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Bangalore: Three months ago, the founder-CEO of a top 10 Indian e-commerce company received an overture from three venture capitalists (VCs), who offered him cash his company didn’t need. When he told them the company was well-funded, the investors offered him a sweetener: they said they would double the start-up’s valuation.

“If I have to raise money at this point it has to be at unreasonable valuations. Why else will I dilute equity when I have money in bank?," said the e-commerce entrepreneur, who requested anonymity.

He wasn’t nearly this confident for a large part of the two years leading up to this overture, when most e-commerce firms were struggling to convince investors to take a punt on them. More than a hundred e-commerce sites shut in that time and some were forced to sell at fire sale prices.

Now, investors are chasing e-commerce firms with offers of cash at lucrative valuations. More than 20 online retailers including Flipkart, Snapdeal, Urban Ladder, Fashionandyou and Limeroad have received money from VCs in the past four months and more are in talks to raise funds over the next six months.

Flipkart’s booming sales growth, the company’s buyout of online fashion retailer Myntra, the rise in shopping on smartphones and the change in the central government have all contributed to changing investor sentiment towards online retail.

Internet businesses attracted about $602 million in 2013, according to investment tracker VCCEdge. This year, e-commerce firms have raised more than $2 billion, Mint research shows.

The hype around the initial public offering (IPO) of China’s e-commerce giant Alibaba, expected in September, has spurred hope—yet again—that if China can come up with large e-commerce businesses, so can India. Alibaba may set the IPO value at $154 billion, according to a recent Bloomberg analyst survey.

No one is denying that e-commerce is here to stay. The convenience of shopping online, home delivery and low prices are real benefits that traditional retail can’t offer.

Online retail is valued at $3.1 billion and is estimated to grow to $22 billion in five years, according to a November 2013 report by CLSA, a brokerage.

And the sudden rush of money into e-commerce—partly from new investors like Temasek Holdings Pte. Ltd, Government of Singapore Investment Corp., BlackRock Inc., and particularly Steadview Capital Management LLc—has significantly pushed up the valuations of Internet businesses.

There are doubts, however, whether this gush of money is backed by a corresponding improvement in the fundamentals of e-commerce in India, whether the market is large enough to accommodate so many online retailers and the viability of their business models.

Several investment advisers and investment bankers, including some who help e-commerce companies raise cash, are sceptical about the valuations being attached to many Internet firms and the rosy projections fuelling these valuations, and they believe another round of consolidation is likely over the next two to three years.

“The reality is that there’s a lot of froth in the global M&A (mergers and acquisitions) market in general, and emerging markets, particularly India, are no different," said Santosh Kanekar, an independent consultant who advises financial firms on investing in Indian companies.

“Investors tend to behave like a herd and since e-commerce is the flavour of the day, many investors are rushing there. It’s clear that e-commerce valuations are being driven more by investor demand than by any significant improvement in their financial performance," Kanekar said.

This year, valuations of several e-commerce firms have doubled.

Flipkart’s value jumped to $7 billion (including the $1 billion fund raise) earlier this month when it received $1 billion in fresh capital. It was valued at less than $3 billion in May.

Snapdeal’s valuation nearly doubled to $1 billion in May when it raised $100 million from BlackRock, Temasek and others, just three months after it received $133.7 million in funding. The company is in talks to raise another large round of funds that will significantly increase its valuation yet again, Mint reported in August.

Other e-commerce firms such as Fashionandyou and Pepperfry that failed to raise funds last year have raised more than $10 million over the past four months.

“With the infrastructural problems that India has, and its consumption habits, I think it will take much longer for Flipkart and other e-commerce firms to achieve the tens of billions in sales than what investors believe," said Sharad Sharma, co-founder of software products think-tank iSpirt.

Flipkart, which claims to have shoppers numbering anywhere between 15 million and 20 million, said in March that it hit a gross merchandise value (GMV), or the value of goods sold, of more than $83 million on its site in February. Three years ago, it was selling less than a tenth of that.

But to keep up its explosive sales growth, the company will have to dramatically increase the number of users who shop on the site, and considering the historical growth rates of online shoppers, that looks tough.

“The new investors in Flipkart are assuming a very optimistic scenario of growth. The reality is that going from 15-20 million transacting users to 100 million transacting users involves a series of pivots (in business models) that are highly unpredictable. I don’t think this is being factored into by investors," Sharma said.

Currently, the most commonly used metric of valuing e-commerce firms is the annualized GMV. About 2-2.5 times a firm’s GMV is considered a reasonable number. Most firms in other sectors are measured on the basis of profits, cash flow or sales.

GMV, however, is a less clear metric as it does not account for the deep discounts most e-commerce firms offer or take into account their returns. So, if a firm says its GMV is $10 million, it can actually book sales of anywhere between $2 million and $5 million.

“GMV is a pretty loose metric—it’s not nearly as reliable as traditional metrics such as earnings and cash flow. However, because e-commerce firms don’t make money, GMV is commonly used," said a senior investment banker who works with e-commerce firms.

Over time, local e-commerce firms are also likely to face competition from global Internet giants such as Japan’s Rakuten Inc. and Alibaba. The world’s largest online retailer, Amazon.com Inc., is already building a large business in the country after it launched in June 2013.

Just a day after Flipkart announced its $1 billion fund raising in August, Amazon said it would invest as much as $2 billion in India over time. Though Amazon has a mixed record in international markets, it says it is here to stay.

“It’s this ‘greater fool’ theory. It all depends on who can go public," Kanekar, the independent consultant, said. “I doubt if private investors will keep pumping in billions for the next 10 years. At some point, they will ask for profits, even if it is five years down the line. Can e-commerce ever make profits? And, how much? Answers to these questions are far from clear as no one has built a viable business model."

Unlike 2010-2011, when more than a hundred new e-commerce sites were raising money, this time around, most of the investor money is going into already established firms.

Even so, there is more room for consolidation as some businesses are likely to fail and large companies such as Flipkart will look to buy sites to gain scale, according to Abhishek Goyal, a former investor with Accel Partners and who first invested in Flipkart.

“There is a bit of investor frenzy but I don’t think there’s a bubble. This is about picking out winners and losers. There will certainly be more consolidation and possibly some failures, but for firms that survive, investors will be handsomely rewarded even if they seem to be paying a premium right now," said Goyal, who runs a start-up called Tracxn which sells data on private companies to investors.

Shrutika Verma in New Delhi contributed to this story.

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