Start-up Bubble
[This article was prepared on February last, but due to certain reasons beyond our control it could not be published earlier. In the meantime there have also been further developments/changes in the scenario of start-up companies which once again we are unable to incorporate because of time constraints. But the basic theme of this article is still relevant today. Hence we are publishing the old article as it is -----FAPP]
From some recent news reports, it seems that all is not well in the start-up front. Especially, Flipkart, valuation-wise which is the biggest of them, is finding the situation difficult. Some of the investors have marked down their investments so much that its valuation has been effectively slashed from $15 billion to around to only $5.54 billion.[1] There has been also an exodus of top-level executives. On at least one occasion, the company has failed to honour its commitment made to students recruited from IITs and IIMs. However, this was not only the case of Flipkart only, some other start-up companies also failed to keep their promises. As a result, some elite institutions had black-listed those companies in their campus interviews. Further bad news in this front is a number of start-up companies have been closed down in the last year. The talk of possibility of bursting of start-up bubble is getting stronger day by day.
One may ask, start-up bubble -- what is that? From the term itself, it is clear that it means that the phenomenal growth of start-up companies like Flipkart, Snapdeal, Ola etc are not real. It has been blown out of proportion, just like a bubble and like every bubble which is going to burst sooner or later. However, to understand whether it is true or not we have to know the real inner workings of these companies. Exactly that will be the aim of this short article.
To say that the growth in valuations of these start-up companies is startling will be an understatement. Despite being very young, the valuations of a number of start-up companies have crossed $ 1 billion. The valuation of Flipkart, by far the largest among such start-ups, had crossed $ 15 billion. According to a report published last September 2015, only eight years old Flipkart had surpassed 99% of the 5500 listed companies in the Mumbai stock exchange in this regard. With a startling valuation of nearly 16 billion dollars (which was its valuation at that point of time), Flipkart had overtaken Tata motors ($13.5 billion), UltraTech cement ($11.7 billion), Mahindra and Mahindra ($10.3 billion) and similar renowned Indian capitalist ventures.[2]
The rise of these start-ups is almost like a fairytale. Nearly all the start-ups were conceived and created, not by experienced businessmen, but by young boys and girls who are just out of their college. Most of them are from the IITs or similar elite institutions. What is the mystery behind such unprecedented success? A large section of the bourgeois economists claim ? the aptitude of these young entrepreneurs to innovate new ideas coupled with their ability to take risks in the context of the present globalized economy of India has enabled them to meet with such extraordinary success. Is it true or there is something else in this fairytale growth?
Some intriguing questions
However, if we delve a bit deeper into the fairy tale like success stories of the start-up ventures, some perplexing questions start surfacing. First, international capitalist economy is yet to recover from the major blow of the global crisis of 2008. Our country too has been affected in more ways than one. Responding to the demands of the big bourgeois, the Indian government had carried out several 'economic reforms'. Yet there is hardly any sign of recovery. Experienced, big capitalists are still reeling under crisis. Notwithstanding this fragile condition of the experienced capitalist camps, the newly emergent young entrepreneurs have been growing at an amazing pace. Do they have some magic wand?
Furthermore, aren't the valuation of the start-up companies bewildering? This valuation appears to be somewhat unreal with very little bearing on the existing real assets of the company. Valuation of a company is primarily based on the share prices of the business in the share market. These prices are usually manifold times higher than the company's assets due to speculative pricing of the share market. Even for the bigger start-ups like Flipkart, the total asset value would be negligible compared to any big and established company. What then is raising the valuation of the start-ups? How it is calculated? Is there any sound logic behind these calculations? Even the Chairman of Nasscom, Mr. Ravi Gururaj, has been forced to say, "Of recent, the valuation game has turned into a 'black magic art' more than a science."[3]
The nature of profit of the start-up ventures
The huge growth of the valuations of these start-ups seems further startling in view of the fact that nearly all start-ups are incurring huge losses! Yes, huge losses. Not only are they suffering massive losses every year, the amount of loss is also increasing every year. Unbelievable but true. We give below the losses of some of these companies in last three years.
The losses of top start-up companies in last 3 years[4]
(all figures are in Rupees crores)
Company | FY 2014 | FY 2015 | FY2016 |
Flipkart | 508.5 | 1932.9 | 5223 |
Snapdeal | 264.5 | 1328 | 3316 |
Quikr | 200 | 440 | 534 |
AskMe | 180.9 | 300.9 | Closed |
Zomato | 37.2 | 147.3 | 492.3 |
Housing.com | 48.9 | 279 | NA |
It is obvious from the table that not only the losses are huge, these are skyrocketing. The losses incurred are massive even when compared to the gross revenue generated. The business standard states, "The losses of the top 22 online start-ups in the country soared by 293 per cent at Rs 7,884 crore for a combined revenue of Rs 16,199 crore for the financial year ended March 2015".[5] In other words, these companies are spending `150 to earn `100. What a innovative and powerful business model !
