The Question of Indian Startup Bubble
“People live in these little bubbles of theirs thinking everything — environment, economy, society — is fine all around them,” said a friend of mine during coffee banter in college.
“Well, if they are happy living in that bubble, who are we to burst it,” I said.
“But it affects you. The decisions they make within that bubble affect everyone,” she said.
There are many words that are relevant to the Indian startup scene — entrepreneurship, innovation, markets, investors, valuation, etc. One of them is being used increasingly — ‘bubble’. Many of you who have been following the startup scene, startup history, or economics in general have heard this word before. In fact, it is a fairly common economic term that has been known by other names such as speculative bubble, market bubble, financial bubble, etc. For the uninitiated, it is broadly defined as an economic cycle in which an economy or parts of it expand rapidly and then, contract.
Though many financial bubbles have occurred over history, the dot-com bubble that occurred in the USA around the year 2000 is the most relevant to any startup economy. With the growth of affordable computing and internet connectivity by the late 1990s, many American businessmen set to take their businesses online. Entrepreneurs would largely come up with e-commerce business ideas and investors would not think twice before injecting their money into any web-based company. Companies that were growing during this time operated at a controlled net loss so that they can build a market share that can be tapped into later. They planned to charge profitable rates once they were a big brand that would be recognized for their services. Also, with a significant market share, theoretically, they should be able to tap into economies of scale in the future.
These dot-com companies would be started by young entrepreneurs — fresh out of college, or even the more popular type, the drop-outs. Andrew Smith, the author of Totally Wired: on the Trail of the Great Dotcom Swindle, calls them ‘kids’. The kids, so to speak, would come up with stellar e-commerce ideas that captured the imagination of investors. Many of the VCs and financiers, having spent a significant part of their lives in traditional businesses closely run by MBAs in suits, were smitten with this new mode of business. They saw investing in startups as being a part of something organic and dynamic. That did not mean that they were willing to risk losing money to bad ventures.
The share price of a start-up typically spikes on the day of IPO (Initial Public Offering) because of the massive valuation accrued over multiple rounds of funding. The financiers were entitled to sell their shares for this peak price thereby getting a profit while employees with stock options could not sell their shares until the end of their vesting period — the time period over which they acquire complete control over their stock options. Once a company went public, speculators would buy shares of these companies in anticipation of future increase in share price. This would push-up the share prices to an extent that the share value no longer reflects the intrinsic value of the corresponding asset. As people realized that a company is losing too much money to be seen as a sustainable venture, the stock price collapsed. The part which saw a rise in the share prices is called a bubble or a boom and the sudden collapse of share prices caused by reduced investor confidence led to a fall in stock indices. This fall is called a burst or a bust.
One may ask how this is relevant to anyone who is not an investor or a financier. Speculative bubbles and market crashes have consequences reaching far and wide. Besides the September 11, 2001 attacks, the dot-com bubble is believed to be one of the major causes of early 2000s recession in the USA. The housing bubble burst of 2006 in the US is understood to be one of the major causes of the 2007–08 global recession. China’s stock market bubble popped in June 2015 leading to a reduced GDP growth rate for the year. Being an export-fueled economy, they devalued their currency twice to sustain previous growth rate. This sent ripples through the global economy.
The dot-com bubble again serves as a simpler model to understand the mechanics behind these effects. When a dot-com company was being financed by financiers and VC firms, these companies often put that money into hiring the best talent that can propel their growth. Public companies would get more funding by selling their shares. Eventually as multiple companies did that, they built a job market with massive salaries and perks. This is what students unconsciously recognize when they remark that there is a boom in infrastructure, real estate, or start-ups. An industry boom translates to fat pay checks for new employees. Also, a stock market boom helped investors earn well by buying low and selling high. Now, there was a whole group of people who have a lot of money to spend and as they say, “one man’s spending is another man’s earning.” As these people spent their expendable income, retail saw a boom in their business. As retail sold goods more than services or SaaS back then, the dot-com boom translated to a manufacturing boom. To a lesser extent, other industries such as real estate, hospitality, restaurants, and travel saw growth. Evidently, a bubble looks beneficial in the short term.
When the bubble popped, many start-up employees either took pay cuts or were fired. Many people who had invested in dot-com stocks were left with worthless stocks as a result of the market crash. This led to a less net disposable income in the economy. “As one man starts spending less, another man earns less.” Businesses that expanded on the basis of previous increased business activities had to scale down or worse, close. This led to rising unemployment levels and a reduced GDP growth.
Analysts had brought down the whole dot-com bubble scenario to this simple reason — there is too much money chasing too few ideas and assets. As of late 2015, many Indian analysts have drawn parallels between startup boom in India and the dot-com bubble. Though there is no consensus on when the bubble began in India, it is widely accepted that investors are driving their decisions on a few success stories while ignoring businesses that fail. Many startups are yet to show profits while they have stellar valuation acquired over rounds of funding. Since these businesses are not sustainable yet, they often need steady funding or multiple bursts of funding to even sustain operating costs. This can be seen in how Flipkart takes a massive loss every time a big online discount sale happens. UBS estimated that Flipkart and Snapdeal will become profitable only by 2020.
