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D2C on the Upswing
A couple of months into the onset of the COVID-19 pandemic, the world seemed like a gloomy place for companies in the beauty, personal care, fashion, apparel and luxury segments. Many of these companies had decided to embrace the direct-to-customer (D2C) model by spending heavily on e-commerce sites, payment gateways, design and branding, advertisements and buying clicks on the internet. The tagline “all dressed up and nowhere to go” appeared to sum up the predicament of such companies. A year later and with two waves of the pandemic behind us, the D2C story has taken a remarkable turn for the better for all players involved, especially so in India. It is no secret that a country with a population of 1.3 billion and a heavily underpenetrated market in terms of e-commerce, presents an exciting field for D2C play. The overwhelming success of Nykaa’s IPO merely confirmed this.
The E-commerce Advantage
Technological developments in digital infrastructure, spread of internet access, rise in disposable income of consumers and the evolution of various fulfilment models have all contributed to the growth story of e-commerce in India. The rapid development of the ecommerce ecosystem, particularly in the backdrop of the COVID-19 pandemic, has disrupted traditional retail models and has paved the way for many D2C brands to enter the market. Late-stage private equity and venture capital investors in India are now more bullish on their investments in e-commerce than at any other time since the onset of the Covid-19 pandemic. As a result of which, numerous pure play D2C brands have emerged in the past few years across all product categories, including the fast-moving-consumer goods (FMCG) space and beauty, personal care and lifestyle space. Under the D2C e-commerce model, sales are typically made through e-commerce websites owned and controlled by the manufacturers themselves or through third-party e-commerce marketplace platforms. Irrespective, various D2C brands with sufficient capital and resources prefer a hybrid model with physical and online presence for better consumer outreach.
Foreign Investment Framework
Entities with foreign direct investment (FDI) should devise their retail trading strategy after factoring in the conditions prescribed under the current consolidated FDI policy (FDI Policy) and the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules), which inter alia prescribe entry routes, sectoral caps, investment limits, pricing guidelines, and attendant conditionalities. FDI up to 100 percent is permitted under the ‘automatic route’, in an investee entity which undertakes manufacturing activities by itself or contract manufacturing through a legally tenable contract (on principal-to-principal or principal-to-agent basis) in India. Investments under the ‘automatic route’ do not require prior approval of the Reserve Bank of India (RBI) or the Central Government. Further, the manufacturer is also permitted to sell its products manufactured in India through wholesale and/or retail channels, including through e-commerce, without Government approval. While the requirement of a Government approval does not apply to manufacturers with FDI who wish to trade their products to the retail segment, there are other conditions prescribed in relation to trading activities under the FDI Policy read with the NDI Rules which should be complied by manufacturers. These conditions have been dealt with below.
FDI in Trading Activities
Trading activities under the FDI Policy or the NDI Rules are classified based on the type of customers to whom the sale is made, the number of brands (‘single brand’ or ‘multi brand’) sold and the medium (online or physical) through which the sale happens. Entry 15 of Schedule I to the NDI Rules, which prescribes investment limits and conditions in relation to ‘trading activities’, further classifies trading into (i) Cash and Carry Wholesale Trading/ Wholesale Trading (WT); (ii) E-commerce; (iii) Single Brand Product Retail Trading (SBRT); (iv) Multi Brand Retail Trading (MBRT); and (v) Duty-free shops.
FDI up to 100 percent is permitted in business-to-business (B2B) e-commerce activities under the automatic route provided that such companies engage only in B2B e-commerce and not in business-to-consumer (B2C) e-commerce. The D2C model, typically, does not contemplate sales through wholesalers and relies primarily on e-commerce and social platforms to reach their customers. Therefore, it is pertinent to examine FDI conditions applicable to B2C ecommerce activities and retail trading, which comprises SBRT and MBRT. Further, FDI is not permitted in ‘inventory-based model’ of e-commerce, where the inventory of goods and services is owned by the e-commerce entity and is sold to the consumers directly. An entity with FDI can undertake SBRT activities under the automatic route only in relation to products pertaining to a ‘single brand’, where such products are branded during manufacturing, and sold under the same brand internationally, in one or more countries other than India. If such entity were to undertake MBRT activities, FDI in such entity will be limited to a mere 51 percent and that too under the Government route and shall also be subject to several other conditions related to (but not limited to) minimum investment norms, investment in back-end infrastructure, indigenous procurement and other conditions prescribed by the States and Union Territories.
Even if a manufacturing entity were to sell multiple brands under the D2C model, irrespective of the exemption from Government approval, manufacturing entities are required to adhere to FDI conditionalities stipulated in the NDI Rules which specifically prohibit companies with FDI from engaging in MBRT through e-commerce. An exception to this requirement is sale of fresh agricultural produce such as fruits, vegetables, flowers, grains, pulses, fresh poultry, fishery and meat products which may be unbranded.
Therefore, based on the above, a company with FDI, operating under the D2C model, cannot trade products through its own e-commerce marketplace platform, since such sales will be classified as ‘inventory-based model of e-commerce’, which is prohibited under the NDI Rules read with the FDI Policy. Further, such companies can sell products (manufactured or produced in India) only under a ‘single brand’ and not under multiple brands (apart from the products stated above), directly to consumers in India, through a third-party e-commerce platform, subject to conditions prescribed in relation to SBRT.
The FDI Policy allows companies operating through brick-and-mortar stores to engage in retail trading through e-commerce. However, if a company with FDI is directly undertaking SBRT activities through e-commerce, such companies will be required to open brick-and-mortar stores within two years of the commencement of online retail. Neither the NDI Rules nor the FDI policy clarifies the number of brick-and-mortar stores to be opened by such companies and or whether the brick-and-mortar stores should be used exclusively for retail activities. In the absence of an express stipulation, a presumption can be made that experience centres and marketing outlets may also satisfy the condition under NDI Rules to have brick-and-mortar stores. Further, companies with FDI in excess of 51 percent engaging in SBRT of products (in all sectors) will be compulsorily required to source 30 percent of the value of goods purchased from India, preferably from micro, small and medium enterprises, village and cottage industries, artisans and craftsmen. Initially, the requirement of domestic procurement will be computed as an average of the total value of goods procured over five years beginning April 1 st of the year of the commencement of the SBRT business (which will be the date of opening of the first store or the date of commencement of online retail, whichever is earlier). Thereafter, such SBRT entity shall be required to meet the 30 percent domestic sourcing norm on an annual basis. For a company having a manufacturing facility in India, the domestic sourcing requirement as discussed above should not be a challenge. However, the onus is on the FDI recipient entity to self-certify that it has met this requirement, which should be confirmed by statutory auditors based on the duly certified accounts maintained by the company.
The Promise is not without Pitfalls
Adoption of a D2C model allows brands to exercise greater control over quality, packaging and marketing of the products and gives them a better understanding of brand perception. From a revenue perspective, investors can expect higher margins as the involvement of middlemen such as wholesalers and retailers is eliminated. Although investment in D2C is an attractive proposition and there is a huge wave of interest among foreign investors in this space in India at the moment, the ambiguities in the FDI Policy and the NDI Rules concerning retail trading may act as a dampener if the Government does not act quickly to resolve these long-standing questions.
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