[Edit Notes: One of the well argued and well written pieces we came across on the Flipkart- Myntra deal. In this post, Sumanth talks about why investor Mahesh Murthy’s ‘topi investor’ theory is completely off the mark.]

The recent announcement of Flipkart acquiring Myntra was greeted with a range of reactions and emotions within the Indian startup ecosystem – exultation from employees to guarded optimism from competitors to hallelujahs from industry observers.

In the midst of all there was one shrill voice that stood out starkly for its vitriol. This voice belonged to Mahesh Murthy – part-time marketer, part-time investor and full-time resident gadfly.

Mahesh felt that this deal was much ado about nothing – just a case of “topi investors” (his favorite term of endearment for investors who don’t share his worldview) rearranging the chairs on the deck of the Titanic by merging two doomed entities in a meaningless transaction.

Short of shouting out his view from the rooftop, Mahesh peddled his view on every possible channel. He tweeted about it, posted it on Facebook and also appeared on TV. To top it, he wrote about it at length in Quartz, an online business news publication – qz.com/212775 – where it apparently became the most-read article ever. If all of this wasn’t enough, this was subsequently picked by mainstream publications as well – CNBC, Business Standard et al.

Predictably no one from Flipkart or Myntra found it worthwhile to dignify this invective with a response. Now, I am in no way connected to Flipkart, short of being an occasional customer on their website. But even to my casual observer eyes, Mahesh’s arguments were at best, misinformed and at worst,malicious half-truths. I have enumerated his points below with a brief retort – read ahead and judge for yourself if Mahesh has a case.

CLAIM 1: Flipkart buying Myntra is just another episode of a long-running saga of acquiring other “wobbly” e-com companies that are funded by common investors

Mahesh quotes the instances of Flipkart previously acquiring companies like Chakpak and LetsBuy – struggling e-com companies with common investors – to present a case that the Myntra acquisition follows the same pattern.

Firstly, while it is true that companies like Chakpak were distressed entities and their acquisitions could possibly have been engineered by common investors, there is hardly anything nefarious in this. The fact of the matter is that closing companies in India is a byzantine and thankless job – it takes years and requires folks to jump through countless procedural hoops to provide a burial for a failed company. One way to short-circuit this process is to merge the distressed entity into another company as a slump sale acquisition for a token consideration thus avoiding the bureaucratic hassles. This is a common practice that is followed by many investors and not restricted to “topi investors”. Don’t believe me? Ask Mahesh himself – in his own portfolio, a failed company, LifeBlob was acquired by Printo, another company backed by Mahesh.

So does the Myntra acquisition fall in the same category of distressed slump sales?

ABSOLUTELY NOT.

Unlike the previously-mentioned startups, Myntra was hardly a failed/failing company and Flipkart buying it was far from being affording it a burial. On the contrary, buying Mytra was an act of “buying strength”.

Here are the facts:

FACT 1 : Flipkart needs Myntra to compete in the fashion/apparel vertical

Hitherto, none of Flipkart’s acquisitions have been strategic in any sense. However Myntra is different.

How so?

It is a well-known fact that fashion/apparel is the biggest e-com vertical – this is true all over the world and is true of India too where it is estimated to be a Rs. 17,000 crore market. It is also the fastest-growing category growing at over 100% year-on-year. So any company staking a claim to be the leader of e-commerce in India needs to win this category. Now, Flipkart has had a presence in this segment for the last year or so but despite investing a ton of effort and money into this, it is far from being the market leader. As things stand, this is largely a two-horse race between Myntra and Jabong who were hitherto running neck-to-neck with around 30% market share each. However after assimilating Myntra, Flipkart is now the market leader with a long lead – the combined entity now has reportedly 50% of the market to itself.

There is another reason why Myntra can be invaluable to Flipkart – while a lot of people are talking about the economies of scale that the combined entity will have, given the fact that the operations of the two entities are continuing in an independent fashion, these scale economies will be limited in the short term. However the fact that Flipkart caters primarily to the VFM segment while Myntra owns the premium category implies that there will be enormous “economies of scale” that will accrue to them. Between the two brands, the combined entity will cover all segments of the apparel category with each entity playing to its strength and even in the niches where there is an overlap, it affords them a wonderful one-two opportunity to capture a customer.