Interestingly, investors are continuing to invest in these ventures despite such huge losses and the investments were steadily increasing till 2015, though it has slowed down somewhat in the last year. These investments are being made primarily by foreign investment firms.
The above facts raise two questions:
First question: how are the start-up companies continuously growing despite such huge losses? If we consider a petty business person starting a venture by borrowing from a bank or by taking capital from some investors ? what would have happened? In no more than two to three years such a person, under similar situation, would have been forced to close the venture and become insolvent. Who would continue to invest or offer loans to a company suffering from incessant losses? Farmers in our country, unable to repay their debts, are committing suicides on incurring losses for two consecutive years. Yet, the start-ups are continuing to have a flourishing business regardless of such losses. Why?
Second question: why are the investors investing in start-up ventures in spite of monumental loss?
The two questions are interrelated ? the answer to the first is latent in the answer to the second. The companies are thriving simply because the investors are investing.
However strange it may sound, these companies are flourishing and attracting billions of dollars of investments because they are suffering losses! This indeed is puzzling and here we shall try to solve this puzzle. To unravel this mystery we first need to know how these companies function.
Why are the start-ups incurring colossal losses?
The abovementioned report of the Business standard has also put forward the reasons for the loss: "Bloated spending on advertisement to attract customers in an increasingly competitive atmosphere led to the whopping hike in losses. This year, losses could mount further as these start-ups continued to spend money on advertisements and discounts to lure customers."[6]. "This year" of the report was the year 2016, when the losses indeed mounted further as it is evident from the table given before.
In an attempt to illustrate this issue of discount we quote here a rather long but important paragraph from an article published in Times of India: "A food app promises a user a 50% discount each time he orders from a restaurant using the app. On its part, the app management pays the restaurant full price. A leading hotel bookings app has blocked and paid top rates for thousands of hotel rooms and is saddled with a huge inventory. However, it has been able to sell less than half those rooms and that too at an extremely discounted, promotional rate. Where is the revenue stream?
"The strangest instance is of a leading electrical and electronics manufacturer, approached by an in-the-news Indian e-retail site with a bulk order for one of its popular kitchen appliances. The site bought the appliance at full price and began selling it at a 40% discount. Sales were brisk, and more orders were placed. It was found that the manufacturer's associates and distributors were themselves buying back the appliance from the website (having registered as regular shoppers). Then they were either selling it offline for the normal price (which would constitute selling the same product twice) or selling it back to the e-retailer (which would constitute a Ponzi scheme)."[7]
The above examples clearly illustrate the mystery behind the thriving existence of the e-commerce start-up businesses. These companies are flourishing not due to the discovery of any new technology or due to innovation of a new business model. Almost none of these companies have any production of their own. Neither do they provide any direct service. They simply sell products of some other production firms as middlepersons or brokers. We all have some idea regarding the massive discounts offered by these e-commerce start-ups. We would have appreciated their business model if they could have fetched at least some profit after all these discounts and expenditure on advertisement. Unfortunately that is not the case. They are successful in attracting a large number of consumers, they are successful in selling an enormous amount of commodities, but in the course are suffering huge losses.
The fairy tale that is being weaved regarding the success of the young entrepreneurs is therefore merely a fairy tale. However, that does not mean that none of start-ups are innovating or doing anything novel. There may be few ventures where indeed something novel is being conceived but they are probably not attracting investments. But this discussion is outside the scope of this article.
How are they attracting investments?
How are these start-ups surviving despite huge losses? How are they attracting investments? We will know the answer of the former question if we can answer the later. This is because the losses are being managed by the money that the investors are throwing in. Due the investments they are capable of drawing an enormous number of consumers which is increasing their sale and in turn attracting further investments. According to writer of the last mentioned article "In all cases, the 'incentive' or 'discounted pricing' is paid for by the massive investment (itself the result of eye-popping valuation) brought in by a familiar bunch of big international funds."[8] (italics ours)
Doesn't this remind us of various ponzi schemes like Sarada? Let us try to carefully understand the entire process. Why are the companies flourishing? Because, they are selling more commodities. Why can they sell more commodities? Through incentives, discounts and advertisements. Why are they able to offer discounts, incentives, etc? Due to the investments. But how do the investors benefit? The rapid growth of these companies due to increased sale is attracting further investment which is increasing the valuation of every portion of the ownership held by the investors. Therefore, the investors are hardly affected even if the companies suffer loss. They can make up for their losses by selling their part of ownership at escalated prices. As long as the companies continue growing and keep on attracting investments, their valuation of the whole company and obviously the portions held by individual investors will keep growing too. Consequently, this increases the possibility of the investors to extract profit. This process can continue as long as the valuation of a company can be inflated like a balloon. So, in a nutshell what is happening is simply creation of a speculative bubble. Now we shall see in detail how this speculative bubble is being created and who are benefitting from this bubble.
