The initial public offering (IPO) boom this fiscal year has been quite
amazing. There have been 181 issues of ₹1.64 trillion in
the first 9 months of the year as companies raised funds ostensibly for
investment purposes. As is the case with any boom in financial markets, the
regulator’s antenna goes up.
The use of funds was the first issue addressed by the Securities and
Exchange Board of India (Sebi); we now have guidelines to ensure that there is
no diversion of money raised. The other nagging issue was that almost half the
issues had quoted at a discount post listing, which is a concern as several
small investors have burnt their fingers. Should the regulator be concerned
about this?
The broader question is whether issuers with records of losses for three
successive years are pricing their IPOs appropriately. As a corollary, are
investors being taken for a ride by merchant banks that have priced companies
which are making relentless losses favourably based on some imaginary future
turnover and profit numbers?
For a listed company, a share issue is transparent enough. The past can
be researched before one decides whether or not the price is right. However,
for several first-time issuers, which include startups, we have no past record.
Companies that have made losses in the past three years cannot show
performance. But they have dreams that could look like reality to investors if
presented well by merchant bankers and spiced up with media interviews that
make startup stories so appealing that their offer prices could be ridiculously
high. This is where the regulator has a role to play.
Ever since the Controller of Capital Issues was abolished and free
pricing allowed of shares, it was the market that decided pricing. Startups,
however, are an enigma. They are mostly technology- driven, sell ideas in a
non-conventional manner, and loosely speaking do not have fixed assets to show.
They typically begin with venture capital (VC) investment. Losses pile up so
high that a conventional business with such a record would close down. But
these enterprises are sold to various private equity (PE) investors who find
value in the enterprise, and hence their shares change hands. Originators often
either move out of the business or start another venture. But they have made
their money by getting a good valuation. The transaction however remains B-2-B,
one with high net worth individuals operating through VC or PE funds. There is
inherently no threat of market disruption.
Now, conditions have changed. The government has given an impetus to
startups through an initiative that provides initial access to funds at a low
rate. Startups are supposed to generate entrepreneurs and also employment.
Therefore, several bright engineers and management graduates set up enterprises
that sound good but can’t generate profits in the medium run. The best way out
if one cannot find an investor is to go for an IPO.
The valuation is now left to an investment bank, which comes up with a
number based on expected future performance. This is accepted by investors when
the stock market is in a bull phase and not surprisingly gets over-subscribed.
Conventional metrics like earnings-per-share, price-equity ratio and
return-on-net-worth cannot be applied, as these are loss-making businesses. The
market is not always lenient, however, and that is why some of these issues
fail at the time of listing.
Sebi has rightly
pointed out that there has to be more transparency in the valuation process and
we need to have certain key performance indicators (KPI) that must be revealed.
But what can these be, given that conventional financial parameters will never
work for a consistently loss-making business? Here, maybe we should look at the
history of the promoters in other ventures. But first-time entrepreneurs would
be hard to evaluate this way.
Using a past valuation if there has been a transfer of ownership in the
past is another option. But what if this was overstated to begin with? Making
comparisons with startups in other geographies may again not be appropriate, as
conditions vary especially for such enterprises. For example, the prospects of
say a food-delivery service in India will vary from one in China or South
Africa. Therefore, drawing such similarities will be tough.
One way out it to cap offer prices. The advantage here is that the
market will finally decide the price, which will help investors in case there
is a price rise post listing; but the promoter will feel let down as the cap
would have worked against enterprise.
Another solution can be that a loss-making company issues shares in
tranches. The first one could have a price cap. But after a gap of one year
once the stock is listed, a second tranche can be raised the standard way
without regulatory intervention as investors would by then have the company’s
share price history to judge it.
Alternatively, a valuation should be done by Sebi-appointed agencies
independently, with the price being revealed to the regulator separately. The
advantage is that it will be an independent view and hence the conflict of
interest that exists between the merchant bank and its client will be lowered.
This seems like a plausible solution because the number of loss-making
companies getting listed will not be too high. The issuance cost will be high
for such a startup, but then, given the premium being demanded, it can be
absorbed.
The third option would be to hold the proceeds in an escrow account,
with the money released to promoters on the condition that projections made by
the merchant bank while evaluating their business materializes, with space for
a certain degree of deviation from those numbers. This will make IPO pricing
more realistic.
Sebi’s discussion paper on the matter is timely, given a new situation
of loss-making companies making merry at the expense of investors. Globally
too, it has been found that 80% of startups fail. With overpriced IPOs,
investors are left holding the can. This should stop.
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