FACT 2: Myntra is a company with strong fundamentals and far from being a distressed one

Assessing the health of a company like Myntra requires evaluating two parameters – growth and cash.

So was Myntra growing?

Myntra was growing like a weed – ROC filings indicate that Myntra grew over 300% to Rs. 263cr in revenue in 2012-13 and based on the quarterly reports, was scheduled to close 2013-14 at nearly Rs. 900cr repeating the 300% growth. All other important metrics – number of registered customers, GMV, number of daily shipments, average basket size, number of sellers in marketplace and number of brands – have all shown equally robust growth over the last three years.

Was Myntra in danger of running out of cash?

According to reports, Myntra was already profitable on a transaction basis with positive contribution margins (which accounts not only for the gross margin but also the cost of delivery, returns and other expenses related to order fulfillment). Obviously, it wasn’t profitable overall as it was investing in growth but the fact that its unit-economics are positive gives Myntra enormous strategic leverage.

Also it might be worthwhile to recognize that Myntra has plenty of dry powder in its arsenal as it had raised $50 million in new funding just a few months back.

So if things were so good for Myntra, why did they choose to get acquired by Flipkart at this stage?

There are two reasons that are fairly obvious . Firstly, combining forces puts them in a much stronger position to compete with Jabong, Snapdeal/ebay and Amazon than if they were to attempt it individually. Secondly, as business scales, Myntra can benefit from Flipkart’s legacy investments in technology, processes and infrastructure directly or at a minimum by learning best practices.

Beyond these, I believe that there are two other reasons why a merger made sense for Myntra (NB: I am speculating here).

Firstly, despite its recent fund-raise, there was a good chance that this wouldn’t have been Myntra’s last round of funding and they would need to raise another round sooner or later to fuel growth and fully capture the growing market. Merging with Flipkart would mean that it frees up the Myntra management from the onerous tasks of setting out to raise yet another round and allow them to focus completely on running the business. It was reported that Myntra took six months to close their latest round of financing which implies that getting funding wasn’t a shoo-in and required considerable time and effort. But now post the acquisition, the onus for further fund-raising for the combined entity would probably fall on the Flipkart founders, who all said and done, are past masters in raising funds – a oft-overlooked trait that top-quality CEOs possess. Flipkart has already announced that they will invest $100 million to grow Myntra – a figure that should take them to $1 billion GMV.

Secondly, now that Myntra is part of Flipkart, they get the undivided attention of their common investors like Tiger Global. Tiger Global is the leading e-commerce investor globally and has a finger in pretty much every major international e-commerce company – from JD.com in China to market leaders in Argentina, Africa, Brazil and Russia. They also back the hottest apparel e-commerce companies world-wide – from Vancl in China to NetShoes in Brazil. Given the relative positions of Flipkart and Myntra in Tiger’s portfolio, arguably Flipkart would have received preferential treatment in terms of access to these global leaders but now Myntra has the privilege of being on top of the totem.

Speaking of common investors, let’s move on to Mahesh’s second claim:

CLAIM 2: Common investors who own the bulk of the company were the ones who engineered this deal

Mahesh’s claim is that “investors owned more than 80% of each firm” and the merger was essentially a “Great Indian Roll-up” made by the investors to protect their narrow self-interest.

Now, there is a neat bit of sophistry at play here where Mahesh outlines this argument.

He starts off by talking about common investors and segues into making a point about investors owning the bulk of the company. The catch is this – while the investors in total might indeed own the majority of the company, not all the investors are common which means that the common investors are far from owning 80% of each company and there are several major investors who are not common and hold significant stakes. The non-common investors include names like IDG, Kalaari Capital, Azim Premji Investments, Dragoneer, Morgan Stanley and Naspers. These are reputed, high-quality investors who by no stretch of imagination fall under the “topi investor” category that Mahesh is so fond of bandying about.

So, while there might have been some common investors who might have encouraged the deal, it would nevertheless require the approval of the non-common investors and perforce would have gone through the mandatory due-diligence process to establish that all aspects of the deal were equitable. Also, it is worth keeping in mind that each and every one of the institutional investors would have a right to block the sale as part of their initial investment terms, both jointly as well as individually, so it is highly unlikely that this was a clandestine roll-up exercise cooked up by the common investors.

