The latest devaluation of Flipkart and Snapdeal by investment firms such as Softbank, Fidelity and Valic underscores the point that the number of customers on board alone may not be a measure of value of the company.
The methodology for calculating value of networking firms such as peer-to-peer messaging firms and e-commerce marketplaces is Metcalfe’s Law that states that value is proportional to the square of the number of users (that is, n2). A classic article written in July 2006 edition of IEEE Spectrum by Briscoe, Odlyzko, & Tilly, disproves the validity of Metcalfe’s Law and proposes the more conservative nlog(n) formula for estimating the value of network firms. In other words, with an increase in the number of users from 10 to 20, value of the network quadruples (that is, 100 to 400) as per Metcalfe; while it will be only slightly more than twice as much (that is, 10 to 26) as per nlog(n) estimates.
We used the number of active users in the nlog(n) formula of the widely used peer-to-peer messaging platforms such as WhatsApp, Skype and Hike with the current active users numbering 1 billion, 300 million and 100 million, respectively and calculated their current valuation as $26 billion, $14 billion, and $0.8 billion (conservative compared to $1.4 billion as per reported valuation) respectively.
These tell the “value” part of the story. The other part is the “cost” side. If total cost is linear (that is, proportional to ‘n’; hence marginal and average costs are non-zero constants), then the value graph, i.e., nlog(n), will cross the cost curve at some ‘n’ value after which subsequent addition of users add more value compared to cost of servicing. In pure digital products such as peer-to-peer messaging, this could well be true in practice. In fact, marginal cost can be even closer to zero such that the value-cost is a winning proposition in favour of the firm.
The digital platform provided by e-commerce firms have the inherent near-zero marginal costs for adding more users on board of the platform. These platforms also have infinite shelf space that allow them to tap the “long tail” effect as propounded by Zipf—items that are bought seldom adding revenue to the firm. However, cost of the physical systems to provide service to an additional customer may be non-linear (that is, the marginal cost of providing last mile delivery to a customer in a relatively remote location may be high). This explains why e-commerce firms that focus on subscriber additions tend to ignore the non-linear cost components during execution and scaling up. This results in cumulative losses, signaling the investors to devalue them.
Are the investors at fault—investing at huge valuation presuming that the network effects are much greater than they actually are? Do they only realise later that their funds have been used by the firms for huge discounts which no doubt brought in more users and transactions; at the same time increasing cost of operations? Does this mean that start-ups should increase value for users (and to themselves), and at the same time be efficient to improve unit economics? Does this mean that the start-up bubble in India has burst? No. Not at all. The start-ups enabled by the digital platforms have brought in enormous social benefits, such as reducing information asymmetry, eliminating intermediaries, and improving efficiencies, to name a few. It is indeed very important that Indian start-ups survive amidst global competition!
The writer is professor at IIIT-Bangalore. S Praneeth Nagu and Sourya Sarthak, both students at IIIT-B, contributed to this article.