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FDI conundrum and the game of matryoshka dolls in Indian e-commerce space

16 January, 2013

For the uninitiated, matryoshka dolls happen to be a Russian creation where multiple wooden figurines or dolls (usually non-identical) are crafted in different sizes so that one can be placed inside the other or nested. And looking at the outer layer, no one can make out if anything at all lies within.

In the corporate world, these dolls are replaced by subsidiaries. Some are born out of business units of a diversifying or diversified firm and many from taxation perspective – a part of the megalith known as regulations.

The structuring and operations of many e-commerce firms in India involve anything but subsidiaries. Yet, they have similarities with the little bundle of mysteries, first crafted by the Russians in the 19th century.

But just like many other Indian regulations which are not iron tight in their scope and objective, the existing norms for foreign investment in e-commerce activities leave enough room for entrepreneurs and investors to find a business opportunity.

Foreign money has allowed e-commerce startups not only to scale up but also to expand with multiple iterations and a few of them ensure satisfactory customer experience (or customer delight, to use their jargon) on par with what is offered by top global players.

But the government had hit hard a couple of years ago by putting conditions to dissuade foreign money from pouring indirectly into retail trading. This has been done through a clause that wholesale retailers with foreign equity participation cannot derive over a quarter of the sales from a group firm. This was, arguably, not implemented with the e-commerce firms in mind, but had stumped the sector much more than physical retailers.

Large foreign retailers have floated wholesale retail chains (which are supposed to sell to smaller retailers) and some of them have struck simultaneous deals with local strategic partners to handle the backend of retail chains where the front-end stores are owned or run by Indian partners. The recent news about Bharti Walmart deriving more than half of its revenues from Bharti Retail is just an example of a bigger scenario that exploits the nebulous definition of a ‘group firm.’

But this becomes tricky for an e-tailer where the foreign investment is coming from a venture capital firm and the local partner is, well, the entrepreneur. In general, both investors and e-commerce firms remain tight-lipped on how they are meeting the riders although they maintain they are in conformity with the law. Still, a few e-commerce firms have been put under scanner for alleged FDI norms violation.

For instance, the founders of one of the large Indian e-commerce firms circumvented the ceiling on the quantum of revenues derived from group firms by simply resigning from the firm associated with the front-end operations and transferring their holding to relatives, ‘well-wishers’ and a few employees of the firm. They, thus, claim that the front-end entity is not a part of the group associated with the wholesale retail firm which has received foreign investment.

They further ring-fenced their move by creating a structure where the ownership of the front-end firm will not pose any risk in the future even if its shareholders turn greedy. This is through a licence arrangement for using the name of the site, a key currency in the overall matrix.

Others have devised their own ways to get around the problem – for instance, outsourcing certain functions such as logistics and customer care (if you are big enough for that). Those wholesale retail firms can then derive a chunk of revenues from other customers.

The red flag for the Indian e-commerce firms is that the government seems adamant in keeping e-commerce out of the recent reforms, which allowed foreign direct investment in multi-brand retailing. There is not much clarity why such a decision has been taken but by doing so, the government has not provided a level playing field for the e-commerce firms against the hypermarts (prime competitor of Amazon in the US, for instance).

Perhaps this can be traced to the fact that e-commerce startups do not have the same lobbying muscle as some of the retail giants who have recently hit the headlines for all the wrong reasons.

Unfortunately, the craft of making matryoshka dolls is believed to be dying a slow death. But what should be really going out of fashion is the smokescreen surrounding the policies, such as selective clamp on e-tailing and also the loopholes which allow corporate lawyers help their clients stay on the right side of law while making a mockery of it. Will the mandarins oblige?

(Vivek Sinha is Executive Editor of VCCircle)

To become a guest contributor with VCCircle, write to shrija@vccircle.com.

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Saurabh D . 5 years ago

Hi Vivek,

This is an excellent summary of the complex situation. It looks like eCommerce was banned, as the multibrand FDI needs state level approval. If this problem was not there i guess the govt would have surely allowed eCommerce. That being said, i believe that govt does not want to shoo away the investors by banning Flipkart/Jabong and the likes.

For the time being i think the govt will not make eCommerce legal. But at the same time the govt agencies will work out a ‘corrective measures’ plan to make the Flipkart and the likes legal.

Foreign Investor is the GOD !! especially if they have already put in their money.

Any update on the ED investigation into flipkart and walmart FDI violations?

vivek.sinha . 5 years ago

@Saurabh .. You are correct, it was probably to bring parity between offline and online retailers due to the state clause..however the govt has ended up keeping one side out of the matrix at least on paper thereby killing parity altogether.

True, the govt would not just go about banning ecom altogether (they never banned Hutch which became Vodafone despite knowing its India boss owns a stake to help the company comply with loopholes in FDI norms). The point here is that most ecom firms are not illegal in the first place. The issue lies in what’s group firm.

My own hunch is that the govt will clarify that the group should not mean relative of the promoters of the wholesale retail entity (not easy to do as even for listed companies, relatives can declare they are not part of promoters or have split and their holding is considered as public) or employees of the firm. I am sure lawyers would easily meet this by ensuring these employees become part of the front end entity instead of the backend or the main VC-backed entity..thereby continuing with the circumvention till the FDI policy is changed to allow them to operate freely. There’s always a way out 🙂

Nops no update yet on the ED probe. Again my bet would be the firm will be asked for some penalty which would be a few lakhs and then the above mentioned process takes over.

FDI conundrum and the game of matryoshka dolls in Indian e-commerce space

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