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A Start-up Bubble – Start-Pps With Almost no Revenues to Show Are Commanding Very High Valuations

Ratan Tata, chairman emeritus of Tata Sons, created a stir recently by saying that start-ups in e-commerce segment are asking for too high a price for parting stakes. Tata, a mastermind of many deals, including the multi-billion dollar ones like Corus and JLR marquee, has taken a fancy to investments in new-age companies after his retirement from the Tata group. Ratan Tata has invested in a number of e-commerce start-ups, including Snapdeal, PayTM, Urban Ladder, Bluestone and also Karyaah, a fashion portal, very recently.

“It’s true that the valuations (of e-commerce) are very high and valuation seems to be driving these companies more than traditional matrix of evaluation,” Tata said at the AGM of Indian Merchants’ Chamber.

Tata’s statement comes at a time when concerns are rising over valuations of start-ups, often six-month-old, with almost no revenues to show, but commanding valuations that are comparable to some of India’s best-known companies that have existed for decades and generated profits for years.

What’s Happening

Start-up valuations are rising multifold with every round of funding, seeing gleeful investors jumping in with moneybags. According to a report, Flipkart’s valuation touched $12.5 billion in March ’15 from $1.6 billion in 2013, an eight-fold jump in just one-and-a-half years while the value of Snapdeal, the second largest player, has risen to $5 billion from $1 billion in a year.

Flipkart, the only Indian firm among the new-age ‘Decacorns’, is valued higher than the biggest brick-and-mortar retailer Future Group. A recent report values the company at $15 billion. Flipkart’s valuation is also almost at par with the market cap of Mahindra & Mahindra, India’s biggest maker of sports utility vehicles. This is also true of small start-ups.

Why The Euphoria

It is the growth potential of the segment that investors, mostly foreign venture capitalists, are pinning their hopes on. India’s e-commerce market will grow 10 times by 2020 to $50 billion from current levels, says a report. A Morgan Stanley report estimates that India’s Internet market has the potential to rise to as much as $137 billion by the year 2020.

What’s The Hitch

It is the absence of current revenue numbers/cash flows. The whole thing is based on future growth expectations. Sample this: Flipkart, Amazon India and Snapdeal had combined revenues of $85 million and a loss of $163 million in fiscal 2014, or they spent nearly $3 to earn a revenue of $1.

Almost all start-ups are bleeding owing to rising operational costs and discounts as firms give prominence to customer acquisition.

Experts say discounts are being offered in a frenzy to acquire more customers in the hope that they will continue to shop online, and that in the future there will be no need to offer discounts. Clearly, with consumers latching up to e-commerce, firms are eyeing big profits through massive volume play.

What Are Investors Looking At

Investors are only focused on the growth potential of companies, and often ignore that the current cash flows are just a trickle. They are enthused by the market, which, according to Goldman Sachs, can rise to 2.5% of India’s GDP, or $300 billion. Financiers also look at the number of people using the product, whether they pay for it or not. Financiers are mostly looking for hockey stick growth curves. Costs, especially for high growth companies, are often ignored.

The Math Behind Huge Valuations

Experts say the numbers are sort of made up. If the start-up is mature, investors typically grant higher valuation, which helps companies in recruiting top talent and building credibility and customer base, a self-fulfilling cycle. In exchange for higher valuation, investors are guaranteed their money back first in the event of the company going public or on sale. Investors also negotiate to receive additional free shares if a subsequent round’s valuations are less favourable.

Either way, the investor is double proof; he gets at least his money back in case of a public offer. In case the subsequent rounds fail to live up to the valuation (or close at a lower valuation, called the down round, a strictly no-no in the start-up world), the investor gets additional stake that maintains/ raises his stake, but that of the promoter/entrepreneur and even employees goes down.

Start-up investors are often hedge funds, investment banks, and sovereign wealth funds, which do not want to wait for seven to 10 years for returns as a venture capital fund would. If a start-up promises a short timeline for taking the company public, investors are more than happy to tag along. These investors may also arrange to get shares at, say, a 20% discount to the initial public offer (IPO) price.

However, such a practice weakens the meaning of valuation. This means that the private investor is not taking the same risks as a public shareholder. Because when the company goes public, the valuation would not be in sync with the start-up’s financials. And can result in spectacular bust of the IPO.

