E-commerce - the internet scale utopia

Way too many people - not just naive observers but people who follow the markets, who are in start-up scene have pretty basic notions about internet business especially in business models where hard money to take home is expected to be made only in future - post growth. Particularly true to E-commerce scene and some media circulations. 

Questions like how come they are having this crazy evaluation? How and why are they burning so much cash? Is this a bubble? They don't even break-even and the biggest of all are they even profitable to command all this?

Frankly I am not aware of their current financials of any of the e-commerce business except Amazon's and there is no incentive for me to be a rumour-monger. But i believe the general thought of looking at this is misleading- people mistake profitability in income statements for cash-flow statement – hence this post. 

I guess with “profitability” one is looking to evaluate their prospects.

The question should rather be in the long term will their investment pan-out or having gained critical mass what their yearly cashflow could be?

They may be cashflow negative (losing money) on yearly or quarterly basis Now but they still might be ‘profitable’ even while losing money. That is because according to basic principles of Accounting - you match revenue and cost in the period in which they occur. Discounting, amortization is put in for and obviously it all comes down to assumptions about future and only after taking all that into consideration one could come up with profitability.

Unless of course one is simply asking what their operating margin i.e. cashflow status or margin on sales is?

Cashflow at the bottom of income statement = Revenue - Cost of goods - Operating cost

Margin on sale = Selling price - Cost of goods 

• If the goods are stocked by the e-commerce venture then
  margin on sale is generally 80-100%, varying with type of goods (expiry date,
  type of partnership etc).
  After taking into account Operating cost (IT + Management + Office + Inventory management - efficiency being key here) this would lead to Negative cashflow or +50% depending on scale.
• In the other case, if the goods are not stocked by the e-commerce company then Margin on sale could be simply 20-50%. Again depending on scale one would get cashflow status.

Two businesses having similar Cashflow or Net profit or Revenue could be in a very different boat - so by just asking like Maruti Ad - 'Kitna deti hai' - How much mileage does this luxury yacht give? won't provide any valuable info. People still go bonkers when they hear Amazon's present net profit (after a decade of leadership) vs evaluation.

What have we not taken into account above -

1. Cost of acquisition (discounted to current fiscal)
2. Marketing and sales effort (discounted to current fiscal) - how much money are they investing today to fuel tomorrow’s growth and profits.
3. Their business model and operating model (which could vary for time to time) - Are they an intermediary or do they stock goods, how do they stock if any, are they offering nonviable discounts in short-term, partnerships with retailers etc
4. Future prospects of growth

So I would try to answer a larger issue here - about profitability (mistaken as money to take home now) rather than cashflow(actual money to take home now).

For a business one has to decide if they want positive cashflow or growth or bit of both? One's goal towards profitability should be driven by what they want to achieve - an exit? Small but profitable venture? Leverage and then scale with proper funding?

• Having positive cash-flow helps in difficult times - going by the trends it hasn't been particularly difficult times for e-commerce in India.
• It also gives you leverage with your evaluation while raising funds or at exit.

The present status of e-commerce demands ambition – rather than small but beautiful cocoon.
But when one is trying to scale by acquiring new customers there is always a lag with which the investments in business bear fruit - for that we need investment. And from the looks of things these ventures want internet scale and for that they have relatively easy access to capital.

As far as the VCs are concerned they too seem to want to go big - so the investments. Also revenue of a decent e-commerce site is always high - disregard to cashflow and that helps in raising subsequent rounds and exits for present investors. May be the fear of recovering invested cash also helps in raising more money.


So to summarize one should be more concerned with following metrics and how one stacks on these with respect to competition rather than present cashflow status or are they making money now (generally mistaken as profitability)-

1. Revenue growth and Revenue-to-operating profit growth.
2. Monthly traffic growth, viral coefficient etc.
3. Conversion percentage
4. Beakeven time for Customer acquisition

There would always be less generic metrics for specific business models.
Hopefully people would stop saying they are not even profitable (they mean not cashflow positive) and still burning so much cash - crazy!

