<p><em>The consumer internet start-up space in India is virtually witnessing what seems to be a valuation war, write <strong>Abhilekh Verma </strong>and<strong> Rishabh Bharadwaj</strong></em><br><br>The growth of the internet has unleashed the most disruptive technologies of our times and is impacting all walks of lives including trade and commerce. E-commerce has grown by leaps and bounds over the past few years and has become all-encompassing, with things being just a click or a tap away. This growth can be attributed to multiple factors like increased consumer demand, greater choices, undeveloped organised retail, ever growing internet access, and efficient delivery models.The investors also feel that they are putting their money where their mouth is, given the huge potential that India offers for consumption of goods and services.<br><br>Broadly, e-commerce activities can be classified into four heads: (a) business-to-business; (b) business-to-consumer; (c) consumer-to-consumer; and (d) consumer-to-business. We see various business models at play, the marketplace model, the inventory model and the sharing model, just to mention a few. E-commerce in India is not just limited to foreign funded entities. More and more domestic entities, especially the ones that have a strong retail or manufacturing presence in India, are becoming active online. Online platforms and portals have provided established business houses with additional avenues and greater market penetration.<br><br>E-commerce in India has had its share of legal and regulatory controversies. The business structures being adopted from the foreign direct investment (FDI) standpoint, data protection and privacy concerns, regulations governing online card transactions like the additional factor of authentication (AFA), indirect tax (VAT) issues on the goods of the sellers stored in the warehouses and alleged antitrust issues relating to predatory pricing and unfair trade practices are some of the oft debated issues.<br><br>Debates on the FDI regulations governing e-commerce in India has been hogging the limelight, given the huge foreign investment inflow in the sector over the past few years being juxtaposed with the reluctance of the Indian government to open the retail sector for foreign investment in its entirety. Currently, the Indian regulations permit FDI only in business-to-business e-commerce and FDI in business-to-consumer e-commerce is not allowed. The government of India has recently reiterated its position on foreign investment in e-commerce and has decided to maintain the status quo. This seems to be driven by its compulsions to cater to the domestic retail constituency.<br><br>Nonetheless, given the potential of e-commerce sector in India, regulation of foreign investment in e-commerce has not deterred foreign investment in this sector. Various innovative structures such as 'back-end' - 'front-end' model and the 'step-down subsidiary' model were tested against the backdrop of Indian regulations before the marketplace model was adopted (currently considered as the most FDI compliant structure). Most foreign funded e-commerce portals in India have switched to the marketplace model.In the marketplace model, the platform serves as a marketplace for buyers and sellers for carrying out the transactions and the platform provider charges a fees/commission therefor, from the sellers. The ownership of the inventory lies with the sellers registered with the platform and the platform provider usually acts as a transaction facilitator. However, there are instances of the platform providers being more than facilitators and providing warehousing and logistics support to the sellers.<br><br>The discussions on e-commerce would be incomplete without touching upon the issue of valuation. The consumer internet start-up space in India is virtually witnessing what seems to be a valuation war. Not long ago, entrepreneurs were struggling to get funding. Tables seem to have turned now as investors as well as entrenched e-commerce players are chasing entrepreneurs having viable business models.In 2014, Indian internet start-ups received around four billion US dollars from investors. It appears that no one wants to miss out on the chance to participate in the next big thing and Alibaba's successful public offer has only helped in fuelling the bullish investment sentiments. The valuation race could have also been spurred by the belief that the winner takes all. Moreover, start-up funding is no longer the bastion of venture capitalists. With the increased participation of hedge funds, mutual funds, and strategic investors, cash available for venture funding is only burgeoning. As of June 2015, more than thirty companies across the world in e-commerce and consumer internet space have been valued at one billion US Dollar or more, per a report of the Wall Street Journal. Indian start-ups - Flipkart, Snapdeal and Quickr - also find a mention in this list. New methodologies of valuation, based on annualised gross merchandising value and gross transaction value, have become popular to justify the valuation in the absence of business profitability. The former is linked to the amount of goods and services sold by an e-tailer, and is more relevant in the inventory based model, whereas the latter is linked to the number of transactions carried out, and is more relevant to the marketplace and the sharing based model of e-commerce. However, these methods of valuation are new and a lot of commentators have expressed their reservations about the current levels of valuations as well as the methodologies being adopted to compute the same.