We could consider price caps, independent valuations or conditional access to escrow funds for such public issues of equity
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.
These are the author’s personal views
Madan Sabnavis is chief economist, Bank of Baroda and author of ‘Hits & Misses: The Indian Banking Story’
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