The dark truth and reality of the tech startup’s IPO game in India

At the end of FY22 and right on the cusp of welcoming FY23 in December, Markets were buzzing with the record number of tech startups in India queuing at SEBI’s doorstep to seek approval to launch their respective IPOs in the new year.

This was excellent news for many, especially as the word recession was gaining ground around the world and it looked like India might be breaking through.

Why not? If so many tech startups went straight for SEBI’s approval, then it just might be the case, right?

Rather than answering this question right away, it is necessary to understand and decipher the actual IPO game and perform a reality check instead.

First, who are the groups behind startups when they are ready to make their debut in the market?

First and foremost are the venture capitalists, the all-important source of funding for any startup; the early stage investors, the founders themselves, the investment banks and finally the mutual fund managers.

With that being said, many of us retail investors will receive advice from financial advisors, planners, bankers, etc. or even ourselves as we do our financial planning to jump on the IPO bandwagon. It’s a good bet they say!

But the reality is that many of the tech IPOs in India are, and have become, nothing more than a “hype and dump” scheme.

Examples abound — Paytm, Zomato, Nykaa, Policybazzar — these four new-age tech stocks wiped out 55% of investor wealth in 2022.

Now, each of the four companies above has seen its stock plummet nearly 60-70% following their respective IPOs.

So what’s the common denominator that’s visible between these companies – they’re all unicorns, they’ve all launched their respective IPOs, each of their stocks have plummeted almost 50-70%, and their founders are one of the most visible figures, the a cult command the following.

But that’s where the thread ends, and the dark truth, unknown to the typical retail investor, is that at the time of the IPOs, many of the company’s founders and insiders were selling their shares or later, ending up making a lot of money for themselves.

So who really benefits in this crazy IPO game?

The founders, the early-stage investors or insiders, the VCs who can boost the company’s valuation, and the investment banks who launch the IPOs through the underwriting process.

But what happens to the small investors, you might ask?

Well, they’re the ones who can take all the risk and end up earning a pittance for investing in these overrated and overrated IPOs.

Here’s another very wired but crucial fact – if you were to review the PE rating of any of these loss-making companies and the outlook given by the fund managers.

One would note that the outlook is still bright in terms of the startup’s growth potential and the PE ratio is high.

Taking Nykaa’s example, the stock has fallen significantly from its peak, and yet it still has an impressive PE ratio of 995, almost 1000.

So, some of the critical questions to ask are:

1. Are IPOs in India Just a Pump and Dump Scheme?
2. If so, then how is the game actually brought on board?
3. What can retail investors do to protect their wealth?

Now we have to go back to the drawing board to answer these questions.

Every startup has early-stage investors; For example, in the case of Mamaearth, which recently went public and was overpriced, Shilpa Shetty is one of the early-stage investors.

Once the IPO is launched, it will be listed on either the NSE, BSE or both, and then retail investors can start participating.

Early-stage investors are attracted to invest in the concept phase of a startup. As they see the potential to double if not triple their invested money in these companies makes sense to them. Stay invested for a few months or over a few years, icing on the cake is if the company goes public through an IPO.

The Journey of Seed Money, Funding Rounds and IPO Debut.

We’ve all heard that a startup goes through many rounds of funding – seed money, Series A, B, C, or D rounds; This is the usual process, and with each round of funding, the company’s valuation goes up or up.

For example, going back to the example of Mamaearth, in January 2021 it was rated with the number “X”.

Let’s assume today that the valuation has become “3X”, so at the time of filing the papers for an IPO, Mamaearth – Rs. 400 crore IPO for Rs named Sequoia, which is also their early-stage investor.

Now companies like Sequoia or other early stage investors are required to invest and also bring in the mix of celebrities who endorse the company and make it more visible by acting as brand ambassadors to play the numbers game that is growing exponentially.

The company’s valuation thus increases with each round of financing. Eventually, it becomes an inflated asset, and after launching its IPO, it’s dumped on retail investors.

Now moving on to the second question – how do venture capitalists play the game?

The global economy grew quite well between 2006 and 2021, and the VCs also injected a lot of money into the companies.

So VCs became prominent during this period, but what do VCs do and what is their business model?

Let’s revisit Mamaearth’s example – one of which is seed funding, and as funding rounds increase, new investors are brought in.

Therefore, the valuation bubble continues to grow over and after each round of funding.

Now a question might come to mind: Why are new investors drawn in every time, and why do they buy and invest in such inflated valuations of a company?

The reason for this is that they know that new investors can be brought in and that the existing investors either have the choice to exit in the next round of funding, or they can wait for the IPO, then they can sell their shares to unsuspecting retail investors .

Another critical point is that most of these companies are focused on revenue rather than profit, which is a key aspect of this IPO game.

If you look at the DHRPs of these companies, you will find some highlighted aspects of the company – how the company has become profitable and therefore charges higher premiums, etc.

But if you were to determine what profit the company is making, you would find that it is actually making losses, but the expected PE ratio is completely skewed when IPOs start.

The model is relatively simple, no matter how much money the company burns, it’s not a problem as long as the company focuses on revenue.

The only thing that matters to VCs is a company’s growth matrix, or revenue growth matrix.

To further support this point, prior to 2020, companies like Byju’s, Zomato, and Paytm were only focused on revenue and had absolutely no intention of making a profit; Why?

Because it was all about allowing the bubble of overvaluation to continue to grow.

Because when the bubble grows, the early investors make the most money and thus benefit the most.

Second, the bubble would have grown to massive proportions by VCs by the last round of funding, and then they have to get out and make their money.

So what is the role of investment banks?

The investment banks take a privately listed company public where the shares can be bought or sold – and this process is called an IPO.

Large investment banks such as Morgan Stanley, JP Morgan and Goldman Sachs undertake the underwriting of an IPO-bound company. The higher the IPO price or the bigger the bubble, the more money they make in the underwriting process through commissions.

A simple example of how the overall game is played is as follows: The founder of the Politics Bazaar, Yashish Dhaiya, was willing to sell his shares in the company and he was asked at the time why he did so.

He replied that he had put all his money into the company and needed the money for “Kharcha Paani”.

The fact of the matter is that when most founders work at their company, they charge huge salaries in the millions; Therefore, the answer above does not adequately reflect reality.

Finally and the final stage are the mutual fund managers who are brought in by investment banks to sell the IPOs. They do this by advising their clients to buy shares in a company’s launched IPO.

As a result, we now have a much clearer picture of how the so-called loss-making tech startups are not only offloading their shares to retail investors, but making huge sums of money in the process for all parties — the founders, the VCs, the early-stage investors, the investment banks, and finally the equity investors. /fund manager.

So what can retail investors do?

• Be careful when investing in loss-making startups.
• Understand why an IPO is initiated; is to allow early investors an exit?
• Wait and watch the stock for at least a year to see how it performs in the market.