Visualize the math on this.

A friend spotted an employee from Grofers at a neighbourhood store. Grofers is a phone-based app that allows you to order pretty much anything and it gets delivered to your place. The intent is to save time you would otherwise spend shopping.

This man picked up a half litre bottle of Pepsi and a Cadbury Dairy Milk chocolate.

My friend was intrigued and asked him if this is all he intended to deliver. The boy said yes.

“Kaise chalega yeh (How will this work)?” my friend asked. His enquiry was directed at finding out how will it make any money.

“Sir, aise hi chalta hai (This is how it is),” the boy replied and rushed to complete the delivery.

I don’t know if the customer paid delivery charges on this order or if it was free. But think about the expenses Grofers may have incurred on acquiring this customer, the time spent on procuring the order, monitoring, delivery, accounting and remitting the money if it was a cash-on-delivery transaction.

Even if Grofers did charge Rs.49 for delivery, the transaction would have cost more than the actual goods. Sometimes, these transactions actually turn out to be free (as in the case of Foodpanda) for customers by applying cashback and first-time use coupons.

Sure, as a tool to drive adoption, these losses are fine. But how many of these one Pepsi and one chocolate customers are sustainable customers?

Incidentally, Grofers has announced that it is rolling back operations in nine cities.

Start-ups will die. 97% will fail. About 1% will get acquired. Another 1% will go on to become paper unicorns. Only the final per cent will actually become sustainable digital-first enterprises.

The problem is that they will die for the wrong reasons. They will not die because the product sucked. Or the team fell apart. Or the competitor got funded beyond what is rational. They will die because their math never added up. They could never have made money.

We saw pain in food tech, hyperlocal e-commerce companies and insta-groceries. We’ve seen deaths in e-commerce, online travel, on-demand cabs and private labels (strategic M&A is still death by another name). Payments will be next. Do I really need 20 electronic wallets, besides the little worn out leather one in my pocket?

Every start-up that dies manages to etch a new neural path in a consumer’s mind as it tries to change an old analog habit. In that sense, start-up deaths are noble. They pave the way for another one to come along some day and actually make money off that behaviour shift.

These firms were held aloft by the constant pouring of fuel by investors. Unfortunately, all that fuel could not help these firms attain escape velocity. Their rockets were weighed down by huge overheads, bad design and piloted by inexperienced-but-overconfident astronauts. And then gravity made a giant sucking sound.

The fatal flaw in our clones

Venture capitalists (VCs) and founders find it easy to launch clones of Western models because they perceive lower risk in future funding rounds, possibilities of a strategic sale and a general comfort around financing such a business model. Clearly, there is comfort that even if things don’t pan out too well, they will be able to sell it to a Western or Chinese strategic investor.

They are not wrong. The potential is intoxicating. You see millions of smartphone-addicted Indians, a ready audience for your established-in-the-US business model, and you want to press the launch button. Success seems to be only a matter of time.

But we have a devastating problem that blows out the projections of every start-up, and puts us many years behind the Chinese Internet economy we love to compare ourselves with. Here goes:

Clone Flaw 1: We spend in dollars and earn in rupees

You buy your Macs and pay for your hosting cost and your fuel in dollars. You pay your rent and talent in near-dollar terms. But Indian consumers count every paisa and leave only rupees on the table.

India is one of the most expensive places for a start-up. Even at seed stage, most start-ups need between $200,000 and $300,000 to kick off and another $2–5 million to prove that they have a business model that works. Silicon Valley start-ups launch with as little as $20,000 and there are genuine incubator networks that propel them along.

To put that in perspective, let’s look at local services start-ups in the US. A plumbing job on average costs $200 and if you make 15% on it, you’ll make $30. In India, the same job costs about Rs.300 and that’ll get you Rs.45. Even on a purchasing parity basis, the US plumbing job makes youRs.600, a far cry from the Rs.45 in India.

How many thousands of plumbing jobs per day do you need to earn back the imputed salaries of founders who studied at the IITs? (Of course, they are paid via equity. But someone needs to do a rational analysis whether a venture can afford them.) Or the actual salary of a lead software engineer? Or the rentals for your offices? Can such a start-up even afford an office?

Clone Flaw 2: Our absolute unit economics suck

Your percentage gross margin or contribution margin may look promising, but on an absolute level it earns you very little.

Here are the numbers for a reasonably sized e-commerce company (sales of over Rs.1 crore a day). It has a gross margin of over 24% and is one of the few that make a positive contribution margin.

