5 Dormant Fissures Explain Why The Startup Bubble Will Burst Soon

Many people predicted 2016 as the year when the startup bubble would finally burst, bringing down the entire ecosystem with it. That’s a bit too dramatic, assuming the entire system would collapse on itself overnight, considering that it hasn’t happened and half the year is over.

That being said, the startup bust will happen. Soon.

We’re beyond a point of no return (if such a point ever existed to begin with) and nothing less than a complete overhaul of the startup system within the country could defer the bust. And even that won’t account for the role of consumers.

For any observer outside of the system, it seems to be the best time to be a young entrepreneur in India. With Internet penetration growing and the resources required to leverage these technologies relatively small (not to mention the large number of investors ready to back your initiative), the idea seems almost too good to be true. It is.

The Startup Evolution In A Nutshell

There are serious discrepancies, certain “dormant fissures”, in the core system itself that remain ignored. To be perfectly clear, “core system” includes investors, founders, their companies, their employees and their market. However, the deepening and intersection of these fissures has set up the stage for a fall.

Startups in India aren’t exactly new. One can trace their origins back to the last decade of the previous century before Internet technologies even became common in India. Since then, the number of Indian startups has grown steadily, with a major spurt post the smartphone market entry circa 2007. Investors were already looking at countries like India and China to try American models, the tried and tested models, in other countries. Soon, this became a race between investors to find the best prospect to invest in and reap returns. If a VC missed their opportunity, they’d simply pick the second prospect and back it to compete against the first.

Therefore, for every Flipkart, there was a Snapdeal and so forth.

The founders were happy because they were being backed by global funds and the funds basically flowed in continuously.

2 Dormant Fissures Make Their Presence Felt

However, there are two deepening fissures here. The first is in the way these companies are financed. Most startup financing is equity-based which dilutes the owner’s share of the company in exchange for funds. The value of the company is estimated through its valuation, done by assessing the company’s tangible and non-tangible assets and liabilities.

But these valuations are generally inaccurate. Since most companies have no public equivalent to compare with, their values are greatly inflated. This is done by inflating the non-tangible part of the valuation, such as the expected reach and target market, assessing the strategies for the future, the product mix in the pipeline, etc.

To put it simply, valuations are driven up by promises and expectations. They are essentially based on assumptions, guesses, and estimates which led to what was described initially as the “startup boom”.  This inflated valuation provides the company with the funds it requires. And here is the second fissure.

The funds the company gets should generally be used to generate assets or as an aid to growth. However, this has been narrowed down severely to gather a higher market share through cash burning, either by providing higher discounts or by spending aggressively on marketing or both.

Therefore, the market share gained becomes the “asset” the company gains. When it runs out of cash, the company uses this increased share to bump up its valuation further and raise another round of funding. Funding is used as revenue instead of a driver of revenue.

Now here is the intersection. The funding that the company received has to be returned eventually. That’s the purpose of an investment, to get returns. With equity financing, the return is supposed to be a multiple of the investment and due to the risk associated with equity markets, VCs tend to take measures that allow them to pull funding at the first sign of trouble (i.e. unlike debt-based financing, which is long-term, equity financing is short-term).

And for most startups with the highest valuations, the returns do not match expectations at all.

This would be okay if it were true for a few companies — VCs recognise the risk of investing and understand that their bets may not always work out. However, with most companies that were supposed to have “made it big” in India, none have come close to the expected level of returns. None have managed to go public.

Indian law requires a company to be profitable for three consecutive years before it can go public. That’s why Flipkart is registered in Singapore and tried its IPO in the US and none seem to be heading for a particularly profitable time ahead. This creates a negative effect for investors since they feel that past investments are a good measure of what to expect. This is why funding is likely to start and already is shrinking.

Domestic Startups v/s International Startups

The third fissure is the increasing competition that domestic startups face from their international or US counterparts. This rapidly deepening fissure has an effect on how domestic startups behave. Besides having deeper pockets than most Indian players, foreign companies (especially those like Amazon) also have a lot more experience and a more robust organisational structure than their Indian counterparts.

Most Indian startups are encouraged to copy the playbook of these companies (as an extension of the “tried and tested” philosophy) which deepens the fissure because most times, this borrowing hardly takes into account the variations in the Indian and American market.

That’s why the decision to expand into Tier II cities in India hardly ever works out. Geographic expansion is capital and labour-intensive, but the investment is made assuming that the revenue generated will be able to offset initial losses.

The problems here are that within India, Internet penetration has not matched the global pace and even where Internet has reached acceptability of Internet technologies has been low — case in point, the popularity of the cash on delivery option. This also creates a third problem wherein rapid growth drives companies to expand geographically without having a hold on the existing geographic market. Therefore, growth needs to be asymmetrical geographically and companies need to manage their strongholds much better.

However, that doesn’t explain why revenue doesn’t match expectations in metros, where acceptability of Internet technologies is higher.

No Brand Loyalty Causes Cash Burn

This is the fourth fissure. As the options increase, companies increase discounting and use other means of cash burning to acquire customers. This would ideally work but the issue is that once a customer is acquired, only a fraction is spent on retaining the customer.

Therefore, while costs of marketing should ideally go down for a customer using the product/service a second time, they hardly do. The customer simply chooses the best option available to them at a given point of time and therefore, brand loyalty is virtually non-existent.

This is the intersection with the first and the second fissure. Since hardly any money received through funding is spent on strengthening the brand or promoting brand loyalty (beyond loyalty offers, which are under thought and badly executed themselves), costs for repeat customers remain high.

Since consumers switch between multiple brands, the cheapest option simply becomes the best option. The company mimics this by trying to be that option in the hopes that once a significant market share is gained, pricing can be revamped. That stage has not yet arrived for any of the major startups (nor will it) and there is almost no chance that this will work either.

Structuring, Recruitment Causes Fissure

The fifth fissure lies in the organisational structure of the companies. Working conditions in startups can be pitiful with employees being asked to put in a higher number of hours for lower pay citing that the company is in a growth stage and needs more effort from its employees at this stage. This would be acceptable if employees had a proportionate share in the growth of the company. Stock options for employees are severely limited (if any) and important policies can be undocumented or flimsy at best.

That’s why recruitment, a major action that the company must invest time and thought into, is currently a mess. Since recruitment is driven by money available and not by need, when investment is thin and revenue is low, recruitment suffers. This creates a serious concern since a large pool of skilled labour is either undervalued or under constant threat of unemployment with no support structure to fall back on.

Therefore, most companies have a hollow base where employees do not feel committed or connected to the company at all.

Conclusion

To summarise, hollow structured companies with little or no brand value are pit against each other by firms that are beginning to feel cautious about their money, the life force of these companies. This is a system set up to fail. All the requirements for a bust already exist. As long as the money flows in, these fissures remain overlooked and therefore, dormant. As soon as one fissure, deep enough, erupts, others will follow.

This is a guest post by Kaustubh Sharma is a student entrepreneur from Delhi. His interests include inbound digital marketing and working on product strategies.