The start-up bubble
The process of creating the start-up bubble is being carried out in a planned manner with utmost dexterity. Let us assume some Mr/Ms. A decides to launch a start-up. First, A decides on the start-up scheme ? the primary outline of what he/she will sell and how. This may be a typical online commercial venture like Flipkart or Snapdeal which sells nearly everything under the sun. Some may decide to focus on few particular items like, folk art and craft related goods. Now, A will approach some angel investor/s, Mr/Ms. B. Who are these angel investors? They are a particular type of investors who provide training and guidance and invests initial fund to assist in launching of a start-up. They are called angel investors. These angels may be simply wealthy individuals or investment firms. To the external world they present themselves as organizations or individuals who provide assistance to new, inexperienced entrepreneurs so as to make them self-sufficient and competent. In reality, the primary job of these angels is to project the start-ups in a fashion so that their valuation goes up and consequently could be sold at roaring prices. So, in our example, B angel acquires some portion (decided by an agreement between A and B) of the ownership of the start-up floated by A by investing, say, Rs. 1 million. Next, B sells his/her portion of the start-up to some other investor/s, at a price of say, Rs. 10 million and makes a profit of Rs. 9 million. Sasha Mirchandani of Mumbai angels, whose family owns consumer durables Onida, claimed, "We got paid 25x for InMobi". Padmaja Ruparel, Vice-President at Indian Angel Network nicely sums up the process by remarking: "one thing to remember is that investors come with an eye on divorce, they do not want to stay married"[9]
At this stage angel investor, Mr./Ms. B retires from the scene and hands over the start-up to some Mr/Ms. C, who is known as a venture capitalist (VC) in this strange world of start-ups. There may be a single Mr/Ms. C or many VCs like C, D, E etc. It must be noted here that the valuation of the start-up launched by Mr./Ms. A is increasing. Now, let us assume C had invested Rs. 1 million to acquire 5% of the ownership of the company. Therefore, the valuation of the company now stands at Rs. 20 million. It is the job of A, the young entrepreneur, to push up the business of the start-up so that the company may now be presented in the best possible way in the world of the VCs. No matter how much expenditure is needed for discounts, incentives and advertisements ? the market must increase, business must 'grow.'
Because more the company grows, more the market, sales, etc., it will attract more VCs. The next round of VCs will of course have to pay more to get same share of ownership of the company, not because they expect to earn more from the company's profit, but because they hope to sell their ownership at higher prices in future since the company is expected to grow. So, we see the price of the same share of the ownership of the company keeps on increasing and for this reason the valuation also increases. Now, if some new investor Mr/Ms. E buys 5% of the company's ownership at, say, Rs. 10 million then the valuation of the company becomes Rs. 200 million. This also benefits the previous investors like C and D since they can now sell their shares, if they still have some, at this higher price and make huge profits. Valuation of the company therefore, is now completely delinked with its assets. It is also delinked with its elusive profit or actual realistic loss, but linked to the number of users or consumers based on which projections of future profit are made. But, the users/consumers are attracted to the companies because of the discounts and incentives they offer. The million dollar question is ? why will the consumers remain with such e-commerce companies if they decide to withdraw the discounts and incentives?
This is how the start-up bubble is being created and inflated. This bubble is bound to burst at some point of time. This process cannot continue indefinitely. If we can understand this simple logic, there is no reason to believe that the bright young entrepreneurs or the VCs are unaware of the same. They are not residing in any fool's paradise. Our A, B, C, D, etc. everyone knows that this is bound to happen. So our hypothetical start-up should have a logical termination before the bubble bursts. C and D (or whoever has the ownership now) will want at least to get back their investment. Of course they do not expect A to pay them their money. What then are the possibilities? To our understanding there are 3 options:
1. As mentioned before, if C and D are able to sell their ownership to some other VCs E, F, etc. they will always try to do so at some inflated price. What C, D will do with the profit, is their business. They may invest in other start-ups or do something completely different.
2. Another way in both A and C+D stand to benefit are to sell the entire start-up to another start-up company. In that case both A and C+D will make some profit. C and D may then opt to invest in some other start-up, while A with all the experience may start afresh with more innovative start-ups.
3. Finally, of course the owners may decide to enlist the company at the stock exchange and sell the equity shares to the common public. In that case A may retain the position of the chief in the company but C+D will naturally withdraw their money from this company, not before making huge profit by selling off their shares at escalated prices to the public.
