Last week, fintech company Zerodha invested ~INR 2.5 Cr in options trading company Sensibull.

Since its inception 8 years ago, Zerodha has been an intriguing watch.

The company operates as a "discount brokerage", a stockbroker that takes very low commissions from trades its executes. The evocative nature of its name, of its close to zero fees, has also made it a target for brokers entrenched in the market.

Brokers have historically been trusted investment advisors for retail investors, who tend to be unsophisticated. These brokers provided advice over and above trading on behalf of their clients and hence took fairly sizable fees.

The advent of technology has resulted in algorithms doing trading, advice and stock picking, which subsequently hammered fees. Commission rates have dropped from 1.2% in the 80s to ~0.1% today. This has resulted in a field day for discount brokers, like Zerodha.

Zerodha, though, is going after a bigger game.

India is an emerging market and has one of the lowest retail investor participation in the world, standing at 4.45%. The US, in contrast, has almost 50% participation.

In India, the definition of retail participants are those whose investment in a year is less than $3K. There is thus huge headroom for growth, and therefore customer acquisition.

Retail participants in India are estimated to do a daily turnover of ~$1.5Bn. Assuming the $3K number is correct, the ~50MM retail investors have a wealth of $150Bn invested that gets turned once every 100 days ($150Bn/$1.5Bn).

India's growing per capita income and retail participation would be a double booster for this market. This, of course, is a fairly rosy picture. The SEBI has been for years trying to increase retail participation and is looking at an 8% participation in the next few years.

As a VC would say, SEBI has a customer acquisition problem, and needs a few startups to solve it.

Brokers, at their small scale, have had a hard time acquiring customers. This is because relationships between the brokers and their clients are built offline.

With the advent of the internet, trading (and traders) began to move online, while the relationship still remained offline. What do we think happens to an industry stuck in an older business model, fragmented but still large?

It gets "disrupted".

Bringing the advantage of technology to trading, and the internet to acquire customers, Zerodha set out to build an internet first trading platform.

The CEO of the company says, tellingly "my initial customers were initially online, and the pricing model grew out of this".

With no requirement to have a live broker, to execute trades or give advice, the company has literally no cost to execute a trade. This allows lowering the price per trade and, importantly, make pure margin per trade.

Taking a leaf out of e-commerce's "deep discounting", Zerodha thus lowered fees to a flat INR 20 per trade, instead of commission percentages.

This incentivized higher volume through Zerodha. Brokerage firms with fixed costs (i.e. broker salaries) per trade felt the heat, and many would have shut down in the process.

According to the company, Zerodha now does roughly $2Bn of daily trading through its platform and has close to a ~1MM users. Assuming 50% of users actively trade every day, you have 500K active users doing $2Bn of trades.

That is $4K per day, much higher than the retail investor daily trade volume. This indicates that the kind of investors on the platform are largely sophisticated, and not only retail.

The company now claims it is the 3rd largest brokerage, doing 2MM trades a day.

This implies, on average, an active user does 4 trades a day. It disclosed it was doing 200 Cr ($30MM) of revenue last year, and assuming 80% of the 2MM trades are at INR 20, the company is likely at an annual run rate of 2*0.8*20*240 = 770 Cr ($110MM), an almost 5x jump in revenue. That can also be seen in its active user growth, which has gone up 5x as well.

We are now starting to get a sense of what kind of machine Zerodha is.

How do we understand unit economics and customer payback? In FY 2017, it did profits of 120Cr (net profit % of ~50%), and one would guess it maintains the same profit margin going forward.

If Zerodha makes pure margin on its trades, where is it spending? Employee costs and customer acquisition i.e. marketing. The company has ~850 employees, and spent INR 390Cr in expenses (50% of profit). Assuming the average salary to be INR 1.5MM, that would put the total cost at ~INR 130Cr ($8MM).

Let's say the remaining was spent on marketing, which is ~260Cr. The company went from ~100K users to ~500K users, and therefore added ~400K users. The customer acquisition cost (CAC) was therefore INR 260Cr/400K = ~INR 6,500 (or ~$100). For a customer that does 4 trades daily, i.e. 80 INR, it would take 80 days (~6500/80) to be profitable on its customer.

Zerodha, therefore, has a customer acquisition cost payback of as little as 3 months!

The real magic sauce for Zerodha, though, is its customer stickiness. Trading is a trust business, and once traders trust you, they rarely leave.

While Zerodha may have a fairly high CAC (given the value of traders), it would have a phenomenal lifetime value. Customers are likely to rarely leave, and beyond the 3-month payback mark, Zerodha makes pure profit on the customer.

It is little wonder that Zerodha has had to ever raise money.

The business has been raising capital every year from its longtime customers, through profits. Its older customers are funding the acquisition of its newer customers.

The art of bootstrapping a business to this scale is marvellous, and it is incredibly hard to do so. The real challenge for the company, though, would be continuing to add customers.

To keep growing, the company either needs to make people trade more, or add more people. This would involve a lot of market education, and add true "retail investors". It is an interesting and challenging way ahead.

Will Zerodha be able to scale its money-making machine?