In times of highly booming markets, entrepreneurs have easy access to capital, which allows them to discount their products and services. Such discount-driven subsidized pricing can lead the entrepreneur to believe that there is a much larger market than there actually is (thanks to the price elasticity of demand). This notion of the larger market can be shared even by generally optimistic investors. As a result, the company raises capital at a valuation that may be much higher than the underlying market potential.
Unless valuations are corrected in a timely manner or new revenue streams are created, it becomes the most important number for founders and existing investors. The growth needs to justify the valuation.
Therefore, a loop is created where there is a need to justify the valuation of the previous round, forcing the founder to increase either the Gross Transaction Value (GTV) or the Gross Merchandise Value (GMV), even though a deeper discount is required. need, i.e. to expand the market (artificially).
This can turn out to be a vicious cycle, which we have already seen playing out in some instances in the Indian market. In such cases, the sustainability of the business entirely depends on the availability of capital from the private market. If the market turns cautious and capital dries up, the company could face an existential threat. We have already seen this in both the Indian and global context.
On a related note, if the company is making a healthy gross profit, its ability to systematically invest in marketing, promotion, brand building and customer services increases steadily. It can begin to fund part of this growth itself and beyond a certain point, the reliance on external capital is controlled. It took some of the best startups who aspire to turn Earnings Before Interest, Taxes, Depreciation, and Amortization (Ebitda) positive and start funding their growth in less than five years for up-and-coming entrepreneurs .
For India, the timing may be a bit longer, as the market is still at an early stage of growth, but investments should be streamlined over time to suit the market potential.
In addition, a company operating on a positive gross margin can control overheads and growth-focused investments to survive in times of tough capital markets. When capital becomes more readily available they can start investing again.
Another related point is that in markets where the path to profitability was shorter, digital startups solved the problems of discovery and convenience than the market could already afford.
In India, spending capacity is also a limiting factor; However, it is believed that it is improving rapidly.
As long as Burn is meant to promote discovery, convenience and better service, this is completely understandable, but attempting to address spending potential through Bern may not be very prudent. Businesses need to operate within the confines of the underlying economics of target markets in order to cater to the population that can actually afford the products and services (unless the digital move significantly reduces cost dynamics). changes and does not bring the price bar down).
Persistent gross margin losses can be counter-productive and create volatile artificial markets. We understand and appreciate the need for startups to persist in making growth-focused investments such as marketing and customer service. In our humble view, an important function of an entrepreneur is to keep an eye on the “investment-profitable trade-off” and to pull the right lever opportunistically.
Finally, most often, the last willing exit route is an initial public offering (IPO), even after consolidation. Public markets generally value both growth and profitability in addition to market leadership.
A high-growth business may justify a negative net income (this still cannot explain negative gross income), but moderate growth with large losses attracts significant interest from public investors in a steady-state market. not likely to.
Even after a high growth phase, a significant difference in potential public and private market valuations can clearly point to an artificially inflated market sentiment. It may be time to reflect and take drastic corrective action.
Anurag Goyal is General Partner at Cactus Venture Partners.