The dotcom bubble

The recent crash in technology shares has had venture capitalists in India rethinking their funding pattern in respect of the mushrooming dotcom companies.

FOR every conceivable subject or every kind of clientele, there are Internet portals that cater to specific needs. Be it shopping, advertising, transactions, research or banking, the Internet takes care of it all. Providing all these services and content are the dotcom companies.

Less than two months ago it appeared as though almost anyone with a good idea and a business plan could raise money to fund an Internet-based company. Internet entrepreneurs, in fact, succeeded so quickly in transforming their business ideas into billion dollar valuations that it completely defied common wisdom about profits.

Seemingly absurd valuations were ascribed to portals or companies which had no profits or even a promise of earnings in the indefinite future. A company less than two years old was valued at a staggering Rs.700 crores. A portal was sold for a staggering Rs.499 crores. Was there any method to this dotcom phenomenon, or perhaps madness? According to a report published by consultants McKinsey and Co., "valuing these high-growth, high-loss firms has been a challenge, to say the least; some practitioners have even described it as a hopeless one."

IT was the "join the bandwagon" mentality that spurred the growth of the dotcom industry, says a venture capitalist. Easy availability of venture capital, Satyam Infoway's acquisition of Indiaworld.com, and the urge to make quick money are reasons cited for the proliferation of dotcom ventures. Even traditional brick-and-mortar companies toyed with the idea of going the dotcom way, and many did. Until two months ago, the potential of the Internet knew no bounds.

Then, on April 14, the Nasdaq index, in which technology stocks are heavily weighted, crashed. Internet company stocks were the worst hit. A direct repercussion of the crisis on Wall Street was felt at Indian stock exchanges on April 16. Technology stocks have been in a bear hug ever since. For instance, Wipro's shares which in February hovered around the Rs.6,000-mark today fluctuates between Rs.1,800 and Rs.2,000. Discussions in financial circles now revolve around whether the dotcom bubble has burst or is about to burst. Perhaps the events of the last few weeks are a precursor to the shape of things to come. What happens now and who will survive the onslaught is the billion-dollar question.

Frontline spoke to venture capitalists, dotcom company heads and corporate finance experts to find out how the shake-out began and what its impact in India is. The unbridled euphoria of the last year has been replaced by caution and talk of consolidations, realistic valuations and the need for a strong story of success.

Since none of the dotcoms, apart from Satyam Infoway, has gone in for an Initial Public Offering (IPO), it could be assumed that the rapidly increasing tribe of dotcom entrepreneurs is safe. However, owing to the fact that technology companies have taken quite a beating, dotcoms do not want to take the risk of going in for an IPO so soon. This in turn, is making venture capitalists jittery, as most paybacks on investments are secured from the sale of the company or portal or by raising money from the public. Commonwealth Venture Capital, for example, picked up an 18 per cent stake in Satyam Infoway for $5 million. It is now worth $800 million.

Following "Black Monday" (April 16), as it was called, investors who were enthusiastically doling out big money to these start-up ventures shut the floodgates and have apparently adopted an approach of caution. While this does not mean that the money supply has dried up, it does suggest that venture capitalists are not going to be generous with capital to every original idea for a dotcom venture.

"The dotcom bubble may not have burst but the scene is set and it may happen very soon," says Subba Rao Telidevara, Director, CDC Capital Advisors, a venture capital organisation. "Almost all the companies are dependent on capital and that is not healthy. Sooner or later they have to run on cash flows." Telidevara said that although venture capitalists had become more careful in funding start-ups, they had not denied that there was still money to be made. As 16 per cent equity holders in Satyam Infoway, now valued at $2 billion, CDC stands to gain plenty from it. "We now, however, look at plans with a microscopic lens. It takes much more than a clever idea to raise money," he says.

ICICI Ventures has funded 12 or 14 dotcom companies. A.J.V. Jayachander, its managing director and chief executive officer, says: "We believe the shake-out is imminent and those who address a niche market with a unique offering are expected to be successful." The criteria for selecting a company for funding, he says, are the "strength of an idea, the value proposition to the customer, the management team and a sound revenue model with foreseeable positive cash flows".

Similarly, Poornima Jairaj of Sivan Securities Private Limited said that it was actually the team of people that mattered, "they should be completely soaked in the idea." Positive cash flows whether "they have started achieving something", are critical, she says. However, one venture capitalist said that it could also be highly "discretionary and subjective, and that the odds should look good."