Looking underneath the numbers, it has an average transaction revenue of Rs.900. The contribution after discounts, returns, logistics, but before customer acquisition cost (CAC) was 5% or Rs.45 per transaction. Accounting for CAC, the company ends up losing over Rs.100 per transaction on a marginal basis. Over and above that you have to account for crores in fixed costs for team, rentals and other infrastructure.

It’s a coincidence that both examples earn Rs.45 a pop.

In the case of local services, when will you ever make enough money to pay off your costs since it’s unlikely Indians will start paying more for plumbing jobs anytime soon? We’ll soon see pivots in this space. Survival here will become not about the plumbers on your network, but about figuring out how you can inspire customers to use you on multiple occasions. This is a frequency problem. Your low frequency customers can kill you.

In the second case, the start-up will never make money without a clear plan to upsell and drive the average transaction value to twice the present number. It has an amplitude problem. Your low-value customers will dry you up.

The next question then is, how soon can you get the transaction value up? Of course, you can solve this by finding ways to upsell, cross-sell or by motivating higher frequency purchasing, but that comes with increasing complexity and costs. It needs to find a sweet spot between acquisition and retention efforts.

In both cases, the firms are living dangerously. With such a thin contribution margin, any expense on growth, any headcount they add, builds up huge pressure to do even more transactions, which, in turn, leads to more overheads to tackle the resultant complexity. Simply put, each product developer you add is creating pressure to do thousands of more transactions per annum just to cover her wages.

Clone Flaw 3: Depth, density and the Indian mindset

Start-ups assume that scale will solve their unit economics issues. But wait. You are dealing with a complex, fragmented audience. The depth and density of the Indian market is a fraction of the West or even of China. (China’s Internet market is worth trillions of dollars and by several estimates, India will take seven-eight years to reach where China is today.)

There are two Indias: the top 10% that can afford your clone offering, and the remaining 90% that can’t or simply won’t.

Discovery, conversion, retention are expensive propositions in India. If your business does not have natural network effects or massive economies of scale, you could be in a tough spot.

The Indian consumer is value-driven, not convenience-driven. We have all the time in the world to research and find the best price. We hate paying for service. And loyalty—what is that?

Servicing the 90% can become a continuous drain on your business. There is no farming with them, only hunting.

Allow me to offer another example. I recently met a firm that showed me how they planned to earn Rs.400 off every transaction worth Rs.2,000. The economics looked good until I delved deeper. They planned to pay Facebook Rs.700 to acquire every customer and they had no plan on how to retain the customer. There was an airy assumption that they’ll get 25% retention—with no basis in customer behaviour, competitive intensity, nothing. It was as if they were working hard to raise money from investors to give to Facebook.

Google and Facebook absolutely love this. Indian start-ups are like giant funnels of VC money. They have this wonderful hypnotic tool called remarketing and start-ups are lured into spending on the same consumers again and again, while they laugh their way to the bank.

They say, “Here’s an easy way to lure back customers who have visited you but you failed to excite; we’ll bring them back to your website or app; and you can hope this time they’ll transact.”

Most start-ups spend that money again, without changing anything about themselves, or the customer’s journey. It’s laziness-on-demand driven by a cheaper cost-per-click offered on remarketing.

Clone Flaw 4: You compete with a man without a calculator

You are competing with a kirana shop owner, a restaurant owner, a beautician with her own Facebook following. These people know the business, they know their customers, they have the relationships. They can do their own delivery. But we are building start-ups that want to solve a problem that probably doesn’t need solving.

The point is that you are fighting a competitor whose cost structures have never been examined under the harsh light of unit economics. Most of them don’t pay taxes, nor do they have regulatory or compliance costs. The typicalkirana shop has a delivery boy who will arrange shelves in the morning, deliver during the day and act as a watchman by sleeping at the shop at night. The marginal cost of home delivery to the kirana owner is near zero.

Let’s consider food tech. Just examine what happens at lunch time—all consumers want the delivery of a sub-Rs.200 order in a two-hour window between noon and 2pm. Imagine the peak and off-peak demand curve it creates for delivery boys. It’s sustainable only if you can drive density—each boy delivers 5–10 boxes in each office.

Unless you are vertically integrated (run your own kitchen and enjoy the 70% gross margins of the food business), you have no hope of making money versus the neighbourhood restaurant, which has a delivery boy who cuts onions in the morning, sets the tables before lunch and knows the delivery beat dead-on.

Of course, your scale, assortment and efficiencies will drive these kirana shops and restaurants out of business someday. But when and at what cost?

Clone Flaw 5: The treadmill problem

VCs are constantly under pressure to get the bridegroom dressed up for the next swayamvar (an ancient Indian ritual where a bride walks through a list of suitors to choose a husband by garlanding him)—let’s open in 10 cities in next six months, or let’s get 10,000 transactions a day—so that we can attract a bigger VC or hedge fund for the next round.

