Jolly’s Volley: It’s Now Bubble Bath 2.0 For E-commerce

09 August, 2011

Let me start off by saying that I had initiated this article towards the end of 2010 or early 2011, but simply never got around to finishing it until recently. So, some of the thoughts may be a little dated, but clearly the euphoria and the exuberance around e-commerce in the recent months have made me cement my thoughts and submit this latest piece for your enjoyment. So, here goes…

I think 2010 will go down as one of the marquis years for the Indian venture capital industry, both from a relative standpoint (as compared with previous years), as well as an absolute one, given the number of deals done and the capital invested. Of course, it was also the year of one of the best Indian IPOs on the NASDAQ in MakeMyTrip (MMYT). But that kind of euphoria and momentum (with several other consumer Internet plays lining up for IPOs), especially after a fairly ho-hum 2009, has, for some, created an uneasy sense of ‘the second coming of the bubble,’ which I will label as ‘bubble bath 2.0.’ It’s not a tsunami, in a negative sense, that the dotcom bust was a decade ago. But it seems to be like a bubble bath, but potentially… on a boat… stuck in the middle of an ocean… with a storm brewing.

Let me put some colour on what I am trying to say. In the last several weeks and months, I and my team have been witness to an interesting phenomenon. The entrepreneur walks into the meeting and either right at the beginning of the meeting or at the very end, says something like, “I thank you for your time, but just want to let you know that I already have multiple term sheets and am expecting another 1-2 in the next week. So, you will need to make a decision in the next 10 days if you would really like to participate in this round of financing.” Typically, VCs expect that kind of rhetoric to be indicative of posturing, often done by entrepreneurs to create a sense of competition and scarcity for a deal. But in this case, it’s different. It’s not a negotiation tactic, but more of an ultimatum. And although, in a couple of cases, I had presented the companies to our US partnership on relatively short notice, we have not pressed forward with an investment in those cases.

What is also interesting is not only the level of interest that companies (especially in the consumer Internet domain) are generating, but as a result, the extremely high valuations that they are expecting AND receiving. There have been several instances now (so it’s more a trend than an anomaly) where companies generating $10K-$20K per month in revenue are able to get valuations at $15 million-$20 million pre-money for their first or series A round of financing, or an 8x-10x annualised gross merchandise value (GMV) multiple. There are several companies who have scaled to $1 million to $2 million-plus per month in GMV (in a fairly short time, which is commendable), but are garnering valuation of $120 million-$300 million pre-money, often within 1-2 years of their existence.

I can clearly see the entrepreneur pointing to the fundraising environment as being a marketplace and as long as there are interested parties willing to pay a high price, so be it. Admittedly, I would do the same if I were in the entrepreneurs’ shoes (so it’s a great time to be an Internet entrepreneur, especially if one has any pedigree in terms of education and work experience). As an investor from the outside looking in, I find those sorts of valuations irrational. But at the same time, as an insider in a few deals which are generating that level of interest, I am delighted to be getting high valuations for our existing portfolio companies (fear and greed are well at work, ladies and gentlemen). The key will be to look at several of these companies getting funded in a variety of sectors (from key verticals to group buying companies, etc.) and see what happens in the 12-18 months from now when they come back perhaps for their next round of financing.

My guess is that there may be some who truly hit the ball out of the park (Flipkart is clearly in that category at this point) and will be seen as worth the high price early on. But the majority is likely to come up short, and both promoters and investors may have to pay a price via a ‘down round’ and/or some other so-called ‘anti-dilution’ adjustment mechanism.

By the way, another caveat that is being put into those term sheets is something called a participating liquidation preference multiple. What it means is that, if there is an M&A downstream, the investors will get 2x-4x of their invested capital out first and then participate pro-rata in the remaining proceeds. For example, if there is a 4x participating liquidation preference in a $25 million round and the company is bought for $200 million, the investors who put in $25 million will get 4x that amount (or $100 million) of the purchase price out first and then participate in the remaining $100 million, according to their shareholding in the company. If the investors own 50 per cent of the company, they get another $50 million, leaving $50 million of the purchase price for the common shareholders.

That can and will create tensions downstream, especially for companies which don’t have an interesting enough outcome for the entrepreneurs. The scenario above is one that investors may clearly push for (with a nice 6x on their $25 million invested), but the entrepreneurs will be left with a less-than-stellar outcome. None of the liquidation preference stuff matters if a company has an IPO, but the universe of ‘IPOable’ companies may be limited.

Obviously, the aforementioned is only a scenario and not necessarily a mainstream structure. Interestingly enough, there are also two schools of thought emerging within the VC fraternity. One school believes that India is clearly at an inflection point when it comes to consumer Internet/media and now is the time to get into interesting companies, at virtually any valuation.

There is yet another school which believes that we are in a frothy phase in India and it may be better to let the euphoria die down, have the companies’ expectations come back in line with reality (around the time they need their next round of financing) and invest at that point – either getting more of a bargain or investing in clear leaders in that particular space, perhaps at a high valuation, but at much reduced risk. By the way, most of these businesses require a lot of capital over time and it remains to be seen whether these companies can continue to raise capital at higher and higher valuations downstream.

The good news in all of this is that – clearly, this is not nearly the same as the scenario 10 years ago. There isn’t the public market craziness of valuing companies with no financial fundamentals and the value being placed on eyeballs, rather than a functioning business model. This time around, companies and entrepreneurs do realise for the most part that they need to generate revenue and eventually get to profitability (but most of the e-commerce businesses suffer from extremely low gross margins and negative net margins for years, which means that they have to be a fundraising machine to survive and thrive in the long run). Business models around advertising, transactions and subscriptions have been figured out with several successful data points to emulate in many cases.

With China’s consumer Internet companies rocking IPOs and market capitalisations in the USA, Indian and overseas investors are clearly seeing similar opportunities in India in the months and years to come, and are betting on who they believe will be the Groupon/Amazon/Hulu/Gilt, etc., of India a few years from now. Confluence of interesting socio-economic, technology and demographic trends in the country is laying the foundation for the momentum and excitement around emerging online start-ups. Young aspirational population, high savings rate, consumption-driven economy, media and entertainment-centric use case and pent-up demand (online and mobile), 3G/wireless broadband, growing middle class, etc. etc., all clearly point towards India arriving (and some would argue, having arrived). But I hope it’s not like my microwave delivery guy who kept promising that he was, indeed, arriving at my house and that he was approaching the gate, and eventually admitted, “I had puncture, sir. I cannot come.” And, at the same time, I hope it’s also a pleasurable bubble bath 2.0, rather than both entrepreneurs and investors finding themselves in a capsized dingy in the ocean with a storm overhead.

I fundamentally believe that the seeds are, indeed, being sown when it comes to consumer Internet play in India and some of them will make it, but many won’t. I do feel, however, that the dreams of multi-billion-dollar market caps a decade downstream (although entrepreneurs may be thinking 2-3 years downstream) are creating an aberration in valuations reminiscent of the ‘irrational exuberance’ of a decade ago.


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Jolly’s Volley: It’s Now Bubble Bath 2.0 For E-commerce

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