How The Valuation Is Done

The number is set by the company and negotiated along with various provisions to safeguard investors’ money. The number can include the market share, growth projections and a founder’s ego. Higher valuation often comes at the expense of employee shareholders and earlier investors, whose holdings are diluted to make room for new entrants.

Such practices have resulted in the creation of billion dollar companies called Unicorns, a name given to them because they are rare. And then there are Decacorns, those over $10 billion valuation – Airbnb, Dropbox, Uber, Snapchat, and the homegrown e-commerce site Flipkart. About 25% of the $48.3 billion invested in start-ups in the year 2014 went to late-stage investment rounds.

Uber raised a good amount of cash at $41 billion valuation, while a $500 million investment took Airbnb’s value to $10 billion.

Last year was also the best one for IPOs in the United States since the 2000 dotcom crash. About 27 venture capital-backed IPOs raised $4.4 billion in the last quarter – a seventh straight quarter with 20 such offers. No wonder that the low risk of getting big returns that occur when the IPO market is booming is driving this late-stage money into start-ups.

This cycle is giving rise to more private companies valued at more than $1 billion. The number of late-stage tech companies worth more than $1 billion rose 160% in 2014 over the previous year. With more IPOs in the pipeline, the list of such firms is only going to increase this year. Experts express concern that if some of these higher-profile IPOs go bust, that late-stage money will flee and the bubble will burst.

How Start-Ups Influence Numbers

Even smaller start-ups speak of lofty targets and dream of NYSE listing when their revenues are not even a million dollars. Such is the frenzy that targets like reaching $1 billion valuations in 2-3 years time frame are regularly bandied about by under-$10 million valuation companies.

In a bid to attract more investments, start-ups tout big growth numbers and metrics that don’t fit into conventional accounting norms. With more investors rushing to take a bigger pie of the growth story, it is a seller’s market. The premium garnered by segment leaders also leads to small entrepreneurs talking big numbers.

One such metrics is gross merchandise value (GMV), which is the total value of goods sold on a platform. This figure can be manipulated; the sale of items with high price tag can raise the GMV. Expensive items can significantly raise the GMV, but actual addition to revenues is nil, according to an industry expert.

Sellers often buy discounted goods in other names to raise the GMV. Only Amazon, among e-commerce companies, doesn’t talk about GMV, but dishes out numbers about the revenue it earns by selling its own inventory, commission and cloud services by selling third party goods.

However, experts say Amazon is not comparable with Indian e-commerce companies. It is ahead of others in revenues because of its web services business, which comprises 7% of its revenue. In addition to this, mature start-ups gobble up newer ones, lest they become a threat, or acquire technology, leading to a rise in valuations of the said company.

Indian Investors

With most Indian start-ups eyeing US listing, given that the US IPO market is booming and there are difficulties in raising money locally, the Securities and Exchange Board of India (SEBI) too has jumped into the fray. It has come out with easier listing norms and a separate trading platform for start-ups.

But experts say easy rules for listing start-ups is unlikely to lead to a flurry of initial share sales as poor liquidity and lack of experience in valuing Internet and technology companies could hamper investor appetite. Also, currently the local IPO market is not good. Start-ups need investors with a long-term view and the capacity to take initial losses.

While SEBI’s decision is to encourage high-growth companies to keep their wealth in India, very few Indian investors have expertise in new-age industries. The issues that deter investors are liquidity and the wrong valuations they arrive at.

Also, valuations overseas would be higher than in India due to the sheer number of investors there. So, the Flipkarts and Snapdeals of India have no other option but to head overseas for listing, say analysts.

Are We In A Bubble Zone

While the valuations are comparable to the 2000 dotcom bust, the firms are on a solid footing now, with the Internet being pervasive, and social media and major Internet companies touching the lives of a huge multitude. The dotcom bubble had seen highly questionable revenue models, which is not the case now, reason out experts.

To sum it up in Ratan Tata’s words, the jury is still out. “It’s actually a feeling that e-commerce is really the new trend for the Indian commerce. It serves millions of people. It’s my personal money and not the company’s money. I don’t see where the debate is,” Tata said.

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