How will startups be able to achieve true, sustainable scale in India?
The decision was a badly planned measure against tax evasion. Perhaps the prime minister thought that it would lead to a week or so of minor inconvenience at best. But that's not how it turned out. Bank ATMs could not dispense the new notes without extensive reprogramming; bank branches were soon overrun by angry customers; and, within a few days, the economy was starved of cash.
Swiftly, the government changed its tune. In a short while, it began to claim that the "demonetisation", as it has come to be called, was actually about creating a digital economy. Indians were encouraged to use more and more digital transactions, as a mark of solidarity in the battle against tax evasion. Support for a digital economy became a marker of patriotism. Digitalisation swiftly became crucial to the government's political image. The government's main economic policy statement, the Union Budget — presented on 31 January 2017, reiterated its support for digital transactions by giving them tax breaks. It also poured money into building a fiber optic network to connect rural India. Earlier, it had even begun to issue smartphone apps that would help people make digital payments.
But the leader in the "mobile wallet" space — the usual way for Indians to transfer money to each other over the phone, a bank account linked electronic reservoir of money — is in fact a private startup called Paytm. Backed by Alibaba of China among others, the company worked out the implications of Modi's move well before the government. Hours after the prime minister's speech on the evening of 8 November, the company placed full-page advertisements in major newspapers, thanking him for his decision. Before too long, "Paytm accepted here" signs began popping up everywhere in India's cash-dependent informal economy, from roadside vendors to barber shops. The organisation's CEO made headlines a few months later when a video recorded at the company's New Year party went viral, in which he went on an expletive-ridden speech praising the success they'd had that year. The general reaction appeared to be he was understandably overcome with joy at the company's unexpected good fortune.
Indeed, as the period without cash extended from weeks to months, an increasing number of Indians began to try out smartphone payments. For many of them this was no doubt the first time they had tried more sophisticated smartphone apps. An enormously intrusive and disruptive state act began to be seen as a potential game-changer for the digital economy — and for Indian entrepreneurs and startups.
India, as a whole, is growing; but that growth is regionally concentrated and unequal. Investing in such high-return areas as infrastructure and real estate is seen as inherently risky by foreign investors — who usually lack the ability that domestic investors have to "manage" the political risk associated with these sectors. Safer sectors, like fast-moving consumer goods (FMCG) for example, are remarkably expensive to invest in now: the S&P FMCG index for the Bombay Stock Exchange lists price-earnings ratios at above 40 on 1 February 2017.
As a result, much foreign interest has focused on startups and technology startups in particular, such as Paytm. Hundreds of millions of dollars have flown into such companies — the third quarter of 2015 alone saw $2.5 billion.
But, mostly, Indian startups have suffered from many of the same illnesses as their peers worldwide. They rely excessively on raising successive rounds of funding; they endlessly postpone the moment when they will turn profitable; and they are unable to either scale up easily or to easily reduce the rate at which they burn money. Unsurprisingly, interest in the sector — while still great — is no longer as white-hot as it was in 2015. There are more, but less lucrative deals being made now. According to the online magazine Inc42.com, there has been a 40 percent drop in total funding in 2016 — but an 18 percent increase in the number of deals.
Most of the money has flown into e-commerce, and it's instructive to consider why. There are patterns to this success that reveal both the weaknesses and opportunities for the Indian startup sector overall.
First, there's the question of government action. For various reasons, the central government in New Delhi has frowned on the possibility of foreign investment in brick-and-mortar supermarkets, which has led to a situation in which, for many Indians, online commerce is the only real alternative to understocked local stores. Several larger supermarket chains have sought to enter India, in order to modernise its retail sector; but Indian government restrictions have been so stringent that few have actually gone ahead and put in sizeable amounts of money.
Second, there's specific, local tastes. When it comes to retail, in particular, marketing analysts have isolated certain stylised facts about consumer behaviour in India as compared to some other larger markets. Indians are sharply price-sensitive, much more anxious to consider alternatives before buying, and less likely to want to shop in uncrowded markets. That might also contribute to why India has proved sharply resistant to organised retail, but embraced e-commerce.
Third, there's the specific nature of the startup ecosystem. Creating an e-commerce website in India is not a massive technical advance over such operations elsewhere. Even if the average customer and the average entrepreneur are from sharply different backgrounds and locations, it does not really matter. The entrepreneur can swiftly response, because of the nature of the platform, to the demand signals that the customer sends out. In a stratified society like India, this condition is not always easily satisfied. We will return to this point later.
Fourth, there's the distribution of possible customers. Many e-commerce entrepreneurs express surprise that smaller Indian towns are such big centres for their business. In fact, the absence of organised retail in such towns, causing them to turn to e-commerce, is but one symptom of a larger disconnectedness. Metropolitan India — the large cities, like Mumbai, Delhi, Kolkata or Bengaluru — is increasingly globalised. But smaller towns are far more disconnected. The internet is a lifeline to the outside world, and so young people there are unusually willing to try something new online.
These four characteristics: government action; specific local preferences; the social gap between entrepreneurs and customers; and the disconnectedness of small Indian towns all have a part to play in how I suspect the Indian digital economy will evolve going forward.
Take the local preferences point first. This is a clear reminder that straightforward adaptation of foreign business models aren't always a good idea in India. In fact, there was one great innovation that Indian e-commerce introduced that helped it to take off: unlike most foreign web sites, Indian marketplaces specialised in cash on delivery. In other words, you could order something off Flipkart.com, the market leader, and pay the delivery man in cash. (This massively complicated the logistics, though not the technical design of the platform.) Any productive investment in a digital venture in India will have to demonstrate that it is tailored to local preferences, not that it has succeeded elsewhere.