Following the crash, venture capitalists have become harsher in their selection of whom to fund. In fact Munesh Khanna, country head of the global corporate finance division of Arthur Andersen, a consultancy firm which helps raise money for start-up ventures, says: "Investor sentiment towards dotcoms has changed over the last couple of months. We are going forward only for those Internet ventures that can clearly differentiate themselves from others in the same space." He says only those ventures backed by a quality senior management team and a convincing revenue model will interest venture capitalists. Strangely, in spite of the crash, the number of dotcom proposals reaching them has not decreased, says Jairaj.

But the reality is that in India most start-ups that had procured funding last year will be looking for a second round of funding this year. If they have not shown progress already, the company might as well close shop because the cash may no longer be forthcoming. Through this method of elimination, several dotcoms will be knocked out of the race. Only one in every ten is expected to survive. "That is still 10 per cent if you look at it positively. It is otherwise not a great statistic considering the number of companies in existence," says Telidevara.

MAKING quick money is part of the game. What takes years for a brick-and-mortar company to achieve apparently takes only a few months for a dotcom. Unfortunately, for dotcoms - unlike traditional companies, which are given more leeway - positive results are expected in a much shorter span of time. Jayachander says that the time-frame in which venture capitalists expect to realise their investment is between three and five years. "But in dotcom companies we expect the exit to materialise earlier - say between two and three years."

Also working against them is the fact that the vast open space of the Internet is filling up. There are a dozen horizontal portals and others catering specifically to finance, real estate, women, entertainment and cricket. The success of dotcoms depend on their revenue model. Almost all of them are dependent on advertising, e-commerce and subscription for revenue, says Vinod Nambiar, CEO, Webshastra, a company that provides technology infrastructure for advertising on the Net. Advertisers check the volume of traffic on a Website before positioning their advertisement. Portals, therefore, need to invest heavily to attract customers without having any guarantee of capturing them. The much-hyped Indya.com, launched a month ago, has already spent Rs.25 crores on advertising. "We need to build a brand if we want to survive," says Sunil Lulla, CEO, Indya.com. However, with a dozen similar portals targeting the same audience, is the advertising pie large enough to be divided to bring in sufficient revenues? "It depends on the content and how well you have positioned your brand," Lulla says.

As for e-commerce, a recent Boston Consulting Group report estimated that the Indian online retail market would reach Rs.45 crores this year. If this were to be split among three or four dotcoms, it would have been profitable. However, the number of existing companies dependent on this resource is close to 30, the report says. Besides, online retailers must have their back-end delivery mechanisms in place. "If they say three days delivery, it cannot stretch to four. Competition, after all, is a click away. The user will immediately get the word around or, worse, post it on the Net," says Y. Shekar, general manager, Marketing Baan Info Systems India Limited, a company that provides technical support for e-commerce.

Moreover, fundamental changes need to take place, before Indians begin to use the Internet to its full capacity, says an industry watcher. The users must have the buying capacity to transact on the Net. Cyber legislation, which protects consumers rights, has been cleared only now. And without the required speed of connectivity and accessibility, how feasible is it to shop or transact on the Internet? Growth of infrastructure, quite obviously, has not matched the pace of dotcom proliferation.

Telidevara says that in the United States the capital market provided the oxygen necessary and kept the Internet going, thus helping it to spread wide and penetrate across the country. In India the penetration is low, as there is no backbone or infrastructure worth speaking. "Eventually the old economy will buy back these companies at throwaway valuations," Telidevara muses. Some dotcoms will die a natural death, others might survive in consolidations, while some others will come out successful.

Among the dotcoms that might survive are the business-to-business (B2B) portals, says Telidevara. "There has to be an economic reason to conduct business on the Net." Through the Net, one can find the best airline ticket without going through an agent; an automobile manufacturer can scout for accessories makers. Buying a perfume, on the other hand, has to be a physical experience - you need to test it before deciding whether you want to buy it, he says.

Rohan Ajila, managing director of Indiamarkets.com, the first B2B portal in the country, says that the benefits of the Internet are most apparent in the B2B segment. You have to see where that content takes you and if you do get revenue, you have to sustain it. Business-to-consumer (B2C) sites, which sell a variety of physical products or provide content, face a much more daunting task.

Nevertheless, there appears to be a silver lining. The National Association for Software and Service Companies (NASSCOM) recently estimated that Rs. 50 crores worth of e-commerce business would be done this year by companies that have launched Internet-based trade. This is expected to rise to Rs.2,000 crores within two years. According to statistics from the International Data Corporation (IDC), there are six lakh Internet subscribers in India and approximately two million users. Goldman Sachs predicts that there will be 70 million users by 2003. The higher the number of Net users, the greater the revenue from e-commerce and advertising, thus making the dotcom idea the spectacular success it was meant to be.