SEBI’s New Guidelines for IPOs: A Welcome Move?

[By Ayush Hoonka and Akarsh Singh]

The authors are students at the School of Law, Christ (Deemed to be University).

Introduction

Over the years, the Indian capital market has undergone significant changes and has evolved over a period of time. This is especially true in regards to the equity segment of the capital market, where just the total market capitalization of the Indian equity market stood at 3.21 trillion dollars which makes it the fifth-largest equity market in the world.

This has been correlated with the rise of the Indian manufacturing sector, which contributed up to 17.4% to the Indian gross domestic product in the year 2020. This has also been correlated with the massive rise of the Indian technology sector, which has been the engine driver of growth of the Indian economy, contributing 8% to the total gross domestic product in 2021 while reaching a peak of 9.5% in 2015. As a result, there has been a rise of early-stage start-up companies being incorporated in the country and ultimately going public through the traditional initial public offering or the IPO route. As a result,  81 IPOs were offered in the time frame between 2020 and 2022, raising almost 1.52 lakh crore, according to a KMPG study.

The performance of most of the new-age start-ups has been less than ideal as shares of stocks such as Paytm, Zomato, Policy Bazar, and Nykaa have plunged 61%,49%,49%, and 46%, respectively, compared to their all-time highs at the time of listing according to data compiled by Bloomberg. Further, this has also correlated with the fact that these companies were primarily “growth stocks” which are yet to achieve maturity in the market regarding their cash flows and business models. This has also led to the Indian capital market regulator, i.e., the Securities and Exchange Board of India (SEBI), floating a consultation paper that proposed that the companies justify their valuation at the time of going public through an IPO, and subsequently, the auditor advising the company to verify the valuation being proposed by the company’s management through key performance indicators.

Analysing the Consultation Paper

The new proposed rules by the SEBI’s Primary Market Advisory Committee (PMAC) not only want start-ups to reveal their price to earnings multiples (PE ratio) and earning per share (EPS ratio).

They also want disclosures and revelations in regards to key performance indicators (KPIs) which venture capital firms use, angel investors as well as private equity firms as a means and a measure to decide whether the newly found start-up is worth investing in.

The KPIs are not just supposed to be traditional financial yardsticks to judge a company according to its competitors but also include metrics such as subscriber growth, market penetration since inception, and future expected growth rate. These metrics are further proposed to justify their valuation, which would further be audited by an accountant or an auditor with which the firm registers. Furthermore, SEBI also wants the companies to declare the correspondence between the venture capital firms, angel investors, and private equity firms during their fundraising in regards to these key performance indicators prior to them being listed through an IPO route.

The proposal aims to disclose the key performance indicators (KPI) of the preceding three years prior to the company being listed and also wants the listed entity to compare the KPI with other new-age start-up firms across the globe in an effort to get a sense of whether the company’s valuation is justified or not. The objective of the proposed disclosure is that newly formed technological start-ups or growth stocks normally are not profiting in terms of their cash flows, especially when going public. As seen recently in the case of Delhivery being listed, these growth stocks usually prioritize gaining economies of scale, economies of scope, and competitive dominance in the marketplace as a means to achieve growth. This has been true historically for the past 20 years. One prominent example is Amazon, whose founder Jeff Bezos has always prioritized future long-term growth over short-term financial returns. This also requires good capital budgeting and investment decisions, which vary among companies in terms of their business model.

Response from the Industry

After the SEBI, in its recent consultation paper, has proposed that all the upcoming new-age technology companies have to justify the pricing of their shares at the IPO, the industry has not welcomed this move. The proposal aims to bring transparency so that the investors do not suffer. This idea was proposed due to the meltdown in the four recently listed stocks.

However, these proposed rules will make it challenging for the new-age firms to list themselves. Another important thing that the new-age technology companies have to take care of is that the company’s auditors should have audited all the information they are providing to SEBI. The SEBI has also asked the companies to inform about the price-to-earnings ratio, how the valuation of shares is done, and how the price per share is decided. The reason behind this is that SEBI wants to understand how the price of a share is fixed.

SEBI, at the moment, asks the companies to disclose their earnings per share, price-to-earnings ratio, return on capital, and return on net worth. However, the new-age technology loss-making companies do not earn any profits; therefore, it would not be possible for them to disclose these as these cannot be applied to the loss-making companies. Therefore, these companies would have to disclose KPIs additionally. These KPIs are valuation based and dependent on the past transactions done by the companies. They are not validated by the companies and are mostly tracked internally. However, if these indicators have to be submitted to SEBI, the act would not be welcomed by the industry as the valuation of these indicators is a lengthy process. If these stringent norms are applied, it will hamper the growth of the companies.

Analysis and suggestions:

Although the disclosures that the SEBI is discussing are being done in good faith and taking into consideration the interest of the retail investors, there is a grey area in such instances.

This is especially true when bureaucrats try to influence the valuation of listed companies in the public markets as these companies are supposed to be valued by the investors in the public market, rather than being asked to justify their valuation by the regulatory agencies,

Furthermore, it has been well documented by various business schools such as Wharton and NYU Stern that the valuation of a company involves art as well as science and there is not an objective answer when it comes to the question of what exactly is the intrinsic value of a public company.

Furthermore, regulations should not be an obstacle for privately held companies to either delay their process of going public or entirely scrap their plan altogether. The recent case of Pharmeasy and OYO hotels serves as a point where the two companies’ draft red herring prospectuses (DRHPs) were asked to disclose more information regarding KPIs which leads to significant delays in their transition from the private market to the public market where in the former there is a significant emphasis on growth while the former focuses upon profitability, this has prevented the eventual gradual evolution and transition of the company due to higher and unnecessary level of scrutiny.

NASSCOM has also submitted a response to the Consultation Paper presented by SEBI. In its response, it has suggested that SEBI must be careful in linking KPIs to the issue price of the company as KPIs are dynamic in nature and they evolve with time. They are not constant and are volatile. NASSCOM has further suggested that SEBI should give a proper guideline about the information which has to be disclosed to SEBI. Not all companies use KPIs; therefore, it should lay down proper guidelines about how the KPIs are calculated and how it is helpful for the investors.

Further, NASSCOM has also suggested that it should not be compulsory for the companies to disclose KPIs to SEBI for the first few years. The companies should not be forced to inform SEBI about the KPIs for the initial years as a new framework is required from SEBI, which informs the companies about the KPIs in each sector. It has also suggested that the disclosure of KPIs by the companies to the SEBI should be based on the reports which are made by the third-party entities to ensure there is no bias.

Concluding remarks

In conclusion, the ideas floated by SEBI have both pros and cons and issues surrounding their implementation. The proponents of the consultation paper would argue that this would impose restrictions and liability on the companies not to overvalue themselves during the DRHP and instead value the company according to macroeconomics and industry trends rather than unfairly valuing them at a premium for a no-given reason at all.

An adversary of the said consultation paper, on the other hand, would argue that the said disclosure requirements regarding KPIs would, in fact, make the capital market a less pleasant place for companies in an effort to acquire additional funds through retail and institutional traction and would disproportionately target growth stocks while shifting the discretion in regards to valuation from the companies and its accountants to bureaucrats.

The authors are of the opinion that excessive interference by bureaucrats in the functioning of markets in regards to their valuation would be detrimental to the whole aspect of a free-market economy where valuations are supposed to be decoded by market participants rather than regulatory or governmental agencies. It is in the best interest of all the stakeholders to have a public market where valuations are justified by the participants of the public markets rather than the company itself. It is also extremely important to ascertain that the valuation of a company does not have an objective answer and is a dynamic, evolving concept that takes into account various market-based factors.

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