CLAIM 3: The founders’ holding was “down to low single-digit shareholdings” which implies that they had no “entrepreneurial passion to hack it “ and had little say in the merger

I wonder if Mahesh Murthy knows how much stake Jack Ma owns in Alibaba?

Answer: 8.9%

How much does Aaron Levie own in Box?

Answer: 4.1%

Single-digit holdings…yet, these are some of the passionate founders that you will find on the planet.

The point is that if Mahesh believes that the passion that a founder has for his startup is directly proportional to his percentage holding in the company, then it makes for a sad commentary on Mahesh’s own worldview on founders and investments. If anything, Mahesh should know better as in his own portfolio company, Redbus, the founders each had single-digit holdings themselves but were yet lauded for their perseverance and tenacity in nurturing their startup from incubation to exit.

Also, Mahesh ought to have known better than talk about holdings in percentage rather than absolute terms. Given the size of Flipkart, even a 10% holding would translate in several hundreds of millions of dollars.

Beyond this, the Flipkart and Myntra investors have a reputation for being entrepreneur-friendly and not forcing their point of view on the founders that they back. Both Sachin Bansal and Mukesh Bansal have gone on record to state that the managements of the two companies were the ones who actively initiated the dialogue and took it to closure and that the common investors actually recused themselves from the negotiations to avoid conflicts-of-interest.

CLAIM 4: “Flipkart is on a timeline – it will likely run out of cash in a couple of years”

So, let’s examine Mahesh’s past statements on Flipkart:

2011: “This is just a bubble and that isn’t going to last much longer. My guess? Another six to 12 months” http://archive.tehelka.com/story_main50.asp?filename=Ws020811OPINION.asp

2012: Flipkart’s best option is to have a quick overseas IPO, cash out the investors, and then prepare for a long hard grind fighting Amazon and others on the ground.The longer it doesn’t do so, the riskier it gets for Flipkart.http://www.quora.com/Amazon/How-do-you-expect-Flipkart-to-fare-against-Amazon-in-India

2013: “Flipkart comes a little more from the iBanker/ topi school of “let’s do spreadsheets on India vs China vs US, continue to lose money forever, and hope like hell someone buys it some day, because it may never actually be a real business “ link/

So we can say at least one thing for sure about Mahesh Murthy – he has been extremely consistent with his views on Flipkart in the last few years – predicting that the company will run out of cash in a year or two each and every year! Of course the fact that he has been making the same prediction every year and in the same period, far from closing down, Flipkart has been going from strength to strength and the goalposts are ever-changing implies that Mahesh’s skepticism is unfounded.

And just to reinforce this point – in addition to the $340 million that they raised last year, Flipkart just announced another fund-raise this week for a further $200+ million (a round that could go up all the way to $500 million reportedly), so they have a deep warchest that will keep them in the game for much much longer than “a couple of years”. Also, it might be relevant to point out that the latest investor is DST Capital lead by the formidable Yuri Milner, one of the most reputed VCs in the world and hardly someone that Mahesh Murthy can classify as a “topi investor”!

CLAIM 5: “After raising almost $600 million, it’s still losing cash”

This is an oft-repeated argument of Mahesh’s – Flipkart is a bad way to build a business and proof of this is the fact that it is not profitable.

The frightening aspect of this line of reasoning is that it is purportedly from one of India’s finest investors who ought to have known better.

If your market is large and growing, profitability is not the holy grail it is made out to be!

Why? Because it means that you are optimizing on the wrong business metric. When there is as much head-room as this, you ought to focus on growth rather than on profitability. Of course, this is something that has been well documented around discussions pertaining to Amazon and other global e-commerce companies.

Also, keep in mind that India’s largest brick and mortart retail chain, Reliance Retail, a progeny of “the patron saint of profitability” has seen seven continuous years of losses before it turned a marginal profit last year.

Mahesh should also remember that even Redbus was a loss-making company almost throughout its entire life as a company and could only return a meaningful profit in the last year of its independent existence – it was not entirely a coincidence that the company was sold off almost immediately implying that the headroom for growth was fast-shrinking.