Thoughts for a Start-upper - Business model

BUSINESS MODEL:

With all the talk about product in the earlier section, now comes the interesting part –
Your product is not your product. WTF!

Yes, because your business model is your actual product. The product is just cloak, a cover-up if you will, what the general population or your consumer perceives.

A mark-up of 150 percent doesn't mean much when you’re only making 75 cents per item. It would take a lot of key chains bought at 50 cents and sold for $1.25 just to pay the phone bill. That is if one just goes about selling them the conventional way. The invisible costs are always there to eat 150% mark-up esp. when earnings per service are so low. Now it is not like one can’t sell key chains - Disruptive revenue model with such small earnings/unit is the key to make good deal of dough. One needs to plan beyond what meets the eye.

Business Plan: Yes you need one. The most important thing to remember when writing one of these is that your product description should only be 10% of your document. The rest should go over how you plan to bring in revenue, the competition, your technology and why you would succeed aka business model. It would be a humbling experience. If you wrote a good one, it should make you reconsider starting a company; you could even have anxiety attacks. Just like a good meal, let that document sit in your stomach for a couple hours. If you're still excited, it's time to try and find money.

My first tryst with business model was when I along with my most cherished business mates started thinking about how we could start an Indian Aramark in a very fragmented facility management industry in India. We had a half-decent idea about the product and the service but questions like - what channel are we going to use to approach a customer, a partner? How would we describe our USP esp. with zero experience in the space? What is our unfair advantage over competition? What are the metrics and assumptions on which our business stands? The answers to all were equivalent to wishful thinking in business terms. One has to solve these simultaneous equations to find a viable footing.

Essentially your actual product/service should be just a small part of your business model and plan or for that matter of any pitch to an Angel or VC. It of course doesn't mean product is as less relevant but that everything built around the product for it to become a business is equally important if not more. Also short and easy to convey solutions are more acceptable for obvious reasons. But then again you can present your complex solution also in a better way and keep it simple. At least one should strive for that. 

PS: Innovation is mistakenly taken as just product, you could equally have an obvious product and have a really disruptive business model to create huge entry barriers and successful venture. Examples galore- retail, food outlets are just a few.

Rule of thumb: The solution you provide to the problem statement should only be about one-eighth of the entire pitch to anyone. If a prospective mentor/investor doesn't quiz you beyond your product – about the business model, he is invariably not your guy. He is not interested, plain and simple.

You should continuously work upon your business model, as you would do on your product.

A simple format to start for b-model: http://ash.wpengine.netdna-cdn.com/wp-content/uploads/2011/06/leancanvas.png
The exact variables, the amount of space they occupy on the canvas would however vary with your product and industry.

Now if you have got many ideas and they successfully meet the criterion laid in the product section of the series- you could develop the business model for each and evaluate on the following basis –
1. How significant is the problem you are addressing to the customer? Is there payable demand or just a need? Is it worth building the product at all!
2. How difficult is to reach the holy customer for that model?
3. What would be revenue stream and cost structure with appropriate cushion?
4. Is the market evolving? The amount of risk of environment – acceptability issues your product could face due to existing perceptions, regulations or players.
5. How many fish are there in the sea both customers and competitors? How big is the market? Healthy competition also signifies demand and willingness to pay.
6. Do you really internalize the customer’s problem?

Essentially the business model forces you to see the reality before you significantly invest in the product development - The risks the venture faces. Instead if you procrastinate it, because most of us are comfortable with developing the product than the tough questions of actual demand, selling, marketing, channels, pricing etc it just hides the tough reality.

To answer these questions and learn, you have to come out of your comfort zone and talk to people, reach out to the market. Or one could trade this with making up stories for presentations and a chance of losing oneself in the same. 

Related posts: 

Previous post in the seriesThoughts for a start-upper - People

Thoughts for a start-upper - Product

Next parts in the series:

Thoughts for a start-upper - The rest