Why are retail investors investing in new Loss-making IPOs, understand the risk before you decide to invest in IPOs, 4 key factors

Why are retail investors investing in Loss-making IPOs, understand the risk before you decide to invest in IPOs, 4 key factors

It’s IPO (Initial Public Offering) season again, and several of India’s unicorns are thinking about turning public. Because money is being raised for companies that many investors are familiar with, these IPOs have piqued investor interest. It’s tempting to want to be a part of a company’s transformation from zero to hero.

The Sensex has more than doubled since last year’s March lows in 2021, indicating a booming bull market. Unsurprisingly, we saw a fury of IPOs last year, with 49 main-board IPOs earning a staggering Rs. 1,01,053 crores from investors. Many startups have used this likelihood to present themselves to the common public.

Tech startups like Zomato, Paytm, Nyka, and PB Fintech have taken the market by storm, raising more than 38,000 crores, accounting for 38 percent of all offerings so far this year. Street’s imminent IPOs of Internet companies like MobiKwik, Ixigo, PharmEasy, and RateGain Travel are highly expected.

However, the Fact that most of these digital companies are loss-making distinguishes them from other companies getting ready to go public. For the quarter ending June 2021, Zomato, Paytm, and PB Fintech, stated losses of Rs. 356 crores, Rs. 381 crores, and Rs. 110 crores, respectively. MobiKwik’s loss levels increased by 11% to Rs. 111 crores in 2021. Even though these companies are losing money, retail investors were looking forward to bidding and participating in these IPOs.

What happened with Paytm’s IPO is evident to all. Despite the Fact that Paytm’s shares are always falling and the company is booking losses, the common public is still set to average down their shareholding.

When a trader buys an asset, the price reduces, and if the trader buys more, the price drops even more. This is known by the term averaging down. It’s termed averaging down since the asset’s or financial instrument’s average cost has decreased.
On March 17, 2022, Ashneer Grover tweeted @Paytm

Stock is a screaming BUY! It’s valued at $7B; Funds raised itself is $4.6B; Cash in
The hand should be $1.5 B. So at a CMP of ₹600, the market is saying value created is
$5.5B after spending $3.1B over the last ten years. That’s less than the Bank FD
Rate. BUY !!

The share price has fallen from Rs. 1950 in Nov 2021 to Rs. 522 by March 24. Still, Bharat pay’s founder suggests buying Paytm shares to the common public.

A few years ago, it seemed that OLA and UBER had destroyed the need to buy a
car for most people. You could book a cab anytime, and it would reach you under
a few minutes- no questions asked. But over the past year or so, the effects of
the unsustainable business strategies employed by these cab companies seem to
have had consequences.

Initially, these companies were burning Cash by giving fat incentives to the drivers and
large discounts to the users, which meant that the driver was happy and so was
the user/rider.

While the unlimited VC money burnt to gain Network Effects. The Network effect in the Case of a cab company means, the more drivers on the platform, the higher the number
of the riders and the more riders on the forum, the higher the number of the
drivers. This was achieved by burning Venture Capitalist’s Money. 

The end aim was probably to get the company listed so that VCs can make big fat returns from public money before the problems of this strategy shows up.

Rising fuel prices have not helped these companies.

Paytm’s IPO has pretty much destroyed the hopes of selling a loss-making company to the public at inflated valuations based on the number of users.

Such a strange scenario raises a number of issues, including

(1) Why are tech companies with tremendous growth potential and a positive future outlook and still, losing money?

(2) Why are Are investors so interested in tech IPOs that are losing money?

(3) What factors should an investor keep in mind before investing in a loss-making company’s Initial Public Offering? Let’s start by calculating out why these IT companies are losing money. The main reasons for such big losses are

(i) high labor acquisition costs,

(ii) expensive sales promotion charges, and

(iii) high technology acquisition costs

To keep competent staff, startup companies must pay higher salaries and provide
better bonuses and benefits. Employee expenditures sum up for 71% of RateGain’s overall income, and these expenditure raised by 11% from FY19 to FY20.

To reach diverse client categories, tech startups must incur strong sales and promotion
costs. MobiKwik spends over a third of its operating revenue on business promotions. Policy Bazaar revolutionized the insurance sector by providing users with faster, more convenient, and transparent digital options for handling claims and providing ancillary financial services.

The insurance sector in India has always been an offline business that depends greatly
on Personal Trust and interaction.

The main reason for investment in Loss-making IPOs

Another the important aspect that has to be realized is retail investors’ eagerness to
make an investment in loss-making IPOs. According to the SBI data, 14.2 million new
Retail investors have entered the equities market because fixed deposits and
good savings plans no longer appeal to them, a viable investment option.

Their desire for bigger profits has led them to make an investment in tech IPOs. They don’t want to lose out on the Indian digital unicorns that provide practical and convenient solutions to the immense Indian market through great user interfaces.