One thing to be noted here is that under all circumstances the VCs are able to increase their money through the investments ? at least that is their sole objective. And they have no qualms about this ? they are clearly interested in divorce, not in marriage. Under certain circumstances the VCs may intentionally try to reduce the valuation of the start-ups when they feel that the inflation is reaching its limits. Just as we would allow some air to flow out of an inflated balloon if we feel it may burst. Nevertheless, one will try to inflate the balloon as much as possible so as to fetch a higher price. However, one also knows that they stand to gain nothing if the balloon bursts. The balance to keep the balloon inflated and yet prevent it from bursting is a tough game the VCs and other entrepreneurs have to play. At times prices of some companies are therefore reduced in an attempt to keep the balloon intact. This may result in temporary losses but may ensure future returns.
What if the bubble bursts?
No one can foretell when, but the start-up bubble will burst for sure at some point in time. An organisation named RBSA, which claims itself as "independent Valuation and Transaction Advisory firm" predicts that the start-up sector will crash in 2018. They have also drawn a possible endgame scenario, where they claimed that "in 2017, Investors start exiting smaller players to corporate houses & other HNIs, Planned & strategized growth to show maximum underlying value to be able to get listed, Smaller players will eventually run out of cash and shut operations" and in 2018, "Upon going for an IPO, company's listed price shall not match the company's valuation at the last round of funding. This is going to cause a major crash where early exits will be lauded & a lot of investors are going to be an unhappy lot. Though, one or two major players will make successful IPO exits for their investors & founders and eventually turn into Industry stalwarts."[10]
What will be the consequences of such a crash? Although we had been discussing about Indian start-ups here, the phenomenon is definitely not restricted to our country. The VC organizations who are investing in Indian start-ups, at least the big ones are mostly foreign concerns who are involved in a worldwide speculative game. Hence, there is an opinion that if the start-up bubble bursts, then the foreign companies will suffer, while the Indians will remain more-or-less unaffected. Needless to mention, this opinion is entirely wrong. First, if the bubble bursts, many start-ups will either close down for good or will be forced to drastically reduce their business. Consequently, people involved with them will lose their jobs. Additionally, these start-ups are playing some role in keeping the manufacturing sector alive by offering huge discounts in their products. If the start-ups crash, the manufacturing sector will also have to face market shrinkage. This is bound to affect the economic depression and unemployment.
The worst sufferers will be those with whose investments the VC investment firms are playing this game of asset bubble creation. The VC investment firms are not fishing out money from their own pocket and investing in start-ups. They are actually investing the capital of teeming millions which they acquire by different means. A large portion of the capital of US VC firms comes from the pension funds of common people. Following massive corruption with the pension fund in 1973, the US government enforced a new law - Employees Retirement Income Security Act (ERISA, 1974). According to this act, the investment of pension fund money in high risk sectors is considered to be a criminal offence. After enforcement of the act, the managers of the pension fund schemes stopped investing the pension fund money with VC firms. This nearly led to complete collapse of VCs in US.[11] Such intimate is the connection between VCs of US and the pension fund. Therefore, if the VC firms lose their money, small savings will suffer, because such small savings form the basis of VC's funds. Common people stand to lose their hard earned savings while the well-informed VCs will probably be able to anticipate the collapse and will try to escape with their money before the burst.
This is the way capitalism is surviving today. Creating one bubble after another ? first, it goes through a period of rapid growth following the creation of the bubble, and then it crashes after the bubble bursts. Probably, this is how they are bound to operate. They have the capital ? dominated by the capital of international monopoly capitalists. Capital that they have accumulated by exploiting the workers and toiling masses around the world. But they are incapable and clueless about investing this capital towards profitable production. Their resort is thus speculation and usury. This will continue till the international proletariat can relegate them to their actual destination ? the garbage of history.
[1] Flipkart valuation slashed to $5.54 bln by investor Morgan Stanley. The Economic Times, November 29, 2016
[2]Startups challenge listed cos' valuations; At $16 bn, Flipkart beats IOC, Tata Motors
ETretail.com
An initiative of The Economic Times, September 8, 2015
last accessed on 3rd February, 2017.
[3] The Great E-Commerce Valuation Crash of 2018? May 2015 RBSA Research Initiative
[4] The data for FY 2014 and FY 2015 from "India's e-commerce startup losses grew 293% to Rs 7,884 crore in FY15", Business Standard, February 11, 2016 and the data for the FY 2016 from other newspaper reports.
[5] India's e-commerce startup losses grew 293% to Rs 7,884 crore in FY15, Business Standard, February 11, 2016
[6] Ibid.
[7] Dotcom bubble ver 2.0. Ashok Malik. Times of India, October 17, 2015
[8] Ibid.
[9] How Angel investors are making money in India, Firstpost, December 20, 2014, http://www.firstpost.com/business/how-angel-investors-are-making-money-in-india-478272.html
[10] The Great E-Commerce Valuation Crash of 2018 ? May 2015 RBSA Research
[11] Creating an Environment : Developing Venture Capital in India, Rafiq Dossani and Martin Kenney
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