BackSome Amazon lessons for start-up investors
Network effects suggest that only few firms will dominate the digital world
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There is no doubt that Amazon has been an exceptional company. It began selling books online in July 1995. These past two decades have seen many hyped digital commerce companies reduced to rubble once they burned through their cash. Few today would remember many of the first specimens of the dotcom bubble, companies that got immense amounts of funding based on airy concepts such as eyeballs. Amazon has been one of the few new companies of that era to actually generate strong cash flows.
But, Amazon has prospered in a very unique way. It has done better with its revenues rather than its profits. Consider this. Amazon has reported revenues in excess of $400 billion in its two decades, but less than a measly $2 billion in cumulative profits. The prophet of the digital economy has essentially been profitless.
This is a paradox that matters at a time when digital companies across the world—including many in India—are sucking in new capital at huge valuations. And, just this week came the news that Facebook now has a higher stock market valuation than Wal-Mart.
A successful capitalist company that does not make profits is what baseball fans describe as a curveball. One view is that Amazon has preferred to use its cash flow to build new lines of business. It has assiduously expanded its range of products all the way into cloud computing. These are investments in future growth.
Some management thinkers point out that Amazon is in this sense quite different from companies such as Microsoft that starved innovative projects of funds in the quest to earn more profits. That is a debatable view. All companies eventually have to show profits to their investors; even Amazon, which generates impressive amounts of operating and free cash flows, cannot keep pushing the goal of profitable growth into the distant future.
There are several lessons that Amazon can offer the new generation of entrepreneurs in India who have been busy launching companies that seek to dominate the emerging digital economy. First, the clarity of strategic purpose that has allowed Amazon to keep at the job despite so many shifts in the underlying technological landscape; its core value offering to its customers (both sellers and buyers in what modern economists describe as two-sided markets).
Second, the fact that there is patient capital out there that is willing to bet on rapid revenue growth even if the profit is not immediately impressive. Third, the ability to build a platform that keeps the customer base locked in through network effects, or what the legendary investor Warren Buffet, no fan of technology investments himself, often describes as a moat to protect the company in question from competition.
India is now in the midst of a new entrepreneurial boom. Like elsewhere in the world, the new digital companies that have emerged in recent years have far more robust business models compared with what we saw during the dotcom bubble at the turn of the century. These companies are also coming into their own at a time when consumers are getting more comfortable with transacting online.
The valuations that these companies are getting continue to boggle the mind. The economics of digital commerce suggests that a few companies will tend towards market dominance. That is the logic of network effects. Building these networks—think Facebook or Uber—takes a lot of time. The competitive advantage cannot be competed away easily.
What this means is that most of the new companies will die; only a few will be around 20 years later, as Amazon is right now. The private equity investors who are pouring money into new digital commerce companies are perhaps valuing each of their portfolio companies as if it is going to survive so that it eventually dominates. That is a brave assumption.
Are Indian e-commerce companies overvalued? Tell us at views@livemint.com
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