So this blind devotion to profitability is quite misplaced.

Let’s examine the other point that Mahesh loves making – that Flipkart is not a real business as it is built on a deep-discounting model funded by VC money that is doomed to failure.

There are three ways to parse this:

Firstly, let’s assume that Mahesh is right and that Flipkart is selling products below its cost price subsidizing the difference with VC funding. Now as long as the gross margins are positive, Flipkart will be fine even if the contribution margins are negative. The latter will be amortized away over time and scale as processes become more efficient and order sizes increase. Is this the case with Flipkart? That certainly seems to be the case.

Secondly, deep discounting is a bigger issue in an inventory-lead model rather than in a marketplace model where Flipkart is serving as a platform that charges the merchants a fixed or percentage fee for selling their goods. On top of this, the merchants also are customers of Flipkart for services such as the payment gateway and delivery which are professional services for Flipkart and are bound to have positive margins.

Finally, margins are highest in the apparels sector which as previously stated is the most important category for Flipkart and the imperative for the Myntra acquisition. Unlike books or electronics that afford 2 to 10% margins, apparel offers 15 to 50% margins. With the acquisition of Myntra and by virtue of being the company best positioned to capture the apparels market, the bottomline is therefore going to be automatically boosted.

CLAIM 6: “The Amazon of India is not Flipkart—it’s Amazon”

Mahesh points to the dominant positions of Google, Facebook and Twitter in India to extrapolate that Flipkart will lose to Amazon.

There are two problems with this theory.

Firstly, given the Indian government’s position of disallowing FDI in multi-brand retail, a position reiterated by the recently-elected central government, Amazon’s strategic options are perforce limited.

Secondly, e-commerce is not a winner-takes-all market. Unlike pure-play internet services and apps, there are hardly any network effects at play and there is no way that Amazon can “kill Flipkart”.

Is it conceivable that Amazon will one day go on to become the market leader in India by displacing Flipkart? Sure, that is definitely a possibility but that hardly means that Flipkart cannot become a behemoth that will have a meaningful position in the Indian ecommerce space. So, it doesn’t really matter if Flipkart is not the Amazon of India. Being the Flipkart of India is a pretty good darn place to be in and as a home-grown company stewarded by young, enterprising Indians, it deserves our full support and backing!

As far as Mahesh Murthy goes, many people wonder why Mahesh has so much animosity towards Flipkart. There is a well-traveled story that Mahesh wanted to invest in Flipkart many years ago but was turned down by the founders because of the low-ball valuation and onerous terms offered.

While this story might well be apocryphal, there is no doubt that Mahesh feels strongly against Flipkart and feels that this is not the “right way to build a business”. In which case, I would humbly suggest that the best way for Mahesh to make his point is not through spewing venom on Flipkart and its investors but rather by beating Flipkart in the market.

After all, Mahesh is not some casual observer – he is an investor with multiple e-commerce investments and the best way for Mahesh to prove his point that there is a better way to build an e-commerce companies is by stewarding Fetise, Donebynone or one of his other e-commerce portfolio companies to a position of market leadership by competing against and defeating Flipkart.

Until then, I am afraid his missives come across as spiteful barbs from a spurned lover!

DISCLAIMERS:

I have met Mahesh a couple of times many years back and had pitched my previous startup to him. Mahesh wasn’t too keen on investing but then given the $1 million post-money valuation and terms such as 2X liquidation preference, I probably wouldn’t have taken an investment from him in any case. I must confess that I found Mahesh to be a humble, diligent and approachable investor unlike several others of his ilk.

I don’t know the founders of Flipkart or Myntra – I have seen Sachin Bansal talk at events and feel that whether Flipkart becomes the Amazon of India or not, there is a good chance that Sachin will become the Jeff Bezos of India! He seemed to have the same drive and sense of destiny. I only hope that his acquisition of Myntra will improve his sartorial sense – the Flipkart-branded felt jacket does not have quite the same impact as a black turtleneck and jeans!

[About the Author: Sumanth is the founder & CEO of Deck. This post was reproduced from Sumanth’s blog. Image credit:PlashLabs]