Second, consider the social gap between entrepreneurs and customers. This is a major issue for Indian startups today, which are heavily concentrated in the southern metropolis of Bengaluru, and which are largely run by the English speaking, upper-caste elite. The lives of the entrepreneurs are at a variance from those of a large chunk of potential users. They can frequently tailor their products to what they themselves, or people around them, would like to use; but getting out of their bubble and figuring out what the rest of India would like to use isn't that easy. This is especially true now that the startup economy is moving to more difficult products and platforms. For example, it is almost certain that health-related digital ventures are going to do well in the coming years. But how can a foreign investor evaluate which one is likely to achieve scale? It is possible that they will have to seek out experts who understand consumer behaviour in non-elite backgrounds. Even big Indian companies have failed to understand this. Tata Motors, India's largest car company — the owner of Jaguar Land Rover — sunk a lot of capital and time in creating a small cheap car, the Nano, only to discover that their targeted working class Indian consumers were unwilling to buy it because they didn't want their neighbours thinking they couldn't afford a bigger car. One startup that has made waves recently is Ather Energy, which makes electric scooters; it is interesting to ask how they think they would avoid that problem.
Indian legacy FMCG companies are past masters at bridging this gap; most of their younger employees, from similar privileged backgrounds, are first ordered to spend years in rural areas figuring out how the mass of Indian consumers think. Any productive investment in an Indian digital venture will have to assume that its market is limited to people who have lifestyles similar to its founders, unless told otherwise.
In other words, a major question is how startups will be able to achieve true, sustainable scale in India unless they get out of their metropolitan ghettoes and examine smaller towns — the third point. This is especially true of digital-only startups. Internet penetration in India has only just taken off. It has essentially tripled since 2012. In real terms, this means that larger cities got connected over a decade ago, and have a head start in constructing a startup ecosystem; smaller towns are only just joining in.
It is difficult to understate exactly how important the internet is in connecting these parts of India to the outside world. India has failed to build good roads. Its banking and financial networks are poor. Its entertainment industry is unusually elitist, run by a few families in Mumbai. The vast mass of increasingly well-off Indians in small towns are far more disconnected from the world than their equivalents even in China. It is commonly said in the West that millennials live on the internet first. But the experience of young Indians in the disconnected part of the country is a degree removed from even that. Young people in the West will be accustomed to a real, offline infrastructure supporting their lives. They have roads, regulators, banks, colleges. These Indians don't. For many such Indians, the first time they undergo a formal financial transaction, their first genuine educational experience, their first romantic experience, their first exposure to entertainment written for them, their first experience of government, will be online. For them, the information superhighway is more real than a "real" highway. Thus the potential from harnessing their energy and their spending power is vast — but, to be successful it will have to be embedded in their lived experience, just as much as in the West one cannot imagine a group of 60-year olds running an internet platform targeting teenagers. Thus the rewards for investors in the sector may certainly appear to be great — but so are the risks. The risks are not as obvious as they are in other sectors of the Indian economy — but they are real, and they must be dealt with.
So how is this risk to be managed? There are several alternatives, but one is insight from the world of infrastructure investment is particularly worth considering. Global infrastructure investors are rightly wary at the moment of coming into India on their own. India is seen as a land of unknowable risk, which they will struggle to navigate on their own. Building of physical infrastructure, while of course vastly different from scalable startups in most ways, has one important fact in common with them: it requires, in most cases, the project to deal with conditions in the "real" India, outside the globalised bubbles of metropolitan cities.
So how do most investors prefer to manage this risk? Rather than partner just with private Indian companies — which are as potent a source of risk, in their view, they view the government as an essential additional partner. The government, naturally, can help moderate political risk. It can deal with local issues more effectively. And it has reach all over India.
This is the crucial insight for global capital that wishes to examine how to benefit from the inevitable growth that Startup India, and especially Digital India, will provide. The government's focus on digitalisation of the economy after its demonetisation of the currency is thus a boon. It has invested a great deal of political capital in the idea of digitalisation, and is anxious to make it a success.
While the Indian state is in general not very efficient or effective — especially not when compared to, say, China's — it does have one interesting feature: projects that are seen as politically supported "missions" tend to be carried out with unusual efficiency. Digitalisation of the economy appears to be one such mission. It is also open to partnering with the private sector, either directly or through institutional equity. In the Union Budget, the government declared that for the first time, one of its online enterprises would be opened to investment on the stock market — the agency that deals with the ticketing and other online work of the vast Indian railway system. Other government projects in the digital space will increasingly be open to private partnership, and the word has gone out that startups must be given a level playing field with legacy players in selecting private partners. Most importantly, the government is directly accountable exactly to those parts of the Indian economy that, typically, startups from Indian metropolitan areas are unable to completely understand — small town and rural India. Scale is built in. It may be a good way to test the waters.
In the end, it is worth noting that India's true arrival as a startup nation is actually a few years away, when mobile internet penetration reaches most of currently disconnected India, and young Indians have had some years to grow used to it. That is the point when young entrepreneurs in smaller towns will themselves begin to discover products and platforms that are relevant to their lives, and are able to build the networks necessary to monetise them. The open question is how these products and platforms will be financed. Indian private capital has various blind spots, and financing such startups is likely one of them. It is a great opportunity for global capital — but anyone interested in that growth will need to start preparing today to understand a country that is still foreign even to many other Indians.
A version of this essay originally appeared in German in Global Investor magazine.
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Mihir Swarup Sharma is the Director Centre for Economy and Growth Programme at the Observer Research Foundation. He was trained as an economist and political scientist ...Read More +