<br><br>Having said the above, it is a free market we are talking about. According to JM Keynes, nothing is as dangerous as the pursuit of a rational investment policy in an irrational world. Any valuation based solely on financials may not be possible in markets where perceptions of the participantsalso play a vital role. The caveat being, in the long term, markets have the ability to correct themselves, and valuations devoid of correct financials do not sustain. The spectre of the investors holding the parcel when the music stops with no exit in sight is most worrisome. How can one forget what happened in March-April of 2000 where nearly a trillion of US dollars' worth of stock disappeared and a lot of dot com companies were liquidated in a short span. Some experts argue that the current situation resembles the bubble burst of 2000, and infact, the scenario is grimmer because the valuations are high in a non-liquid market. Once the flow of money stops, the party will be over. The contrarian view being, the dot com bubble was a result of an unreal market created by the retail investors, while the current e-commerce scenario is based on market reality and a robust ecosystem, the unconventional valuation methodologies notwithstanding. It is also felt that once the consolidation phase kicks in, the absence of public money in the system will prevent the repeat of the dot com bubble, provided that the investors are patient and have a long term perspective on their investments.<br><br>Investments at higher valuations create an expectation of even higher returns. However, if one were to look at the options through which investors can seek returns on their investments, they are limited. Usually, for financial investors, exit through initial public offering is the most ideal one. However, the current Indian regulations on listing and public offerings hinder listing of e-commerce entities, inter alia, on account of lack of profitability and minimum promoter holding norms. Further, foreign exchange regulations in India prohibit assured returns on foreign direct investments. Therefore, the only possible mode of exit available to the foreign investors in the e-commerce space is by way of strategic acquisitions. While strategic acquisitions are one of the modes of exits, it does not necessarily result in exit, and at times results in consolidation of investor holdings in various entities. We have already started seeing this. Acquisition of Freecharge by Snapdeal and TaxiForSure by Ola are the recent examples. In the past, we have seen the acquisition of Myntra by Flipkart.<br><br>E-commerce and consumer internet businesses have created employment and have contributed significantly to the nation's economy. This would not have been possible without the influx of foreign investment in these activities since they are cash incentive businesses to begin with. Given its all-pervading impact in our lives, it is nobody's case that the e-commerce sector should be left totally unregulated. At the same time over-kill or unreasonable regulations may stymie the growth of the sector. Therefore, there is a need to create a balanced and technology neutral regulatory environment for e-commerce. It is about time that the long pending comprehensive law on privacy is made a reality. Further, clearing the maze on transfer pricing and indirect tax issues would help provide more regulatory certainty to the sector. Indirect taxes, in the absence of the much awaited unified goods and services tax regime, remain scattered. On exit routes for investment, the securities' regulator has proposed a new regime for alternate listing norms for technology based start-ups. This also needs to be expedited, failing which, start-ups will opt for listings in jurisdictions with a more favourable regulatory environment. Making the current intellectual property (IP) regime more robust and providing attractive incentives for housing IP in India would provide further fillip to the growth of the sector. The uniform application of the current FDI restrictions on assured returns across all sectors also needs to be revisited and the Reserve Bank of India has acknowledged this fact in its monetary policy statement of February 2015. The government of India would do well to take up these matters on priority, otherwise there is a real threat of flight of value from India (created in the e-commerce sector), to other jurisdictions providing favourable dispensation.<br><br><em>The views of the authors are personal, and should not be considered as those of the firm<br><br>Abhilekh Verma is partner, Khaitan & Co, and Rishabh Bharadwaj is an associate Khaitan & Co</em></p>
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