Furthermore, many tech startups have received multiple rounds of investment from Venture Capitalists, causing their valuations to skyrocket.

Some investors believe in the Digital India story, which includes increased internet and smartphone penetration, and hence don’t want to lose out on a valuable company.

Another group of investors is only looking for a way to profit from the company’s
listing, and hence aren’t in real dedicated towards it. Overall, it seems that
Indian retail investors are consuming a potent mix of FOMO (Fear of Missing
Out) and greed.

Is there a logical way to assess a loss-making IPO? 

Profits are used in traditional Valuation approaches. Investors should be aware that these tech startups are not the same like usual manufacturing and service businesses. They are asset-light companies that use creative digital solutions to disrupt the sector.

They spend a a lot of money to gain and keep their market share, even if they are growing quickly. As a result, investors who participate in IPOs that are losing money
must understand that they are investing in potential rather than profit.

Thousands of startups have shuttered their doors for every Amazon-like story.
So, how can start-potential up’s be assessed fairly? Meaning, Management, and
Moat is the three Ms that determine a firm’s potential. The startup’s business
should, first resonate with one’s own. One must learn about the industry in which it operates and the start-unique up’s solutions.

Understand risks properly before you decide to make an investment in IPOs

Just because these showy new companies that have seen unusual growth in the past do not ensure that they will continue to do so in the future. When evaluating these businesses, there are a few factors to keep in mind.

1. Evaluate prices on listing day

On the day of the first Public Offering, these stocks may rise higher due to the
tremendous amount of retail demand. However, if you look at the history of many
IPOs, you’ll notice that Initial profits don’t always convert into long-term success.

Furthermore, because of the way IPOs are divided, individual investors may not receive enough shares in their accounts to build considerable wealth. When people see the stocks move up quickly on the first day, they may be influenced into believing that the stock is on the rise and, accordingly, they may be enticed to purchase more in the secondary market—that is something to be wary of.

It is preferable to make an investment based on fundamentals rather than looking at either someone else has benefited from a company.

2. Reason for going public

A the corporation is soliciting capital for a reason. Occasionally, the monies gained are used to expand the underlying firm. However, in many situations, especially for new unicorns, the main aim of going public is to provide current investors and stockholders a way out. These stockholders are usually important institutional funds and firm personnel. These are some of the world’s sharpest investors, with a thorough understanding of their own business. No one outside the company would know much like they do about the company’s future prospects.

Everyone wants to maximize their earnings. Thus these IPOs are meticulously priced to
maximize profits for current shareholders and in addition merchant bankers. Sure,
they probably be mistaken, but an investor must evaluate what value they bring to
the table and what insights they have that the promoters and current shareholders have ignored. Is this advantage, though, enough to allow new investors to profit from their investments?

3. Reason for Growth and profits:

Many new unicorns have risen to prominence in recent years being a result of burning money and Offering discounts. Profits are often put on the back burner, and corporations are, in reality, losing money. Shareholders in public companies, on the other hand, have
different expectations than private investors. Profit and Growth are expected by public shareholders. However, many of these companies are finding it difficult to move away from freebies and generate income. Furthermore, removing discounts will have an important influence on Growth. Investors don’t have to go far like Uber in the United States, where we’ve seen it again and time again.

Although this is not true of all companies, and it is crucial to be aware of the dynamics
that alter when a business goes public and the impact it probably have.

4. Timing of IPO

Why are all of these Initial Public Offerings happening at the same time? Each unicorn
operates under a unique business strategy. Is it a coincidence that all of these unicorns have suddenly realized that now is the moment to take their firm public? Is it possible that many of their existing investors believe the stock market is frothy and that they can make the most money now rather than a few months down the road? They probably be wrong, but it’s something to think.

Startups have a high innovation Factor, making it appealing to want to be a part of their
success story. After all, we’ve all heard that it’s important to know what you’re investing in. But there’s a difference between understanding a firm and being able to decide whether you can profit from being a part of its narrative. As a result, a retail investor should seriously evaluate where his or her competitive advantage rests. Some people may still believe that they have a thorough understanding of the subject and that they may profit from it.

However, for most people, it is preferable to avoid the hype, diversify, and
delegate investing to Expert managers or basic low-cost passive funds.

SEBI Proposes a New Disclosure Framework For Loss-Making Companies’ Initial Public Offerings (IPO)

SEBI, the the market regulator suggested that loss-making new generation technology
businesses wishing to list their shares disclosures in Offer documents relating to the main performance parameters used to determine the issue price.

Furthermore, before publishing draft Offer documents, such businesses should display
their values based on fresh share issuance and acquisitions in the last 18 months, according to a consultation paper.

Much new age enterprises that do not have a track record of producing an operational profit for at least the last three years are turning to the Initial Public Offering (IPO) route to seek funding.

