Is the Party Over? New rules cause turmoil in Indian e-commerce​

For those of us who witnessed the orgy of investments in Indian e-commerce firms and wondered if there was any sanity left in this world, a glimmer of reason has finally appeared, ironically though, in the form of two government diktats that appear to be counter to the free market principles that India has embraced over the past few decades.

On the surface of it, the Indian government has opened up foreign investments in retail businesses by up to 100 percent which seems like a pretty good pro-market move since it gives a green light to foreign companies itching to get into the game but stymied by the rule that capped their investments to 49 percent. In reality, though, many say that this is simply a velvet glove concealing an iron hand delivering two life-threatening blows to companies like Flipkart and Amazon -- the new rules govern retail in India in general but it is the ramifications for e-commerce that has attracted the most attention.

The first blow is the decree that states that e-commerce firms can no longer, directly or indirectly, influence the pricing of goods thus preventing the industry-wide practice of offering deep-discounts that have so far been the life-blood of online retail companies like Flipkart and Amazon.

Mint newspaper succinctly describes how deep-discounting has worked in India: You like a shirt on Amazon India that costs Rs 100. In actuality, the short costs Rs 180 but Amazon has 'recommended' a discount to the seller of the shirt -- in this case Rs 80 -- like it has for a gazillion other products sold on its site. It doesn't force this seller to sell the shirt for Rs 100, but the seller knows which side her bread is buttered and sticks to Amazon's suggested price because the online giant finances the discount of Rs 80. The seller sends a debit note to Amazon at the end of a certain period and in return it dispatches a cheque to the seller.

This has been the underpinning of the tsunami of investments in Indian e-commerce -- the ability to grow and attract customers by selling stuff for ridiculously low prices, financed by eager venture capitalists who have so far pumped more than $9 billion into Indian e-commerce firms over the past two years for one, pure goal: Market share. Profitability and other such whimsies be damned. The gargantuan online extravaganzas such as Flipkart's Big Billion Day sale during the big-spending festival season all fed into this strategy.

Much like the last internet bubble fifteen years ago, the metric this time around to evaluate and judge the performance of online retail has been gross sales which has in turn influenced what VCs desire most -- sky-rocketing valuations.

Flipkart's $15 billion has been the most eye-popping of them all. But there's a catch. It isn't as if the market is determining these valuations. Instead, all of the parties have been drinking the same Kool-Aid from the same tub, with the expectation that when the dust settles the biggest dog gets to eat the most thereby instantly justifying those self-set valuations that currently have little to do with the saner principles of valuing businesses, such as those espoused by Warren Buffett.

Now, overnight, nixing deep-discounts has essentially strangulated the one and only existing strategy towards online supremacy. It is also going to force these online retailers to compete with their offline brethren -- who have been decimated over the past years because of their inability to compete with lavish online discounts.

What makes this worse is that the Indian government's stance towards online retail has for over a decade been ambiguous, even muddled and tracing this history reveals a 'don't ask, don't tell' compact that existed between all parties before the equivalent of an electric cattle prod being inserted into the mix.

Until now, the rule was that foreign entities were not allowed majority investment in multi-brand retail, such as Walmart, but allowed in single-brand retail like Nike. With e-commerce, the government was at first ambivalent or just plain confused about how to deal with foreign companies acquiring a majority stake in online retail in India. Outfits like Flipkart, Snapdeal, Paytm and Amazon -- all majority foreign-owned -- made hay amidst this confusion. Then, a series of lawsuits, some claiming foreign-exchange violations and others FDI ones, began to be filed against Flipkart and Amazon, spooking them into action.

As the wire explains, these online retail biggies now couldn't just buy stuff from wholesalers and then flog them on their site in the classic 'inventory-based' model like Amazon does in the US. So they effected what they thought was a clever workaround: Migrate to a 'marketplace' model, like Alibaba, where they were simply hosts to multiple sellers. But a marketplace model comes with weaknesses. Customer satisfaction isn't nearly as high compared to the inventory-based model as a plethora of entities are now responsible for packaging, shipping, delivery and payments and fraud proliferates.