In the desire to create the most eligible clone, start-ups end up wantonly spending on customer acquisition. Resources are spread thin. The cost structure balloons and a few months into this, you discover you are not the rocket you thought you were, but are running on a treadmill—running faster and faster, going nowhere.

Here is an illustrative Excel sheet for an online grocery start-up (it eventually shut down). See Table 1.

Click here for enlarge

The story was that we’ll build efficiency and start making money once we do over 2,000 deliveries a day. But folks, you are in India, you are in a tough market, in a tough business. As you scale, the points of failure go up, not down. Your short shipments will keep going up, the challenge of managing inventory will go up.

And finally, if you earn just Rs.118 per transaction after managing all this complexity, is it really worth it? Will you forever be on a treadmill that keeps needing more and more transactions per day to cover fixed costs that keep going up rapidly with scale? Break-even is a distance away and profits a mirage.

Clearly, no hyperlocal grocery business will make money for a long time. My guess is seven-eight years out, if not longer.

Unless a firm creates a uniquely Indian model—asset-light with low inventory, low complexity and combines it with high-density consumer clusters— there is no rationale for any of them to churn out a rupee of profit.

This treadmill effect has killed several hyperlocal delivery firms already.

Here are estimated numbers for hyperlocal delivery start-ups in October 2015. The names have been blanked out. Half of these have already wound down, but the wastage is there for everyone to see. These start-ups serve local businesses. It means that there is no brand franchise or stickiness being generated as a result of this carnage of cash burn. See Table 2.

Click here for enlarge

So what will work?

In India we need to work harder and think smarter. Our clones have to address uniquely Indian economics and mind-sets. Unless you focus on thinking about how to create network effects, density and low churn (low or zero customer retention cost), you’ll never make money.

What I find utterly baffling is that while our start-up entrepreneurs put up Amazon, Uber and Airbnb as their idols, they never focus on how these folks did it. It’s ironic that while Amazon prides itself on frugality, the clones in India are hiring people by the thousands, setting up fancy offices with free lunch for their teams. Their fixed costs, payrolls are astronomical.

Why do we need so many people? Do people add to the complexity and inflexibility of your operations or do they reduce it? Ditto for Uber. It runs a 50-country operation with much fewer people than Ola for its India operation.

What happened in 2015 was good. It shone light on our blind clones. And this is very unlike the tech bubble of 2000. Then, there was no demand, no habit and no zillions of hand-held devices on 3G and 4G connections that Indians wanted to stare at over 300 times a day.

We now enter the third generation of the start-up ecosystem in India:

Generation 1.0 (1999–2007): Hype of the West + Hype of India

Generation 2.0 (2007–2015): Hype of the West + Hope of India

Generation 3.0 (2016–2023): Reality of India, the second largest Internet market.

The issue this time is not the demand. The market is there for the taking. This time it is about the cost of doing business and how you build out your firm.

Most models are established. The math is visible. The complexity is not hidden. Now if start-ups fail, or if VCs continue to have blow-outs, there is no one else to blame.

Examples abound of good start-ups that are doing their work quietly, away from the media hype. Some are building world-class products and competing with the best in the world. Businesses like Urban Ladder and CaratLane are aimed at organizing fragmented markets to create online brands with positive unit economics.

The same can be said of some vertical e-commerce firms in the lingerie space or the social discovery platforms for fashion. If they are lean, these destinations will create sustainable value from aiding consumers discover merchandise.

Shuttl, I think, has found the perfect niche between poor experience with public transport and expensive cabs.

OYO Rooms, too, is actually filling a gap (assuming they will stop cash burn after having acquired their competitor).

In the financial technologies space, if you look beyond payments, there are sustainable opportunities in online insurance that are ripe for start-ups to disintermediate and pass control to consumers so that they may compare and transact.

And finally, there are start-ups that have been around for a while now, and that continue to innovate and maintain their market share and economics. BookMyShow is a case in point that is able to charge consumers by being super-convenient.

The new ones that come up for funding will have to answer some tough questions. The fact that you fail to raise your funding rounds may be a blessing; it will force you to think harder and come up with a solution that fits the Indian market and circumstances. And then you are ready to win.

(Disclosure: I have no interests in any of the examples quoted here.)

Read an unabridged version on www.foundingfuel.com

Haresh Chawla was founding chief executive of Network18. He joined the firm in 1999 when it had revenue of Rs.15 crore. When he moved out in 2012, he had built it into a Rs.3,000 crore media conglomerate. He is now partner at India Value Fund, and mentors several start-ups.

[“source-Livemint”]