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Some start-ups may be too big to fail

LiveMint logoLiveMint 09-03-2017 Ashish Pandey

Something snapped recently in the start-up fairy tale. Snapdeal, Craftsvilla and Yepme announced employee lay-offs while Stayzilla suspended operations. The All India Online Vendors Association and eCommerce Sellers Association of India requested members to stop selling on the Snapdeal platform, citing credit risk. There is an ongoing conflict between the mobile application-based taxi aggregators, Ola and Uber, and their drivers. Even drivers in the National Capital Region and in Bengaluru have resorted to a strike. Uber’s Bengaluru office was vandalized by the protesting drivers. 

Sceptics have questioned the business model of certain start-ups for a long time but their viability does not deserve wider concern. These firms were started by entrepreneurs and funded by professional investors, both parties being fully aware of the risks and uncertainties involved in disruptive business models. The issue that should concern us is the impact of the failure of certain start-ups on the broader ecosystem. Did we unknowingly create Frankensteins in start-ups that are “too big to fail”? 

If Ola and Uber reduce their incentives further, what will be the impact on drivers who purchased cars using bank loans? How will banks deal with a high inventory of repossessed cars of similar make? What will be the effect on the public transport system when there is a sudden increase in passenger load? How smoothly will retailers navigate the journey from the brick-and-mortar channel to the online channel and back? How will retrenched employees convince prospective employers that they will remain committed and satisfied at a much lower salary? Will the concurrent failure of multiple businesses taint India’s reputation as an investment destination? These may be uncomfortable questions but they are certainly not irrelevant.

Business cycle booms, asset bubbles and investing fads exhibit similar characteristics across geographies and time. They divert precious human resources from the traditional sectors of the economy and mis-allocate capital. Both, the Dutch Tulip-mania in the 17th century and the US housing bubble in the 21st century, consumed a wide cross-section of skilled population and capital. In the mid-1630s, Holland famously went wild about tulips. Bloemisten, those who grew and traded in tulips, were more important to the Dutch economy than any productive sector. Similarly, in the early 2010s, the US was consumed by a housing mania and house flipping became a national pastime. 

History shows that none of these “enterprising” businesses was financially viable and the economic contractions that followed their failure were indeed painful. There was a contagion effect that had an impact on businesses which may not even have appeared related to the booming sector of the economy at first glance. 

Our reliance on a laissez-faire economic system where private actors control the use of property in their own interests with the invisible hand of pricing-levels coordinating supply and demand may be misplaced in the context of emerging business models. There is limited information available to the general public about emerging business models which impairs their decision-making ability. The lack of information and the absence of an established market framework means misinformation is easily percolated and gullible stakeholders are effortlessly enlisted. 

Well-defined capitalism is a system of indirect governance for economic relationships, where markets exist within institutional frameworks and safeguards established by governments. Markets coordinate supply and demand with the help of the invisible hand while government coordinates the modernization, safety and stability of market frameworks. 

The Indian government must think about these issues and reconsider its policy framework in the context of emerging business models. It needs to consider whether to establish a fund under its start-up policy that pays out retailers and suppliers if an e-commerce platform fails. It should deliberate on whether firms need to make a minimum level of disclosures regarding the variability of incentives, in an easy-to-understand language, when contracting partners. 

The concerns related to predatory pricing and their effect on the competitive intensity in the market micro-structure need to be investigated and followed with a policy prescription. The banking regulator should analyse the differential risk involved in evaluating the persistence of income based on fees or compensation derived from start-up firms and issue an advisory, if needed. Transportation authorities should be aware of the consequences of Uber’s and Lyft’s departure from Austin, Texas, and should have a contingency plan in place. 

The government has a distinct role in modernizing frameworks while keeping in mind the implicit costs and benefits for the broader ecosystem. It cannot abdicate that responsibility. Regulatory policies and supervisory practices must respond to business model innovations and help prevent feedback loops to minimize the damaging effects on the economy. The government need not intervene in individual cases but should have the willingness to intervene in the event of systemic crises. It must promote a policy framework that internalizes the third-party costs imposed by emerging business models, so that the costs and benefits will only affect the parties that choose to incur them.

Ashish Pandey is founder and managing partner of Quadrature Capital.

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