Internet Commerce Valuations: Pay for strong fundamentals, not for hype – Deepak Srinath

(This blog was first published on the VC Circle blog on 29 July 2011)

There is a raging debate in the US tech and financial media about the ‘tech bubble’ we apparently are in the midst of. Every journalist, blogger, VC and academic is either painting doomsday scenarios or vehemently denying there is a bubble. Either way, we’re seeing unprecedented valuations for social media and social commerce startup’s, both from VC’s and public markets.

US tech valuations seem to have had their affect on the Indian startup scene too. A few days ago The Economic Times carried an article on Snapdeal’s next round of funding – ‘sources close to the deal’ are quoted as saying that the deals site is raising INR 200 cr at a valuation of INR 1000 cr. Rumors are doing the rounds that Flipkart is raising its next round at a billion dollar valuation. If these valuations are halfway close to the truth, we’re talking multiples of 10 to 15 times their annualized run rate or Gross Merchandize Value-GMV (i.e., their current monthly sales multiplied by twelve). Are investors justified in paying such valuations? What about margins and net income, have they become irrelevant?

This debate about VC’s over paying for e-commerce startup’s is particularly important in the Indian startup context. VC funds in India, barring a handful, are still going through their first or second investment cycles and very few of them have seen big exits yet. Most early stage funds have significant exposure to e-commerce and need to show good exits in order to raise future funds. It may not be an exaggeration to say that the early stage ecosystem will suffer if VC’s have overpriced these investments and don’t make good returns.

I actually don’t think these valuations are as crazy as they are made out to be.

E-Commerce companies take a long time to become profitable. Amazon took seven years to turn in its first profitable quarter. Even today Amazon’s net income is small compared to Google or other tech giants. The market values Amazon (P/E of 82) for the kind of profitability it will deliver in future. If you take a closer look at investments in the internet commerce space in India, it is only the category leaders who command such valuation premiums. E-commerce worldwide is all about becoming the no. 1 or no. 2 player in a category and dominating it. So investors are essentially taking bets of firms who have demonstrated early traction and paying in anticipation of what they hope these companies will grow into in two or three years.

However, investors must be wary of paying valuation premiums based on GMV alone. GMV spikes can be achieved by deep discounts or cashback schemes and these will ultimately prove unsustainable unless you build loyalty and repeat purchases. Critical success factors in the long term are low Customer Acquisition Costs and high Customer Lifetime Value (CLV). Profitability will ensue if these two metrics are under control. Investors should be very careful not to pay for hype. As long as premiums are being paid for real fundamentals, all of us will be fine in the long run.

Advertisements
%d bloggers like this: