We must correct IPO pricing for startups with no profit records

The utilization 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 the money raised. The other troubling issue was that nearly half of the issuances were quoted at a discount post-listing, which is a concern as many small investors have burned their fingers. Should the regulator be concerned about this?

The broader question is whether issuers are properly pricing their IPOs with three consecutive years of loss records. As a consequence, are investors being taken along for the ride by merchant banks, which are priced at companies that are consistently making losses based on some hypothetical future business and profit numbers?

Share issue is very transparent for a listed company. One can research the past before deciding whether the price is right. However, for many first time issuers, including startups, we have no previous record. Companies which have incurred losses in the last three years cannot show performance. But they have dreams that could seem like reality to investors if presented well by merchant bankers and peppered with media interviews that make startup stories so compelling that their offering prices are ridiculously high. There may be more. This is where the role of the regulator comes into play.

Ever since the control of capital issues was abolished and free pricing of shares was allowed, it was the market that decided the pricing. However, startups are an enigma. They are mostly technology driven, sell ideas in a non-traditional way, and don’t have the fixed assets to show off the obvious. They usually start with venture capital (VC) investments. The losses are so high that a traditional business with such a record would be shut down. But these ventures are sold to various private equity (PE) investors who find value in the venture, and so their shares change hands. Promoters often either go out of business or start another venture. But they have earned their money by getting good valuations. However, the transactions remain B-2-B, with high net worth individuals operating through VC or PE funds. Naturally there is no risk of market disruption.

Now, the conditions have changed. The government has encouraged startups through an initiative that provides early access to funds at a low rate. Startups are entrepreneurs and job creators. Hence, many bright engineers and management graduates have set up ventures that look good but may not make profits in the medium term. If one is not getting investors then the best way is to take 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 bullish phase and not surprisingly over-subscribed. Traditional metrics such as earnings-per-share, price-equity ratio and return-on-net-worth cannot be applied because these are loss-making businesses. However, the market is not always generous, and this is the reason why some of these issues fail at the time of listing.

SEBI has rightly said that there should be more transparency in the evaluation process and we need some Key Performance Indicators (KPIs) which should be disclosed. But what could these be, given that traditional financial norms will never work for a business that is consistently making loss? Here, perhaps we should look at the history of promoters in other ventures. But it will be difficult for first-time entrepreneurs to be evaluated in this way.

Another option is to use the past valuation if there has been a transfer of ownership in the past. But what if it was exaggerated to begin with? It may again not be fair to compare with startups in other geographies, as the conditions are different especially for such enterprises. For example, the prospects for a food-delivery service in India will be different from one in China or South Africa. Therefore, it would be difficult to draw such parallels.

A way to limit offer prices. The advantage here is that the market will eventually set the price, helping investors in the event of a post-listing price hike; But the promoter would feel disappointed as this limit would have worked against the enterprise.

Another solution could be to issue shares in instalments to the loss making company. The former may have a price range. But once the stock is listed after a gap of one year, the second tranche can be raised in the standard manner without regulatory intervention as by then the investors will have the share price history of the company.

Alternatively, valuations should be carried out independently by SEBI-appointed agencies, the price being separately reported to the regulator. The advantage is that it will be an independent approach and hence the conflict of interest that exists between the merchant bank and its customer will be minimized. This seems like a plausible solution as the number of loss making companies listed will not be very high. The issuance cost would be higher for such startups, but then, given the premium being demanded, it could be absorbed.

The third option would be to hold the proceeds in an escrow account, with funds issued to promoters on the condition that the estimates made by the merchant bank when valuing their business, with room for deviations to some degree from those numbers . This will make IPO pricing more realistic.

In view of the new situation of loss making companies to have fun at the cost of investors, SEBI’s discussion paper on this matter is timely. Globally also, it is found that 80% of startups fail. With a high-priced IPO, investors hold on to the can and let it go. It should stop.

These are the personal views of the author

Madan Sabnavis is Chief Economist, Bank of Baroda and author of ‘Hits and Mrs: The Indian Banking Story’.