The narrow exit road for India's billion-dollar start-ups

[Photograph by PhotoAtelier under Creative Commons]

Half a pound of tuppenny rice,
Half a pound of treacle,
That’s the way the money goes
Pop goes the weasel

It amuses me no end when I walk into a room full of senior corporate-types discussing “excesses” by start-ups in the dotcom 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 sustainable? Has everyone gone crazy? 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. It is, how much will they actually create.”

It is not whether they will create value. It is, how much will they actually create.

To explain that, I must first embed three thoughts in your mind.

Thought 1: We are in a phase I call “tech bubble shrinkage” in India. The bubble will not burst—India has huge headroom for growth—but it is certainly shrinking.

Thought 2: 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.

Thought 3: Indian e-tailers are worth more if the tech bubble shrinks—since it is unlikely anyone will get funded and the winners are visible.

Personally, I think Indian Unicorns (start-ups with valuations exceeding $1billion) 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 investors is an exit—a public one (via an IPO) or a private one (by a sale of shares to the next incoming strategic or financial 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 earning multiples that range between 40 and 60 times their earnings. Listed Indian internet companies like Naukri, Justdial and Makemytrip trade at similar multiples.

You may point to the oddball trading at 200X earnings. But my submission here is to exclude SAAS, software, cloud and subscription-led firms. They are “pure play” internet businesses. These are companies that serve customer needs almost entirely over the internet. For instance, those in the communication, social or media space, companies like Facebook, Google, Netflix, Pandora or even Airbnb.

These companies have a minor offline component to their business and enjoy almost infinite leverage and network effects. So they deserve higher multiples.

I’ll also ignore that silly notion of gross merchandise value (GMV) multiple or revenue-multiple. To the uninitiated in e-commerce parlance, GMV is the sale price charged to a consumer multiplied by the number of units sold. For instance, if a company sells 10 books at $100, the GMV is $1,000.

It’s the kind of metric you can use to value early-stage companies growing at 200-300 percent in the absence of any other relevant metric. But I don’t think it 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. In fact, given how some of these firms are blowing cash, I’m tempted to tell investors they ought to ask the question “does more GMV imply more value destruction?”

And leave Amazon out of it as well. Every investor presentation is inevitably dotted with a slide that hollers I-am-building-the-next-Amazon.

To assume any of the Indian Unicorns 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. Its valuation may seem like an oddity in the market, unless one accounts for the cash it generates and reinvests in innovation.

To assume any of the Indian Unicorns will get valued like Amazon is plain silly. Amazon is an outlier.

So if any VC has bet your start-up will be the next Amazon, you’re better off trying to beat the roulette at a casino close to you.

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 as well. Mainly that:

• These companies 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 to five years.

• That 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 earning multiple at IPO (assuming they will aim to leave some upside for public investors!)

Mind you, I’m being extremely generous here. Despite the $650 billion valuation Apple commands and fantastic earnings growth, it actually trades at a multiple of 13X today (it hasn’t crossed 50X in the last 10 years). You can argue it’s an unfair comparison, but it is intended to put things into perspective.

Anyway, to get back to the point, 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 rework the assumptions.

Let’s push everything three years out into the future 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 as well. Assume it’s valued at $10 billion in three years. By the yardstick I articulated earlier, 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 of the companies will generate profits of the kind I just spoke of 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? The last innovation we saw from Flipkart was when it added a social media layer called Ping that allows users to chat with friends while shopping online. No one knows how that played out. We are yet to see Snapdeal’s future with the Freecharge acquisition for which it paid a whopping $400 million.

And why are these companies still called start-ups? These are enterprises. With thousands of employees, they are now large and unwieldy cruise-liners slow to maneuver. 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.

So far they have been more ambitious than others and have been able to convince investors they will build value in the future. It seems their idea of innovation is to acquire teams and then hope to integrate them into their larger enterprise. But we are yet to see a single one of those experiments work successfully. Their ability to retain founders post acquisition remains dismal as well. 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. I am sure people in the know can answer this one. But the markets suspect none of the late stage investors have conducted any kind of rigorous due-diligence on these companies. 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?

This is a bigger imponderable. Should these companies list at this stage of their evolution? It sounds fancy to list and make billions of dollars in Employee Stock Options (ESOPs). But until now, these firms have just reached a fraction of their potential audience.

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.

• To that extent, I am willing to punt 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. Instead, the stress of showing earnings will become the driver of decisions.

Constant scrutiny from the markets will destroy their ability to ward competition off or pivot the business model

• Then there is that big daddy of them all—Amazon. It can play spoiler and continue the price war and drain their profitability. If that happens, the earnings numbers we spoke about above may not show up for the next five or seven long years.

Amazon can play spoiler and continue the price war and drain their profitability.

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. The company is under siege. 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 at the firm said: “If I had another life, I would keep my company private. Life is tough when you IPO.”

“If I had another life, I would keep my company private. Life is tough when you IPO.” - Jack Ma

Clearly, private investors have a deeper appetite for Unicorns compared to 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.

Ironically, the fact that we are not in a tech bubble like we were in the 1990s is working to their disadvantage.

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 the VCs go, they are unlikely to “lose” money. Liquidation preferences (LP) are beautiful things—they are protected from any value destruction that may arise due to downrounds 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 percent—that means the valuation can drop by 75 percent without any cash loss to investors. This cushion can be attractive for late stage private equity (PE) 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, just maybe, with a small set of investors in Japan, Russia and perhaps Korea).

Chances are that Americans won’t bite. They are the creators of the “original” business models. They know the language and 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 rapid scale-up in India proved that beyond doubt. Amazon has built a massive business with half the resources and half the time compared to their Indian counterparts. Coming late to the party actually helped them. In a way, Flipkart and Snapdeal have lubricated the ecosystem and changed consumer habits for Amazon.

Emboldened by Amazon’s relative and easy success, the Americans will want to enter the battle themselves—not buy.

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 players, 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.)

The Chinese know an assault on Silicon Valley is difficult and Europe is too small.  That leaves India.

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.

The Indian online market is the new battleground for the war between the Americans and the Chinese

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 players.

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 it is time mid-tier players 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. The days of show-me-a-100-transactions-per-day-and-I-will fund-Series A are over. If funding dries up, there will be casualties.

In this madness to show market share, sensible founders who are building lean businesses will get destroyed.

We’ve seen parallels in the online travel space when a frenzy was whipped up in 2007-08. The valuations were huge—relative to that period that is. But look at where things stand now. Makemytrip is trading at a third of its peak. Everyone else is skating on thin ice. Their GMVs have grown massively since 2007-08. But valuation multiples have shrunk dramatically.

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. Focus. The start-up days are over. You are running a company that needs to focus on the bottom line.

Focus. The start-up days are over. You are running a company that needs to focus on the bottom line.

All around the cobblers bench
the monkey chased the people;
The donkey thought ’twas all in fun,
Pop goes the weasel.