August 02, 2020
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Value For Losses

Mistaking users for customers has been the bane of start-ups

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Value For Losses

The purpose of business, said iconic management guru Peter Drucker, is to find or create a customer. He defined a customer as someone who pays a business for goods sold or services rendered. Drucker made this point way back in 1954 in his book The Practice of Management. But several decades of boom, bust, bubbles and corporate collapses later, it seems businesses are still to come to terms with the truth underlying this one simple sentence.

Today’s start-ups, in India and abroad, many in the digital world, have confused ‘users’ with ‘customers’. They have conflated an expansion in the usage of their goods or services with the creation of customers. Whether it is the world of digital publishing, or online groceries, or e-marketplaces, or even ride-­sharing apps like Uber and Ola, the stupendous growth in usage has often increased losses for most players. In other words, potential customers have been bought with freebies or discounts, but they are yet to become truly paying customers where revenues are at least Re 1 above costs.

The fundamental error promoters have made ever since venture capitalists have been plying them with oodles of capital is to play the valuation game rather than the revenue model game. In the former, you get more capital at ever-inflated prices by showing huge additions to the user base; but without the conversion of users to customers there is no revenue or business model worth the name. Capital is being set on fire. Valuation models have a shelf-life dependent on the investor’s patience quotient.

Flipkart, India’s market leader in e-commerce, was going great guns till mid-2015, when it raised capital at a valuation of nearly $15 billion. Today, many investors are sheepishly marking down their valuations to a third of that level, thanks to mounting losses despite rising gross revenues. Users were paying, but not enough to cover costs.

One reason why investors have been indulgent so far is that the world has been awash with capital. With US, European and Japanese interest rates ruling near zero post-2008, investors were willing to take more risks to earn more. In 2016, America Inc had cash surpluses of nearly $1.7 trillion.

But risk appetites sooner or later reach satiation point and investee firms are called to account.

Aswath Damodaran, finance professor at New York University’s Stern School of Business, has a term for this moment when high-growth start-ups are made to realise that business means more than just accumulating free-loading users. He calls it their bar mitzvah moment, a “time in their history when markets shift their attention away from surface measures of growth (number of users) to more operating substance (evidence that users are being monetised)”. This is the moment when such companies not only have to grow users, but also start converting a steady stream of users to customers.

This logic applies not only to start-ups, but even large companies in new businesses, like Reliance Jio, which aggregated 100 million users in the shortest possible time by giving them free voice and data services. During the launch in Sep­te­mber 2016, Mukesh Ambani called Jio “the world’s largest start-­­up”, and his moment of truth will come in 2017-18, when users must start paying for Jio serv­i­ces. Hav­ing invested over Rs 1.5 lakh crore, and with further commitments to invest upto Rs 1 lakh crore more, Ambani has essentially bet the farm on data revenues when tariffs are crashing due to hyper-competition. His challenge is to ensure that rev­­enues not only cover the cost of running the net­­work, but also the humongous cost of capital inv­ested. An investment of Rs 1,50,000 crore, ass­uming a minimum return of 10 per cent on capital, means Rs 15,000 crore of annual operating margins merely to break even on capital costs. Other costs—like mai­­ntaining the network, retail presence etc are extra.

While Ambani needs no lessons on the creation of a paying customer, many of India’s thousands of smaller start-ups, driven by nothing more than entrepreneurial excitement and a desire to change the world, need to take another peek at Drucker’s 1954 tome. Damodaran of Stern says in his blog that “young growth companies have to be managed at two levels—delivering the conventional metrics on one level, while working on creating a business model to convert these metrics into more conventional measures of business success (revenues and earnings) on the other”.

For many of India’s much ballyhooed start-ups, valuation is no longer the name of the game. The goalposts have been moved, and they now need to deliver on the bottomline. Creating users can be a hobby; making them pay is business.

(The author is a senior journalist)

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