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SEBI’s new IPO norms: A window into start-ups’ performance and prospects

Sandeep Parekh

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Co-authored with Sudarshana Basu, Associate, Finsec Law Advisors

The last couple of weeks have been marked with massive market volatilities and corrections following an anticipated hike in US Federal Reserve interest rates,foreign-portfolio-driven outflows, and the ongoing Russia-Ukraine conflict. Coupled with the investor losses of the much-awaited IPOs of new-age technology companies such as Zomato and Policybazaar, rising concerns and investor skepticism over the profitability of such companies have compelled SEBI to undertake a review of the present norms for IPO pricing and provide a more realistic view of the future of such companies.

In this regard, a consultation paper was floated by SEBI in February, which proposes to mandate more disclosures and strive for further transparency from new-age technology companies. The idea is not to regress to a 1988-style merit-based system, where a bureaucrat decided the pricing and size of an IPO, but to improve the quality of disclosures so that investors can make a more informed decision.

At present, the Sebi (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations) require companies to disclose metrics forming ‘basis of issue price’ such as earnings per share, price to earnings, return on net worth and net asset value of the company as well as a comparison of such accounting ratios with peers. However, as per Sebi, such traditional metrics are typically applicable to profit-making companies and are inadequate performance indicators for new-age technology companies.

The regulator recognises that such companies are primarily loss-making entities for a longer period until they break even as they typically aim for scale overprofits. This makes it difficult and inappropriate for retail investors to view them through the same lens as well-established industries. In fact, over the past year, almost all IPO listings of technology start-ups have witnessed a higher IPO valuation than in the pre-IPO stage, only for such companies to trade well below their issue price post listing.

The proposed rules in the consultation paper, which are based on the recommendations of SEBI’s Primary Market Advisory Committee, suggest that the disclosures of existing “basis of issue price” metrics should be supplemented by disclosure of non-traditional parameters and any other key performance indicators (KPIs) shared with pre-IPO investors at any point of time during the three years before the IPO, to justify the pricing of its shares in the IPO.Such companies would also be required to explain in detail how these KPIs contribute to the issue price.

Further,to lend more credibility to such disclosures and ensure that the KPIs disclosed in the offer documents are not misleading, the KPIs would also have to be certified by a statutory auditor. The companies would also be required to compare their KPIs with their listed peers in India and overseas.

Additionally, the proposed rules, if implemented, would require companies to disclose the valuation of their shares previously purchased or sold in secondary markets over a look-back period of 18 months before the filing of the offer documents with SEBI. In this regard, the consultation paper proposes disclosures of weighted average cost of acquisition of both primary issuance and secondary transactions. Issuers would also be required to disclose the rationale for offer price being (x) times of the primary issuance or secondary transaction price.

The above proposals would ensure that investors have a clear idea about the company’s past performance and the company’s ability to fulfil estimated projections.This would also eliminate any potential unfair IPO valuations, especially in light of recent times where some start-ups have reported sky-high valuations.

The year 2021 witnessed landmark fund raising, of more than $17 billion, with most of the IPOs oversubscribed. Considering rising consumer demand, issuers need to ensure that investor confidence and participation in equity markets are sustained. Further, Sebi’s dual role—to protect investors and promote securities market development—would require it not only to ensure that such valuations are fair and transparent but also, at the same time, avoid excessive scrutiny of IPO pricing.

As the above-proposed rules would apply to companies that have not profited for the three years preceding the IPO, it would better equip investors to make informed investment decisions about such companies and balance all stakeholders’ interests.

Often, apart from consumer demand, industry comparables, growth prospects, etc,constitute key parameters for an IPO valuation. Since media hype and favourable demand could potentially sway investors in relation to the performance of a company’s shares, notwithstanding the actual fundamentals, reviewing offer documents containing key financial information has long been considered as a legitimate basis for making investments.

However,some new-age technology companies employ alternate performance metrics such as number of subscribers and sign-ups, website traffic, etc., which means that the existing parameters may not provide a clear insight into the company’s performance to prospective investors. Moreover, reviewing the financial statements of new-age digital start-ups is a challenge faced by many investors,especially since such information is usually not available in the public domain.

To prevent such information asymmetry and to ensure that investors have access to all relevant information, the above recommendations have been proposed. Infact, shorter lookback periods of three years and 18 months, for disclosures of KPIs and pre-IPO valuations, respectively, would ensure that despite fast-paced technological advancements, investors have an accurate picture of the company’s past performance and future projections before investing.

The proposed recommendations also become increasingly relevant at a time when the Indian securities market has seen maximum participation of retail investors in IPOs. Given that recent market corrections have wiped out much of these gains,a review of the current issue pricing norms is welcome. In fact, with a few other technology start-ups looking forward to tapping into the capital markets,an upgrade in disclosure requirements in offer documents in line with technological advancements is overdue.

(This article was first published in Financial Express)