Do You want to Find the Next Amazon? Think Like a VC

'Is Zomato worth buying now'?

That was the query being posed in a WhatsApp friends group. Not to me, but to another who used to work at a senior position at in a rival food tech company.

But this person, despite being an insider in the industry, had no idea. Neither about the valuations, nor about how long it might take to make profits.

Over the last few months, you've heard my views on the internet economy and the IPOs of platform businesses.

We might have looked wrong when some of these IPOs, priced to perfection in the first place, got listed with superb gains.

But with the slightest correction in the market, some of these much hyped IPOs have halved in value.

The almost free fall in these stocks is a revelation for anyone who blindly fell for the tech narrative, without analysing it well.

It's not just the global market sentiment. If you deep dive into the results of some of these businesses, the deterioration in their key performance indicators for some is hard to miss.

For instance, Zomato's contribution margin that turned positive just ahead of the IPO, has dropped from 4.6% (in the prospectus) to 1% now. There is also a decline in average order value since. And the cash burn continues.

As if the food tech itself wasn't tricky enough to value, potential investors have another task - to assess the economics and viability of these businesses.

What makes all this is worse is lack of announcement of a call with investors and analysts.

Now it's easy to dismiss Zomato and the like citing myriad issues including cash burn and losses. Some of these businesses could leave a permanent sour taste in the mouth of even their staunchest proponents.

That said, Amazon, Alphabet, Microsoft, Tencent, the most valued companies in the world have digital platforms as the core of the business models. Some of these have been loss-making for years.

As such, despite the challenges, this space is worth tracking. It promises to offer a platform winner.

We are lucky to be analysts and investors at a time when this movement is in its infancy, as far as listed space is concerned. While the opportunity is big, so are the risks.

On the top of all this, it doesn't help that financial statements are not a real reflection of the value in these companies. To track and assess the potential in these stocks, conventional tools are of little help.

So how do we assess the opportunity and the risks in this business model?

Let's first understand what a digital platform business is...

Platform businesses are often aggregators, a marketplace or facilitator that brings suppliers or producers to consumers.

This reduces friction and creates value in the ecosystem. And once the business reaches a particular scale, the platform gets to monetise it.

A typical platform business model has a network effect. This means value of the platform for its users increases as more users join it.

What makes WhatsApp so popular is the number of people that are on it.

A platform like Zomato will attract more customers if it has more restaurants listed on it. More active users on Zomato versus a competitor further incentivise more restaurants to list on Zomato.

And just like that, a virtuous feedback loop is formed, where growth in the business becomes automatic to some extent.

Similarly, for a platform like Ola, availability of more drivers will attract more ride hailers on that platform, because of lesser wait times. Again, more active users on Ola will further offer more business opportunities to drivers. And at certain scale, this will become a self-feeding loop.

Once a particular scale is reached, the platform has to incur lower investments for incremental growth. Exponential growth and profits usually follows.

This is because a platform does not have to own the assets or produce goods itself to meet the need of growing customer base. For instance, Ola doesn't have to own any cars. Oyo does not own hotels. Zomato doesn't own any restaurants.

Not All Losses Are Bad

Until the business reaches this particular scale where the growth is self-sustainable, it burns money.

And that's fine.

You see, the expenses in developing the platform and technology, and to acquire users or suppliers or both are all front ended.

Monetisation happens at a later stage. After a critical mass is reached and the network effect kicks in, exponential growth in revenues and profits follows.

As such, financial statements do not capture the value of a platform that is still growing and is yet to attain a critical mass.

If you want to invest in a future Amazon, you need to evolve from being a conventional analyst to having a VC (venture capitalist) like approach.

VCs are the investors in early-stage businesses, mostly in the unlisted space. When they make their bets, it's not on the past performance or profits. Most businesses they invest in are loss making. And it's fine with them.

What they bet on is not profits, but on how scalable the platform is. If they think the platform has the potential to be biggest in its niche, they don't mind burning money.

Given the network effect, platform businesses follow the principle of winner takes all.

At most, there could be two players that win. The entry or presence of a third player leads to pricing wars and discounts. This makes the road to monetisation longer in which everyone loses.

It's no wonder that we often see the weakest players getting acquired by the top platforms. For instance, Zomato acquired Uber Eats in India.

So if you have to get into the minds of VCs, you need to think of not revenues and profits and capital invested, but Total Addressable Market, often called TAM.

Why is this metric critical?

In the best case scenario, a business can have a 100% market share. Its peak revenues could be limited to the TAM. Its profits and cash flows will follow that level.

For instance, if you're looking at Car Dekho i.e. Car Trade, and comparing it to a US peer, you should be aware the TAM for used cars in India is US$220 bn. But in the US, the TAM is US$800 bn.

Before VCs invest, they identify niches where growing scale and a potential monopoly, can lead to a huge profit opportunity. In this scenario, the cash burn could be justified.

TAM is like a top down approach, starting with the size of the total opportunity.

What follows next is the assessment of user based metrics.

I'll write to you about this in my next edition of Profit Hunter.

Stay tuned!

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure