Why Prof­itabil­ity Mat­ters

In the ab­sence of cor­po­rate gov­er­nance that nur­tures the in­ter­ests of pri­mary stake­hold­ers, the en­tre­pre­neur­ial ecosys­tem will col­lapse.

Business Today - - CONTENTS - (Subra­ma­nian is anAs­so­ci­ate Pro­fes­sor in Cor­po­rate Gov­er­nance at IIM-Kozhikode.Kaul is the au­thor of In­dia’s Big Gov­ern­ment –The Intrusive State and How It Is Hurt­ing Us) ByS.SUBRAMANIANANDVIVEKKAUL

In the ab­sence of cor­po­rate gov­er­nance, the en­tre­pre­neur­ial ecosys­tem will col­lapse

Kalyan Kr­ish­na­murthy, Chief Ex­ec­u­tive of Flip­kart, re­cently said, “Prof­itabil­ity is not the high­est pri­or­ity to­day.” He was not the first boss­man of a large e-com­merce com­pany to say so. Nei­ther will he be the last. But what the CEO of Flip­kart and other top e-com­merce hon­chos say, goes down to the trenches and is picked up as gospel by the smaller e-com­merce en­trepreneurs.

Re­cently, one of us got talk­ing to a small e-com­merce en­trepreneur who started an ag­gre­ga­tor web­site and ap­pli­ca­tion some time ago.

Swiggy is a great ex­am­ple of an ag­gre­ga­tor. It al­lows restau­rants to list on its web­site and ap­pli­ca­tion. Peo­ple can log in and or­der food from these listed restau­rants, and that food is home-de­liv­ered. An­other great ex­am­ple is redBus, which al­lows in­di­vid­u­als to book bus jour­neys on­line.

This en­trepreneur we hap­pen to know had got a few Mumbai-based small ven­ture cap­i­tal­ists ( VCs) to in­vest in his ven­ture (SoftBank does not in­vest ev­ery­where after all). And like the e-com­merce com­pa­nies and en­trepreneurs he looked up to, this gen­tle­man also wanted to cash in on the prin­ci­ple of net­work ex­ter­nal­ity.

What does net­work ex­ter­nal­ity mean? The more the num­ber of peo­ple who join a par­tic­u­lar net­work, the more valu­able it be­comes to peo­ple who are al­ready a part of that net­work – that is what it means.

Take the case of Swiggy. The more the peo­ple who use the ap­pli­ca­tion or are reg­is­tered on the web­site, the

more the num­ber of restau­rants which would want to list on it (The op­po­site would be true as well). Hence, the idea in case of many ag­gre­ga­tors and e-com­merce com­pa­nies is to first get as many peo­ple on the net­work as pos­si­ble with­out wor­ry­ing about prof­itabil­ity. It is typ­i­cally done through dis­counts and of­fers, the costs of which are borne by the com­pany and not its cus­tomers.

Our en­trepreneur friend also wanted to get as many peo­ple on the net­work as pos­si­ble. And like Flip­kart’s Kr­ish­na­murthy, he was not wor­ried about prof­itabil­ity. The VCs, who were fa­mil­iar with the con­cept of net­work ex­ter­nal­ity, backed him.

The ven­ture quickly started burn­ing a lot of cash. The VCs pumped in more money to keep it go­ing. They also brought in a few more an­gel in­vestors. But after two years, the ven­ture be­came com­pletely un­sus­tain­able and folded up. The VCs lost their money and vowed never to fund an e-com­merce ag­gre­ga­tor ven­ture again.

The trou­ble with this model of op­er­a­tion is that it re­quires an end­less sup­ply of money (read in­vestors) and every­one does not have ac­cess to it. Also, it makes the en­tire struc­ture sim­i­lar to that of a Ponzi scheme. As long as the money be­ing brought in by the in­vestors is more than the money that the com­pany is los­ing, the com­pany keeps run­ning. The day this equa­tion changes, the com­pany col­lapses.

The prob­lem is lack of cor­po­rate gov­er­nance. Our in­ter­ac­tions with the cur­rent gen­er­a­tion of en­trepreneurs, small VCs and an­gel in­vestors sug­gest that most of them think cor­po­rate gov­er­nance is a prac­tice meant only for the large, listed com­pa­nies. And they can­not be more wrong. Cor­po­rate gov­er­nance is as im­por­tant for new ven­tures as it is for the big listed com­pa­nies. Cor­po­rate gov­er­nance is about guid­ing, struc­tur­ing, oper­at­ing and con­trol­ling a busi­ness firm to achieve long-term strate­gic goals and sat­isfy the pri­mary stake­hold­ers. It means that the ven­ture needs to make a profit to sus­tain it­self in the longterm to pro­tect the in­ter­ests of the stake­hold­ers. ‘Long-term’ is the word that cur­rent en­trepreneurs of­ten for­get. The ques­tion is: Why do VCs and an­gel in­vestors come on board with­out a proper busi­ness model? Why do they, in­stead of en­sur­ing a proper risk man­age­ment sys­tem – an es­sen­tial part of the cor­po­rate gov­er­nance ex­er­cise – al­low en­trepreneurs take un­sus­tain­able risks? To un­der­stand this, we need to clas­sify the ob­jec­tives of the VCs in­vest­ing in such new ven­tures into two cat­e­gories. One set of VCs would en­ter the busi­ness with an ob­jec­tive to sell the stake after some time, ex­pect­ing to ride on the in­no­va­tion buzz that the ven­ture has cre­ated. They do not worry about long-term profit-mak­ing po­ten­tial of the ven­ture. They just want the buzz about the ven­ture to grow so that they find an­other suit­able buyer at a higher val­u­a­tion. The sec­ond set in­vests in such ven­tures and al­lows them to keep spend­ing money in a bid to cre­ate a buzz and gen­er­ate the net­work­ing ef­fect.

Fi­nally, when the money runs out, the Ponzi scheme col­lapses. But when a ven­ture fails, most of the en­trepreneurs get out of the busi­ness with­out much scare as they also take salaries for be­ing the chief ex­ec­u­tive or the chief op­er­a­tions of­fi­cer of the ven­ture. There is also a ten­dency these days for CEOs to be in­vestors in other in­no­va­tive firms. But the in­vestors, typ­i­cally small VCs and an­gel in­vestors, lose their money. In fact, such fail­ures not just de­stroy the in­vestors’ money but the whole en­tre­pre­neur­ial ecosys­tem.

For ex­am­ple, when start-ups ex­pand ag­gres­sively, they hire a lot, and when they quickly fold up, it re­sults in se­vere job losses. It leads to a sit­u­a­tion where the cream of the tal­ent is re­luc­tant to join start-ups. It also means those with a gen­uine busi­ness idea do not feel mo­ti­vated enough to start their ven­tures. The re­luc­tance of in­vestors and em­ploy­ees to fo­cus on start-ups is not good for the en­tre­pre­neur­ial ecosys­tem, es­pe­cially for those who have a gen­uine busi­ness model. Given these rea­sons, it is now time for en­trepreneurs to fo­cus on cor­po­rate gov­er­nance and prof­itabil­ity. ~

As long as the money be­ing brought in by the in­vestors is more than the money that the com­pany is los­ing, the com­pany keeps run­ning. The day this equa­tion changes, the com­pany col­lapses

Newspapers in English

Newspapers from India

© PressReader. All rights reserved.