In a 2014 interview, Kishore Biyani, the CEO of Future Retail (Big Bazaar, Central, Brand Factory, and previously, Pantaloons) was asked if retail is being hit hard by e-commerce. He answered in affirmative, but remarked that the discounts provided by e-retailers are sustained by funding which is finite and volatile. As e-retailers run out of funding, the market will be a level ground for e-retailers, and brick-and-mortar retailers. In fact, discounted shipping costs might be unsustainable in such a scenario leading to a higher total cost for customers relying on e-commerce. A significant part of funding for growing Indian companies is in the form of foreign investment by American VC firms. Analysts today are apprehensive of stability of this stream of funding as it depends on US macroeconomic policy.
In 2015, Zomato, TinyOwl, and Housing.com have laid off employees to cut down their operating costs. A few companies have already closed down and many have been acquired. Simplistically put, if too many companies are doing the same business via e-commerce, the most successful ones are bound to acquire well-valued less successful ones. In 2015, Housing.com acquired HomeBuy360, BigBHK, and Indian Real Estate Forum. Snapdeal acquired FreeCharge, Quikr acquired CommonFloor, Ola acquired TaxiForSure, Grofers acquired Spoonjoy, and CarTrade acquire CarWale. This is just the surface; over a hundred startups were acquired over the year. NASSCOM estimates 65 acquisitions by October, 2016 and the general perception among startup employees is that the market is moving towards consolidation. Large-scale consolidation occurred in the US dot-com market after the bubble. Many businesses that had failed were acquired by big corporations and ecommerce increasingly started to look like traditional businesses.
At this juncture, it is worth noting that Indian market moved towards consolidation before majority of the startups went public. “The speculative bubble is majorly in VC funding stage, not in stock markets. It’s not a bubble as such, it’s just distribution of wealth for now. None of them is a public company and only one in ten will survive after three years,” argues one of my friends working for a Hyderabad-based startup. The argument basically implies that there would be no stock market crash if the bubble were to pop today, but a stock market crash is only one face of a burst. An economy can be influenced by a burst even if there is no stock market crash. On the subject of making a startup profitable, he remarked, “It all depends on how you monetize the entire organization’s cost. Flipkart, in spite of 10 million users, reports a loss of 1200 crores. So do Myntra and Snapdeal. You don’t need thousands of engineers to achieve scale. Uber around the world has only 800 employees while Ola in India alone has 3K.” The layoffs that have been occurring across startups are in agreement with this argument. Another friend says, “VCs don’t bet on businesses, they bet on the team and the people. They do know that business model changes and evolves and they look at the ability of the team to be successful. Execution and growth matters, but revenues and profits are coming into the picture along with these aspects.” He remarked how iD Fresh, a Bangalore-based packaged foods startup has been running on minimal finances for 7 years until it became profitable. In his TED talk, Bill Gross remarks that the most important factor for any startup to succeed is ‘timing’. Considering that many startups are incorporated way before the market is ripe, it is only natural that only the ones that can survive until the right timing eventually succeed.
Entrepreneurs and investors see layoffs as an inevitable part of startup lifecycle. They also believe that only startups with clear business plans make it through the boom and bust cycle. It is the fiery crucible in which true heroes are forged. Entrepreneurs and investors also argue that much of the capital invested into the dot-com bubble has fuelled the growth of American internet infrastructure, built a lot of software that works, databases, and novel workflow systems. In a way, the dot-com bubble is what made today’s internet possible. Nothing important has ever been built without irrational exuberance.
Looking at the Indian startup scene as a separate ecosystem (it’s not, because of globalization), e-commerce is said to be the hottest. Similar to how many American entrepreneurs wanted to launch a web-based business in the late 90s, many Indian entrepreneurs today want to launch an ecommerce website or an app. The government’s Startup India action plan to encourage entrepreneurship may serve as an unintentional corrective measure. Improved domestic capital and credit availability, IP rights awareness, legal support, and infrastructure among other benefits can help in insulating the Indian startup ecosystem from external policy decisions to a satisfactory extent. Collaborative efforts between Startup India and Make in India executives can make entrepreneurship options other than e-commerce viable since manufacturing startup ideas tend to go unpursued for want of capital.
India is projected to have 11,500 startups by the year 2020 and yet, as of today, policymakers and economists have not assessed the contribution of startups towards the GDP. This can be attributed to the problem of defining what a startup is in a specific economy. The traditional definition that a startup is a company with limited revenue, high costs, and negative cash flows takes under its umbrella many of India’s small scale businesses operating under losses. From a finance perspective, a tailor shop still to recover their capital expenses is the same thing as a startup yet to break-even, but the cultural perception of the word ‘startup’ also adds a dimension to its definition. This does not mean that startup contribution towards GDP is not counted — it is included in the traditional sector-wise (agriculture, industrial, and service) GDP calculations. Most startups fall under service sector, but it also includes well-established companies.
Perhaps, seeing how investors run after hot businesses, it may be fair to say that the bubble itself adds a dimension to the definition. Without a clear definition of a sector and therefore its contribution to the economy, it is almost impossible to assess the damage that can be wrought by a speculative bubble burst. This is one of the reasons why many economists believe that bubbles or bursts cannot be predicted and that a burst is the only way out of a bubble.
Assuming that the situation is as worse as analysts say and assuming that the startup economy is big enough to significantly dent the economy, we should be really concerned about policy decisions towards this end. Assuming that the startup economy is not big enough to cause serious damage to the economy, we as an economy are in the green, but won’t it be big enough to matter by FY 2017–18 when the bubble is expected to burst?
