Internet economy: Reality check at start-ups

For Indian Internet start-ups, this year turned 2015 on its head. Valuation markdowns, executive departures, job cuts, market share losses (to American rivals) and a lack of big-ticket fund raises dominated the headlines in 2016.

It was a total departure from the previous year, when start-ups touted high-profile recruits from the Silicon Valley, hired thousands of engineers and enjoyed the fruits of a fast-expanding Internet market, attracted massive funding and were assigned jaw-dropping valuations.

Start-ups pulled in only $4 billion in funds in the year, down from a heady $7.55 billion in 2015, which was largely powered by large rounds at Flipkart, Ola, Snapdeal and Paytm, according to data from start-up investment tracker Tracxn. The number of mid-stage and late-stage deals has dropped significantly this year as the likes of Tiger Global Management, SoftBank Group Corp. and DST Global, three of the most active backers of Internet companies, pulled back.

After a funding boom in which Indian Internet start-ups attracted more than $9 billion over 18 months, venture capital firms changed their approach in 2016, asking entrepreneurs to cut costs and avoid pursuing sales growth by offering deep discounts. Many of the start-up stars of 2015—Flipkart, Snapdeal, Ola, Grofers, Oyo and Zomato—went into cost-cutting mode. Mergers among struggling companies, distress sales and start-up shutdowns increased sharply.

If GMV (gross merchandise value)—a vague measure of gross sales, excluding discounts and sales returns—was 2015’s favourite term, unit economics (revenue and cost per unit or user) was the buzzword in 2016. This shift will continue in 2017.

Some other trends, too, will stick: focus on cutting losses at consumer Internet start-ups; generating less-costly sales growth; mergers and acquisitions, possibly even among Indian unicorns; strong investor appetite for start-ups in digital payments, financial technology and enterprise software; and increased efforts by venture capital firms to get exits from past bets. One event will go a long way in determining the investor sentiment next year, especially for late-stage start-ups: the fund-raising efforts of Flipkart, the torch bearer of the Indian start-up ecosystem that has seen its valuation chopped by some of its own investors. Yet, things are not all as bad as they look on the surface.

A few winners emerged this year. Paytm, the country’s largest digital payments provider, saw its valuation more than double to roughly $5 billion.

India’s demonetisation initiative provided an unexpected and massive boost to Paytm’s business in the past quarter. Freshdesk, backed by Accel Partners and Tiger Global, became the breakthrough enterprise software start-up, offering hope to investors that SaaS (software as a service) start-ups may be much more capital-efficient bets than their consumer Internet peers.

In fact, the overall volume of deals actually increased slightly this year. More than 1,030 deals have been completed this year, compared with 1,027 in 2015, indicating investor appetite for early-stage start-ups is still strong. E-commerce, digital payments and, in particular, enterprise software or SaaS were among the top sectors this year.

There’s still a lot of capital available for Indian start-ups. Venture capital firms including Accel Partners, Sequoia Capital, Kalaari Capital and Nexus Venture Partners raised more than $2.5 billion in 2015. Typically, it takes at least three years for VCs to exhaust funds. And while the euphoria over Indian start-ups wore off this year, VCs still raised more than $1 billion in 2016.

Then, the launch of 4G services by Reliance Jio Infocomm in September is expected to reduce data charges and improve mobile Internet speeds, which will help in expanding the Internet market.

In any case, much of the pain at top Indian start-ups was self-inflicted. It’s probable that if the top Indian start-ups hadn’t messed up so badly in the go-go days, funding wouldn’t have slowed so sharply in the first place.

Flipkart, India’s largest e-commerce firm, lost its way badly in 2015 after making disastrous and wholly unnecessary decisions, the most embarrassing of which was an experiment to ditch its websites and become an app-only platform. It spent much of 2016 undoing the mistakes of 2015 and now, finally, seems to be amid a turnaround.

Instead of putting all energies in keeping Uber at bay, cab-hailing service Ola distracted itself in 2015 by launching services such as food delivery and grocery ordering, which failed to take off. In 2016, Ola shut most of these services and doubled down on its cab business and held its own against Uber.

To be sure, however optimistically one looks at the events of 2016, it’s become clear that investors overestimated the potential of India’s consumer Internet market.

A population of more than 1.25 billion, rising mobile Internet penetration and increasing incomes are supposed to make India the last big unconquered e-commerce market.

But this year, the online retail market is estimated at around $14-14.5 billion, barely higher than last year’s.

The weakness in online retail highlighted an awkward truth: while the number of Internet users is growing rapidly, the number transacting online isn’t increasing at the same rate, raising concerns whether Internet firms can attract enough new paying users to back investors’ rosy projections.

It means Flipkart, Amazon India and others will have to come up with innovative products and services to push the growth of online retail in 2017 rather than relying on just macroeconomic factors.