Why start-ups like Flipkart are worth more than Tata Motors

Got a great new idea? Are you from IIT? Here's a $5 million cheque.

That's the dream conversation every 20-year-old has with a fantasy venture capital (VC) or private equity (PE) firm. And there are lots of people living out that fantasy. Flipkart's valuation is now over $15 billion (Rs 100,000 crore). In comparison, the stock market values the venerable Tata Motors at a mere Rs 95,000 crore.

Hindalco, India's largest aluminium company, has a market valuation of Rs 16,000 crore. Snapdeal, which began trading just five years ago, is valued at Rs 35,000 crore. India's biggest airline, Jet Airways, with large assets, is valued at Rs 3,800 crore. In stark contrast, asset-light Ola Cabs, the app-based taxi-hailing start-up, is worth Rs 30,000 crore.

So what gives? In short: the internet and mobile phones.

App-based firms (Ola, Snapdeal, Flipkart, Grofers, Foodpanda) are essentially brokers and couriers. They connect service providers with consumers. The web cuts through the infrastructure clutter. Small town buyers who don't have a physical store to pick up a pair of branded jeans or a set of bluetooth speakers can do so through an e-commerce site. And they can be assured of delivery the next day.

But are these start-ups worth the money VCs and PEs are paying for them? Conventional wisdom suggests they are not. Dig deeper and a more complex, nuanced story emerges.

But first let's dispel some myths. Myth number one has to do with revenue. Most e-commerce sites like Flipkart and Snapdeal focus on gross merchandise value (GMV) to pitch their stories.

Now GMV is misleading for two reasons. First, it reflects the total value of goods and services transacted through the site, not the actual revenue earned by it. Second, the huge discounts offered are not excluded from GMV.

The real revenue of e-commerce sites is broadly around five per cent of their GMV. It's like a stock broker who buys shares worth Rs 1,000 crore for clients and whose actual brokerage revenue is one per cent (Rs 10 crore) but claims Rs 1,000 crore as revenue.

GMV is pass-through revenue. Real e-commerce revenue is the commission the site charges the brands it sells through its app. That's rarely over five per cent of the discounted retail price.

When VCs and PEs do valuations of start-ups, they use GMV as the primary metric. No start-up is listed; so scrutiny by financial analysts is limited. Their balance sheets, though, are available on the Registrar of Companies (RoC) website and it's clear that actual annual revenues are a fraction of the GMVs.

Does that mean e-commerce start-ups are overvalued? Not necessarily. The Indian retail market is huge and growing rapidly amidst an aspirational middle class. Mobile internet is exploding. VCs and PEs are betting that sheer volumes will eventually make even five per cent of GMV a big number. Flipkart, for example, has "real" annual revenue of just over Rs 3,000 crore on a GMV of Rs 40,000 crore. That's a ratio of around 7.5 per cent. Its audited annual loss on account of discounts in 2013-14 was a staggering Rs 719.50 crore.

That had got investors worried. Questions are now being asked: is the hype overcooked? In a recent piece in Mint, Shrutika Verma and Mihar Dalal searched for an answer: "Investors have started to step back, take stock and ask questions about how consumer internet start-ups plan to make money before writing cheques, according to investors, analysts and entrepreneurs.

"About time, some analysts say, pointing to the mushrooming of such internet start-ups, some of which have questionable business models. For instance, more than 25 start-ups in food and grocery delivery and home services market places - start-ups that deliver food, groceries and services - have received venture capital (VC) money. 'There's a definite slowdown in terms of the pace at which deals are being struck since the last seven-eight weeks,' said Avinish Bajaj, managing director at VC firm Matrix Partners. 'Investors are starting to ask questions about long-term sustainability. The number of $50 million deals has gone down. Deals are taking longer. This is a soft landing and it's a good sign. The time correction is likely to be followed by a price correction.'”

The US offers a glimpse of the future for e-commerce start-ups. Amazon, only recently, announced a quarterly profit after 21 years of being in business, but commands a market value of $260 billion (Rs 17 lakh crore), which is more than that of America's largest retail chain Walmart (market value: $230 billion). Uber, the taxi cab aggregator, founded in 2009, is valued at $50 billion (Rs 3.30 lakh crore), higher than auto giant General Motors ($44 billion), which was founded in 1908.

In a recent article in The New York Times, Katie Benner sounded a warning from the Silicon Valley: "Start-ups that cannot adapt to a world that prizes profit over growth may ultimately be forced to raise money at the same or lower valuation than in the past, something referred to as a 'down round'. Those can be debilitating: employee stock options usually become less valuable when a firm's valuation falls, making it harder to retain people.

"If a firm has raised many rounds of capital, later investors often have protections that guarantee a specific cash payout or return on investment. In a down round, those protections are paid for out of the returns that would have gone to earlier investors and employees."

And yet, there's little doubt that technology will change the rules of business.

E-commerce, mobile wallets, payment banks, driverless cars - these disruptive technologies will transform the way we work, consume, travel and pay. It is this transformation that VCs and PEs are betting on.

The future of private/public transportation, for example, is Uber and Ola. With tech companies developing driverless, sensor-laden cars, the General Motors, Fords and Toyotas of the next decade could be Google, Apple and Tesla. All three are in advanced stages of testing sensor-driven autonomous vehicles or selling battery-powered electric cars. Tesla has already sold over 21,000 Model S electric cars this year to rave reviews. Apple has quietly begun testing a driverless prototype in San Francisco, dubbed by geeks as the iCar. Google too is testing advanced models of driverless cars with sensors to detect and avoid the smallest object on the road.

Meanwhile, start-ups are surviving on VC/PE/angel money, not earned profits. When that source eventually dries up, some will go belly-up. Only those with business models that generate real cash profits will survive and a few thrive.

But when six-year-old Uber is valued higher than 107-year-old General Motors, we know that a brave new world is already upon us.