Startups buzzing in India, profits like pin-stripe suits, will be back in fashion

Published: December 15, 2016 6:10:24 AM

At some stage in the Indian start-up evolution, profits, like pin-stripe suits, will be back in fashion

The yearly losses of most B2C unicorns, alarmingly, far exceed their turnover.The yearly losses of most B2C unicorns, alarmingly, far exceed their turnover.

The start-up movement in India is buzzing, making the country the fastest-growing base of start-ups. Over 150 active PE/VC funds and hundreds of angel investors are competing to provide funding. Exploding valuations and the success of early-stage funds has billions of dollars chasing more than 19,500 start-ups. Fast-rising internet penetration, increasing smartphone usage and growth in online retail has resulted in stratospheric valuations and multi-bagger returns for investors in B2C enterprises. The government has also hopped on to the bandwagon with the “Start-up India” initiative. But, this dream run is about to end, like all good things do.

Most of the large start-ups in the B2C segment are engaged in a frenetic race to grow market-share and customer count rather than profitability. Like those who lead a marathon by sprinting for the first kilometre, but crash out at the end, many run the risk of running out of fuel before the finish line. More than 46% of start-ups funded last year are struggling to raise follow-up capital.

Many of the B2C start-ups are premised on replicating the success mantra of the West. The investment ‘story’ for these start-ups is based on grabbing “real estate” and growing market-share and size. Profitability is a dirty word.

The yearly losses of most B2C unicorns, alarmingly, far exceed their turnover. The reported losses would be even higher if one excludes other income (interest income emanating from investing surplus funds raised by them). Moreover, most losses are not for physical asset creation or technology deployment but for “customer acquisition”. Following the Western model, the most asset-light start-ups with a growing customer base command the highest valuations. The deliberate selling of goods and services much below cost is based on the assumption that the consumer will show long-term loyalty, and eventually prices will move to ‘normal’ or that competition will die allowing for better realisations. Both are fallacies as the Indian consumer is extremely value-conscious and very amenable to switching providers for a better deal. The Reliance Jio example, where 50 million subscribers came on board thanks to freebies, is a case in point.

The ‘skin in the game’ for most promoters is primarily their time. Own-cash investments in their companies is usually limited to the initial bootstrapped amount. This has created a situation where mostly it is “other people’s money” that is being invested. The young founders of these start-ups are encouraged by VC funds to focus on ‘buying’ market-share at the expense of profitability. Valuation is determined by the compulsions of existing investors who need to show that their initial investments are marked-up in subsequent rounds. Ultimately, it is the VCs that bear the brunt of this correction once the music stops.

For India to attract and sustain the VC funding momentum, the paradigm needs to morph to sustainable innovation and IP creation rather than predatory pricing. The flow of funds to enterprises which create genuine IP or are focussed on manufacturing and R&D has been limited, as revenue takes time to appear. But the irrational exuberance for marketplace start-ups will slowly move to the above category which has a better chance of sustainable profitability. There is also an untapped opportunity in B2B ventures provided they bring innovation. India, given its large pool of talent, can be the source of R&D for the world. Government-supported VC funds should restrict themselves to investing only in social enterprises in sectors like water, agriculture, etc. For B2C start-ups, it is time they look at every rupee of spending to see if it creates sustainable value. Also, many of them may need to pivot their business models from being pure B2C ones to other niche sectors. They can also benefit by adding experienced leadership from brick-and-mortar industries, which are used to a certain tradition of frugality.

Technology provides the opportunity to build differentiation and innovate on experience. In India, we need to move beyond copying Western models. Several companies that failed to do so are now at risk of being dislodged by the ‘originals’ as India opens up its markets. The first signs of this realisation are the recent write-downs in the valuations. Looming global slowdown combined with the short-term pain of demonetisation may hasten this process. Some of those affected are now asking the government for protection, but that is unlikely to work.

VC funds that have been complicit in the rush for market-share need to realign their focus, on returns and investment in building technology differentiation. Companies like Infosys and Wipro, which have created sustained encashable wealth, have done so with judicious use of capital and control on costs. The ultimate test for start-ups will be when they go public and value is determined daily by millions of investors.

The Indian start-up movement has transferred billions from the pockets of global institutional investors to the average Indian consumer. Till this largesse continues, the smart Indian consumer will be the greatest beneficiary. After that, at some stage in the Indian start-up evolution, profits, like pin-stripe suits, will be back in fashion.

Sudhir Mehta is chairman & MD, Pinnacle Industries and chairman, CII, western region. Views are personal. Twitter: @sudhirmehtapune

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