In order to game the system and have the best of both worlds, Indian e-commerce outfits erected local entities that would do the warehousing and selling, but would act like independent sellers. Amazon, for instance, set up Cloudtail India Pvt Ltd which, according to estimates, sold at least 40 percent of the company's goods. Cloudtail happens to be a joint venture between Infosys co-founder Narayana Murthy's Catamaran Ventures and Amazon. Similarly, Flipkart set up WS Retail Services in 2009 for the sole purpose of flogging the majority of its goods in an inventory model. However, when the law came knocking it tried to distance itself from the entity via some fancy structural maneuverings that Mint described lucidly.

To fully understand the murky, incestuous world of FDI rules and e-commerce in India, here's a good article in Mint by entrepreneur Kashyap Deorah who sketches out how so many e-commerce outfits in India architected clever workarounds such as building 'Indian-owned front-end entities that invoiced the customer,' and 'partially foreign-owned back-end entities that provided a range of services.'

Which brings us to the second hammer-blow. The Indian government also states that "an e-commerce entity should not permit more than 25% of the sales effected through its marketplace from one vendor or their group companies."

Will these outfits figure out other work-arounds to combat this restriction? Will the government police them strictly like it did in the Facebook Free Basics fracas? Only time will tell, but it's safe to say that it's a brave, new and infinitely challenging world for online retailers in India who were used to easy money and a forgiving business model.

Out of all of this, there is one winner: Snapdeal, which elected to go the true marketplace model route right from the beginning and consequently didn't attract the soaring valuation of its competitor Flipkart.

There are other positives: Finally, companies will be forced to do something that they were paying little attention to before -- product innovation.

Easy-money fueled 'deep discounts' will no longer be a way to attract customers. Instead, all of those 'old-school' metrics such as customer satisfaction, profitability, service, and efficiency will come into play, making the sector more streamlined. Meanwhile, other brands and players who were scared of competing in this e-commerce-on-steroids model can finally throw their hats into the ring. Also, offline retail which was hammered by their online peers will see some necessary life breathed into it, allowing it to compete more-or-less on equal terms with e-commerce.

How companies like Amazon and Flipkart manage to fulfill the new rules is questionable. Indeed, the government should be chided for not giving e-commerce companies some time to reconfigure themselves to play by the new rules. After all, previous governments including the current one have all turned a blind eye to the billions of foreign dollars pumped into e-commerce outfits that were clearly not playing by the somewhat hazy rules. As more time passed and more of these billions sluiced into India, there was clearly a tacit approval of what was transpiring despite the rules in place. Now, the government expects a crucial industry in its formative stages to instantly contort itself into a configuration that fits the new rules dreamed up the previous night. In the last few days Amazon has apparently tried to lobby the government to defer the implementation of the rules by six months, but to no avail.

As far as how much will actually change, no better words to lean on than those penned by entrepreneur Deorah in Mint: "On the face of it, the policy clarification legitimises what was already happening for several years. De jure just caught up with de facto and that is neither a no-change nor a big-change. I do think it is a step in the right direction. It simplifies the artificially complex structures of e-commerce companies, if only by a bit. It keeps the bureaucratic trouble makers away, if only by a bit. It simplifies business contracts between entities, if only by a bit. It levels the playing field for retailers, if only by a bit. It diffuses the potentially controversial political rhetoric, if only by a bit."

According to Deorah, the policy clarification was essentially necessary to retain investor confidence. Things will change but there will also be some fancy number crunching and re-structuring to adhere to the new rules, and inventory-led e-commerce will continue in some form.

My addendum: Yes, our governments have been daft, lazy and hypocritical. But Indian online retail got what was coming to it -- namely a swift kick in the pants. And India is better off for it.