Fifty Shades of Red

Last month during a dinner with business leaders from traditional sectors like manufacturing, cement, textiles, hospitality, the discussion veered towards the soaring losses of digital businesses and whether this was on account of “spray & pray” optimism about a fortune to be made down the road. In the preceding weeks, a small number of Internet firms had together reported losses worth Rs 11000 crores. One firm had managed to increase net losses nine-fold within the year. And hence this conversation was topical.

Losses have become the dominant theme for most Internet businesses in India – with growth potential, land grab, intense competition and the willingness of deep-pocketed investors to play for the long-term, offered as an explanation.

However, the rising swell of losses in Indian Internet businesses masks some interesting questions. Are all losses the same? Are all these losses inevitable? Are there good losses vs. bad losses? In order to have a meaningful understanding, it is important to recognise that there are various shades of red colouring the digital landscape.

All enterprises make initial investments to get the idea off the ground. Digital businesses invest in technology, in creating peer networks (buyers and sellers), supply chain linkages, data-analytical capabilities, marketing and human capital. This is not very different from traditional businesses investing in production technology, physical infrastructure (land, factories, office buildings), marketing and human capital. These investments, while leading to initial losses, help create long-term value.

However, losses on account of continuing negative unit economics do not create any economic value for the enterprise. Unit economics refers to the margin a business makes on each unit of product or service sold after factoring all variable expenses associated with servicing that order. In other words, a business with negative unit economics is paying its consumers to use its product/service. As a corollary, positive unit economics is the premium a consumer is willing to pay, valuing the product/service being provided to them. It is the only incontrovertible definition of product-market fit.

Acquiring customers by burning money and hyper-growth fueled by discounts create arbitrage and opportunity for savvy shoppers and suppliers, but not lasting customer value or network effects. Actions that may seem to create valuation shouldn’t be mistaken for creating value.

Some examples of negative unit economics are direct discounting of the product – cab rides at 25% less than cost, Rs 10,000 off on a phone, a hotel room at 40% off etc. Fulfilment losses are another recurrent theme – a user pays a fraction of the cost required to ship an e-commerce packet. More ways to convince the undecided include cashbacks through wallets and exchange offers. Similar is the case on the supply side – minimum guarantees to drivers of cab aggregator apps and no-cost returns to sellers for e-commerce shipments.

The key issue for these losses on account of operating inefficiencies is not the quantum, but the unwillingness to address them. For instance, losses on account of logistics can be reduced by resizing packages, re-negotiating better rates with courier partners, moving shipments by surface transport rather than air, altering the choice of packaging materials, revising shipment charges levied to users, among others.

However, calculations in many digital businesses go like this: a shipment costs Rs 400 to deliver and if I charge more than Rs 100, my customers will leave me. So, I will lose Rs 300 per shipment. Hence, what quantum of sales do I need to achieve so that I can find new investors to fund this loss.

The business calculations are more about building a business that can raise more funds rather than a business that is moving towards self-sufficiency. The overarching desire to attract more funds also leads to the creation of vanity metrics like Gross Merchandise Value (GMV) in e-commerce companies, number of orders in food delivery companies and transaction volume in payment companies. The correct indicator for any business is the money it makes – real revenues and margins.

Truth be told, it is a lot of hard work to build things the right way. It needs acute cost consciousness and a granular understanding of where money is being lost and can be made. Other than deep data analysis, it needs constant discipline of first defining and then steering the business within well-defined guardrails.

The most important part in stemming losses is the conviction of saying no. Saying no to throwing money at all problems, saying no to users who won’t pay for your services and saying no to kicking the can down the street when it comes to tough calls. Converting negative unit economics to positive also needs a different set of levers and a different mindset. The transition is deliberate, effort consuming and borderline painful. While it may appear that different yardsticks may be relevant for digital businesses, the world of Internet is no different from traditional enterprises, in that all businesses have to make money.

In summary, investments create long-term value and should be executed with clarity, conviction and a sense of desired timelines. Subsidising a product or service for an extended period of time does not create value and fixing the unit economics is inevitable for every business.

Speaking as somebody who has lived through a lot of what is described above, there is no greater wrong than not fixing a problem, once you have understood the issue. Appreciating the varying shades of red presents a compelling landscape for change for India’s digital businesses that aim to build enduring enterprises.

[This post by Kunal Bahl first appeared on LinkedIn and has been reproduced with permission.]