunger for growth has overshadowed internal processes expected from enterprises of this size. The declarations that a US listing calls for are daunting.
To me, it looks unlikely the Indian or US markets are in a position to support an IPO any time soon at the valuations these companies command today.
Is an IPO sensible?
Should these companies list at this stage of their evolution? Once listed, will the likes of Flipkart and Snapdeal be able to fight two fronts? Pressure on earnings to sustain valuations will mount, as will pressure to invest so they can maintain and grow market share.
• An IPO will handicap these businesses. Constant scrutiny from the markets will destroy their ability to ward competition off or pivot the business model when it is most needed. The stress of showing earnings will become the driver of decisions.
• Then there is that big daddy, Amazon. It can continue the price war and drain their profitability. If that happens, the earnings numbers we spoke about may not show up for the next five or seven long years.
The wipeout in Alibaba over the last few weeks is testimony to that. It was valued at $295 billion just 10 months ago. It stands at $160 billion now. Alibaba’s earnings multiple on last year’s numbers was 80. Today it is closer to 25. Stock analyst reports debate that this could drop even further.
There seems to be very little reason for the valuation to run back to original levels unless Alibaba innovates hard. Earlier this year, Jack Ma, the founding CEO, said: “If I had another life, I would keep my company private. Life is tough when you IPO."
Clearly, private investors have a deeper appetite for unicorns compared with public markets, and that is not changing in a hurry.
So what’s next?
An IPO looks neither feasible nor sensible. Ironically, the fact that we are not in a tech bubble like we were in the 1990s is working to their disadvantage. They can see growth and the chance to build valuable businesses. But their valuations can no longer be supported.
Where do these arguments leave existing investors? Their choices are limited. They have to get a strategic exit or are staring at a long, long wait to IPO. We haven’t seen the last of fund-raising either. These companies will raise more rounds of funding to ensure they can survive this tech winter.
As far as VCs go, they are unlikely to “lose" money. Liquidation preferences are beautiful things—they are protected from any value destruction that may arise due to downrounds (dilution of ownership for existing investors) or under-water IPOs. But the wait for exits will be long—and may not give them the VC-type returns they look for.
The current cushion on liquidation preference in both Flipkart and Snapdeal is about 75%—that means the valuation can drop by 75% without any cash loss to investors. This cushion can be attractive for late- stage private equity investors who use this to trade. They are investors with lower return expectations and derive comfort from structured deals and liquidation preference. This may create exits for some smaller investors in the interim like we saw with eBay’s part-exit from Snapdeal.
But let’s see who will create the big exit opportunity. Now, the money to buy such expensive multibillion-dollar unicorns exists only in the US or China (and maybe, a small set of investors in Japan, Russia and South Korea).
Chances are that Americans won’t bite. They are the creators of the “original" business models. The only reason they’ll invest is for sheer entrepreneurial energy that a local founding team can bring.
Market access is not an issue for the Americans. India does not have a regulatory and language moat like China. Amazon’s (and Uber’s) rapid scale-up in India proved that beyond doubt.
Emboldened by Amazon’s relative and easy success, the Americans will want to enter the battle themselves—not buy.
That leaves the Chinese. They are live examples of how the holding-company model works. Between Baidu, Tencent, Alibaba and a few other firms, they control a significant chunk of the Chinese online market. They have seen success in “controlling" large chunks of an ecosystem. They believe they can force network-effects into unrelated businesses. They know an assault on Silicon Valley is difficult and Europe is too small. That leaves India as their next beachhead. They will want these Indian unicorns. (As I write this piece, Ola, another Indian unicorn, raised money from Chinese strategic investor Didi Kuaidi. The Chinese invasion has begun!)
These holding companies have traditionally enjoyed huge earnings multiples in their markets due to the Chinese moat. The multiple arbitrages may work in their favour. And they’ll want to replicate the holding company model here. The cumulative value of India’s largest Internet companies is sub-$30 billion. I think it a great deal to take control of these assets today and make a go to dominate what is expected to be the world’s second largest Internet market in the next decade.
That is why the Indian online market is the new battleground for the war between the Americans and the Chinese. I think the latter have the upper hand. They understand mobile-first behaviour better; understand large and under-penetrated markets; and want to win desperately to shore up their falling market capitalization.
Implications for the ecosystem
The endangered species are the mid-market and vertical e-commerce companies, which are all in investment phase. Add to this the losing-money-hand-over-fist hyper local e-commerce firms.
All of them are growing on the back of cash burn. If you stand on the street and offer currency notes, there will be takers. It’s only when you stop will you actually get to know if you’ve managed to build a business. That is why I think mid-tier firms like ShopClues, Jabong, PepperTap, Grofers and FabFurnish, to name a few, ought to step back and check if they have created any sustained business advantage by burning cash to acquire customers. From what I have picked up, Jabong is on life support and could make for a fantastic distress-purchase sometime soon.
I fear, in this madness to show market share and transactions, sensible founders who are building lean businesses will get destroyed. If funding dries up, there will be casualties, and the baby may go out with the bathwater.
Times have changed. For all of us. The unicorn founders who seemed to have all the time in the world to attend conferences, show up on front pages and become Superangels, need to settle into the slow and rigorous grind that any consistently profitable enterprise demands. The start-up days are over. They are running a company that needs to focus on the bottom line.
Read an unabridged version on www.foundingfuel.com
Haresh Chawla was founding chief executive of Network18. He joined the firm in 1999 when it had revenue of ₹ 15 crore. When he moved out in 2012, he had built it into a ₹ 3,000 crore media conglomerate. He is now partner at India Value Fund, and mentors several start-ups.