Snapping the deal

I am writing this column in the middle of August on a very rainy day before the Independence Day. Some interesting things have happened on the e-commerce front over the last few weeks. The merger talks of Snapdeal and Flipkart have failed. Media reports suggest that Snapdeal is likely to fire more than 80 per cent of its remaining employees in an effort to continue operating. Further, after the merger idea between Snapdeal and Flipkart did not go anywhere, Flipkart received an investment of $2.4 billion from the Japanese technology and telecom giant SoftBank.

A report in The Economic Times says that Flipkart is the world's third most funded private company. Up until now, it has raised a total capital of around $7 billion. The only two companies that are ahead of Flipkart are the Chinese Didi Chuxing and the American Uber, which have raised $15 billion and $12.9 billion, respectively. Both Didi Chuxing and Uber are taxi cab aggregators.

The question is what has Flipkart done with the close to $4.6 billion ($7 billion minus $2.4 billion raised recently) that it had managed to raise up until now before its latest round of fund raising. In a conventional business, companies raise money in order to build assets. Flipkart is basically a market place on the internet and is a very asset-light company.

So, what has it done with all the money that it has raised up until now, and why does it need so much money in order to continue to operate. Also, why are investors funding Flipkart but not Snapdeal, given that both companies are in the same line of business and are losing money hand over fist.

Before I go about answering these questions, it is important to understand that Flipkart is in a business with network effects. In Fifty Things that Made the Modern Economy, Tim Harford defines a business with network effects as a business where "the more people use a platform, the more attractive it becomes."

Economists also refer to this situation as a positive direct-network externality. As James Evans and Richard L. Schmalensee write in Matchmakers: The New Economics of Multisided Platforms, "When one person joins a network, she directly benefits other people who might want to reach her. Economists call this an externality because one person is having an impact on another. It is positive because the effect benefits that other person."

Telephones, when they were first invented, are an excellent example of it. If only a limited number of people had them, they would be of next to no use. As Evans and Schmalensee write, "If a new telephone system acquired a critical mass of subscribers, it would become attractive enough that others would want to sign up. If it had fewer, however, current subscribers would be inclined to leave, reducing its attractiveness still further. Business success or failure depended on building up a critical mass of subscribers."

What was true about the telephone became later true about personal computers, fax machines, video games, VCRs and so on.

In the mid to late 1990s, the United States saw a bubble in dot-com companies and it was during this time that the usage of the term 'network effects' exploded. Along with this came the usage of the term 'first-mover advantage'. So, while it was important to build a critical mass of customers as the network effect suggested, it was also important to do it at a quick pace in order to be able to outsmart the competitors operating in the same space.

As Evans and Schmalensee write, "By the mid-1990s, when the dotcoms flooded the market, supported by plentiful venture capital funding, the view that entrepreneurs should build share quickly and worry about money later was the accepted wisdom."

This is the logic that has been used by matching platforms/e-commerce/dot-com companies since then. As Harford writes, "That's why Uber and its rivals - Didi Chuxing in China, Grab in Southeast Asia, Ola in India - have invested massively in subsidising rides and giving credits to new customers: they wanted to get big first." And this aim has been targeted at by offering massive discounts to prospective customers.

This is precisely what the likes of Flipkart and Snapdeal have also done. They have basically burned almost all their capital in offering discounts to customers in order to scale up quickly. The idea is to become a monopoly (like Amazon, Google and Facebook) and then cash in on it. The trouble is that everyone cannot become a monopoly. Some companies will fall by the wayside in the process as investors stop funding them.

This logic explains only one part of the process, i.e., how to acquire customers. But that is simply not enough. Economists over a period came up with another term: 'indirect network effect'. As Evans and Schmalensee write, "A network effect is indirect when the value of a matchmaker to one group of customers depends on how many members of a different group participate."

An excellent example of this YouTube. For YouTube to survive, it needs two kinds of people: people who watch content uploaded on it and people who create that content. It had to attract both kinds of people on the platform to ensure that it was successful. Otherwise, the concept wouldn't work.

The same was true about the likes of Flipkart and Snapdeal as well. Take the case of Flipkart. It started attracting customers by selling books at a discount. Once book distributors saw that customers were buying books from Flipkart, more of them registered to sell on it. It was a sort of chicken-and-egg story.

Gradually, people moved on from buying books to other products and other distributors also registered on the website. For this, Flipkart offered discounts on products across the spectrum. This meant a lot of cash burn. Other websites followed a similar strategy.

As mentioned earlier, not everyone can survive this model of operating because there can only be one monopoly. From the looks of it, Flipkart (along with Amazon) are all set to be the likely survivors in India. And this explains why SoftBank invested more than two billion dollars in the company recently, just after the merger effort with Snapdeal failed.

Snapdeal is now more likely to shut down or be a shadow of its former aggressive self. Flipkart is the one that will survive.

Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected].