Searching for Margins in India’s B2B Commerce Platforms
Way back in 2014, a former colleague and I spent time looking at the first wave of B2B commerce platforms in India. We went around the country, spoke with value chain experts for various supply chains, and came back with one fundamental question that we wanted to answer: how are you different from a wholesale distributor, especially in terms of margins? This was a growth equity framework, but I have not been able to shake some of the fundamental tenets of the framework over the last 9 years.
At Vertex Ventures Southeast Asia & India, we are strong believers in startups’ ability to impact efficiency in value chains. Suffice it to say, B2B value chains in India are fairly inefficient, and there is a massive opportunity to invest in every single segment. However, this is only a part of the story. As we start to analyze the micro-segments of each of these value chains, we begin to realize that the individual components of these value chains are actually incredibly efficient and that inefficiency creeps in at the edges.
Let’s illustrate this: in retail, the kirana store is the most efficient unit of retail. There is no rental (real estate is usually owned and close to the customer), no wages (the entire family works at the store), and no leakage or wastage (truly entrepreneurial). It is extremely difficult for a corporate store to compete with this setup. It is even more difficult for a chain of corporate stores to compete with a disparate set of kirana stores in a city like Bangalore. However, as you scale a kirana store to a large format, increase SKUs and add slow-moving inventory, the inherent advantages break down, and you have a very interesting opportunity in larger format modern retail. The same principles apply to retail wholesalers, distributors, and several other segments.
Before we dive into what could be a framework for evaluating B2B commerce companies, I want to outline the market. Particularly, the size of the markets we are talking about, which is the most attractive part of evaluating the B2B Commerce Opportunity.
Here is why I am writing a take on a market that has been discussed ad-nauseam in the ecosystem: it’s 2023, and we need to discuss the economic model in B2B commerce, and that it cannot just be lending.
We believe that great entrepreneurs can create a tremendous amount of value in every single B2B value chain. This is not to say that all the attempts have been successful, but rather that approaches have failed markets rather than market-failing entrepreneurs. I contend that the biggest driver of failure in B2B has been access to excess capital. B2B businesses are best built on frugality, finding tiny pockets of inefficiency and scaling those, whilst kicking out incumbents in the process, and ultimately making a lot of money in the bargain. An abundance of capital has meant that organizations are not singularly geared towards finding the last bps of margin in the value chain.
A Framework for Assessing B2B Commerce Platforms
I won’t delve too much into the evaluation framework. Buyer and supplier concentration is a key consideration, as is the need to ‘own’ as much of the value chain as demanded by the specific segment. Another factor that is often over-indexed, is the ability of the sector to absorb technology. Many businesses start out as pure exchanges, assuming price transparency will solve for a very large set of problems, only to realize buyers and sellers are maybe five years away from bidding on their phones. B2B trade is often RFP/RFQ based, and unlike consumer, it’s not easy to change buyer behavior.
I believe that three topics warrant deeper discussion on the economic front:
1. Margins in B2B Commerce
The Gross Transaction Value (GTV) on the buyer end, less the cost of goods, is the Gross Margin (GM), which is seemingly the most important aspect of B2B commerce. Delving a little deeper, GM, less the cost of fulfillment is the Contribution Margin (CM). I think B2B commerce platforms need to be evaluated from the perspective of logistics-adjusted margins.
However, there is an added nuance: margin analysis should also compensate for working capital. How should one think about this? I take a simplistic approach: assume that the platform can potentially get working capital financing at 18–24% per annum, and therefore, ascribe a 1.5%-2.0% additional cost for every 30 days of working capital in the value chain. Goes without saying, assessing the number of Net Working Capital (NWC) days is somewhat of a journey as a company scales.
Therefore, the true definition of margins in B2B commerce is Logistics-adjusted and NWC-priced Gross Margin.
2. Operating Leverage in B2B Commerce
The second part of economic analysis centers around a topic that is not discussed often: operating leverage. Traditional B2B commerce platforms (think wholesalers and traders) have tremendous operating leverage. They often suffer from an inability to scale teams but are constantly trying to grow topline, resulting in an ever-expanding free cash flow.
Part of the analysis around operating lies in the gross margin (adjusted, obviously). B2B commerce has an extremely low gross margin, and therefore, operating leverage will be significantly lower than, say, selling software. However, a large part of the seeming lack of operating leverage comes from the need to add warm bodies to solve problems. Most companies employ armies of people to call up customers for every part of the business: placing orders, tracking shipments, confirming receipt, and chasing payments.
I am increasingly starting to think that a core decision-making criterion, very much like in software, is customer account growth, without the need to add an army of account managers. There are some businesses where this is inherent: payments is a great example. I think this characteristic makes B2B commerce platforms extremely attractive.
C. Working Capital and Payment Flows in B2B Commerce
Here is a cynical take on B2B commerce: as long as you don’t manufacture goods to trade, your job is Money Management. Seemingly, every B2B commerce platform is in some shape and form a fintech platform. Why this is cynical is obvious: it oversimplifies both B2B commerce and Fintech.
However, if you continue to humor me: based on how you think money gets best managed, you decide to own a certain part of the value chain in B2B commerce. For instance, if you think the existing logistics supply chain is inefficient in your industry (think seafood cold chain for export quality farmed shrimps), you might as well build it because it helps you manage your money better. Some of the obvious tenets of money management in the context of B2B commerce include credit, payments, and escrow (there are many others).
The analogy, however, breaks down if you think about the risk factors of both businesses. The core risks in Fintech are extremely different from those in B2B commerce; therefore, the way these organizations must be built is also very different. One is a sales org, while the other is a risk org.
I think it is extremely important to understand how joined-at-the-hip are commerce and credit in a B2B platform, and where the real value lies. If the value truly lies in credit, it might make sense to invest in a lending business and not a commerce platform. Or at least acknowledge that commerce is just the GTM for driving low acquisition costs.
We continue to remain excited about B2B commerce platforms. If you are a founder building in this space, please reach out at helloasia@vertexventures.com.
