Are You Unable to Make Head or Tail of Ecommerce Valuations?

Why Ecommerce Valuations Do Not Follow Sound Business Valuation Principles

Ecommerce Investors
Ecommerce Investors. FingerMedium / DigitalVision Vectors / Getty Images

As an angel investor, I get to see close to a hundred business plans every month. Ecommerce is certainly in the top five sectors that these business plans address. Compared to other types, ecommerce valuations tend to be the highest.

The Problem With Ecommerce Startups

In a recent article, I talked about why most ecommerce businesses fail. If you read that article you see that some of the fundamentals of business are often ignored by ecommerce ventures.

Despite the Screw-Ups, Why Do Ecommerce Businesses Attract Hordes of Investors?

The basic principle here is that all aspects of our existence are moving online. So, though ecommerce accounts for a small percentage of the retail industry, it is bound to keep growing, until one day almost all retail transactions are conducted online – that is the premise. Based on this premise, and armed with investible funds, private equity players are placing risky bets that their investee companies will be the last people standing in the ecommerce marketplace after the shakeout occurs.

Do Investors Truly Believe That Their Investee Companies Will Make Tons of Profits?

Who can be sure about what motivates any set of people. Psychologists and sociologists have spent a lot of ink and paper trying to understand motivation. But when I interact with private equity investors, I do find that their vision is rather short term.

It is this tenure mismatch between the entrepreneur's horizons and the investor's that has probably led to a lot of irrationality in the investment landscape.

For instance, as an investor, it is not my responsibility that my ecommerce investments turn profitable. Ignore responsibility, in many cases, it seems like it is not even a concern!

That is because the rewards to an investor usually come from the next investor, and not from a share in the profit of the ecommerce venture. This explains the investor's willingness, not just to tolerate unending periods of losses, but also encourages them to shore up revenues even at a very high cost of acquisition of each customer.

Where Is All This Headed?

You will read my mentioning this in my ecommerce in 2013 article too, but the idea is that a shakeout in investor's confidence is likely to take place at the same time as the shakeout in the ecommerce industry itself. Today, there are:

  • too many ecommerce players.
  • too few profitable ecommerce ventures.
  • exceptionally high costs of customer acquisition.
  • still many ecommerce ventures that get funded across the globe.

But once the music stops playing, and the party is over, it still remains to be seen how many ecommerce businesses will survive.

What Happens in the Event of a Shakeout?

From experiences in other sunrise industries, we can say that excellent ecommerce assets will become available at pretty low prices, upon shakeout. Since many of the investors will exit at pretty low valuations, there will be a dampener on the valuations of all ecommerce businesses -- regardless of their quality.

Investors will move on to newer pastures. I wish I could predict what those new pastures would be -- maybe investors will get into the business of augmented reality!

Conclusion

It is almost as if investors just do not learn. I know that would be a nice populist slogan. But the fact is that investors in the private equity space usually know what they are getting into. Their high-risk investments allow them a chance to play the game where winning has a low likelihood, but a high pay off. But I agree that sounds a little like Las Vegas.

Note: When I refer to "private equity players" in this article, I am not restricting myself to what are traditionally called PE (Private Equity) firms. Instead, I use the term broadly to include all of those who invest in unlisted stocks. These could be the PE firms themselves, or they could be VCs (Venture Capitalists), angel investors, seed investors, or other such.