Such businesses are more probable to be loss-making for a longer length of time before
breaking even, since they focus on extending their operations rather than producing profits in the early years.

Traditional factors like important accounting ratios are at present displayed in the
‘Basis of Issue Price’ part of an Offer document. This accounting statistics include the company’s earnings per share (EPS), price to earnings, return on net worth and net asset value, and a comparison of such accounting ratios with its rivals.

These factors, according to Sebi, are usually descriptive of profit-making enterprises and do not apply to a loss-making company. These characteristics may not be helpful to investors when deciding whether to make an investment in a loss-making firm.

“It is self-evident that disclosures in the ‘Basis of Issue Price’ section, specifically for a loss-making company, must be supplemented with non-traditional parameters like key performance indicators and disclosure of a few additional criterion like valuation based on past transactions/fund raising by issuer company,” Sebi wrote in the consultation paper.

Apart from providing financial ratios in accordance with current regulations, Sebi has
recommended that the issuing company additionally display the Key Performance
Indicators (KPIs) that were considered/have an influence on the ‘Basis of Issue
Price’.

During the three years leading up to the IPO, an issuer business should provide relevantly KPIs, and an explanation of how these KPIs contribute to the ‘Basis of
Issue Price.’During the three years leading up to the IPO, an issuer business should provide relevant KPIs and an explanation of how these KPIs contribute to the ‘Basis of Issue Price.’

However, for those KPIs that the issuer believes are irrelevant to the proposed IPO, the
issuer shall Offer an enough explanation with a cross-reference to a table containing
the relevant KPIs.

A company’s KPIs should be articulated and defined correctly, constantly, and accurately,
and they should not be deceptive. Furthermore, statutory auditors should certify or Audit all KPIs. Furthermore, Sebi has recommended that comparisons of KPIs with Indian listed peer companies and/or globally listed peer companies (where available) be included in the Offer document, and the explanation of comparisons over time.

Aside from KPIs, it has been recommended that an issuing company display its value based on secondary and main sales in the 18 months before to the DRHP/RHP filing
date. This is conditional on either the acquisition or sale of at least 5% of the issue
firm’s fully diluted paid-up share capital in a single transaction or a series of transactions in a short period of time.

In relation to the valuation of an issuer firm based on secondary sales or acquisitions of
shares, and main or fresh issues of shares, Sebi has recommended that the floor price and cap price, multiplied by the Weighted Average Cost of Acquisition (WACA) be published in a tabular format.

Sebi in addition stated that an issuer firm should provide a detailed explanation for the Offer price, and a comparison of the issuer’s KPIs and financial ratios, such as EPS, return on net worth, and net asset value for the last two full financial years and any Interim period included in the Offer document.

The the regulator stated in the consultation document that this would allow investors to
compare KPIs and other financial parameters for the same time.

Here are the key changes recommended:

Key Performance Indicators

SEBI has suggested that the issuing must display disclosures on the main performance metrics of the business on which the Issue price was determined, in addition to the financial ratios. The following information may be asked from the company: During the three years leading up to the IPO, display all KPIs discussed with an pre-IPO investor. Give a rationale for the KPIs they don’t think are important for the IPO.

The company’s information should be thoroughly stated and stated. Auditor certification would be necessary for all KPIs. Comparisons of KPIs with Indian or globally listed peer companies (if applicable) and comparisons of KPIs overtime should be provided in the Offer document.

Past Transfers/allotments

Before publishing draft Offer documents, the the market watchdog has asked that new-age technology businesses display information relating to their values based on fresh share issues and acquisitions in the last 18 months. This is subject to circumstances when the purchase or sale in a single or multiple transactions equals or exceeds 5% of the issuing firm’s fully diluted paid-up share capital. The recommendations were made after SEBI find out that many new-age companies do not have a track record of
operational profit for at least the last three years and are relying on an
Initial Public Offering to gain capital.

The consultation document stated, “Such enterprises often stay loss-making for
a longer period before hitting break-even since they choose for strategies to
develop the scale of operations rather than profits in the first years.”

A thorough understanding the industry, business, and goods will help you to carry out
a thorough study and be eager about investing in it. As an investor, you must confirm that the tech startup’s management is clever and trustworthy.

It’s important to take the time to assess management’s history, plans, and before success. The safety of your equity Investment is ensured by stable and progressive management. Finally, the tech startup must have a moat or a distinct competitive advantage that not only secures future Growth but makes it tough for competitors to take market share.

To summarise, while investing in such loss-making IPOs is fraught with risks, doing one’s study and being judicious with both the amount of fund invested and the length of time invested should allow an investor to turn this into a profitable Venture. “When you find a truly strong firm operated by first-class people, chances are a price that seems high isn’t excessive,” Warren Buffett said. Because the combination is so rare, it’s well worth
the money.”

edited and published by nikita sharma