India is seeing a boom in private investments in e-commerce and technology startups and a large number of funds have invested billions of US dollars in such online companies. Most of these private equity investors are expected to exit their portfolio companies through share listings, putting a spotlight on the sector and the potential candidates for an initial public offering (IPO).
Bankers expect them to explore overseas markets, mainly the Nasdaq exchange in the US, due to various regulatory requirements in India as well as the difficulty in finding valuation benchmarks on exchanges on which no comparable rivals trade. This has also motivated startups to externalize their business models to offshore jurisdictions, particularly Singapore.
Taking the above into consideration the Securities and Exchange Board of India (SEBI) floated a discussion paper on an "alternate capital raising platform" as a next step to address the lacunae. Some of the implications that would be required to be considered in this regard are discussed below.
Key considerations:
Pre-tax operating profit: Regulation 26(1)(b) of the SEBI Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR Regulations), prescribes that a company may float an IPO if it has a minimum average pre-tax operating profit of `150 million (US$2.3 million), calculated on a restated and consolidated basis, during the three most profitable years out of the immediately preceding five years. SEBI's tight grip on profitability adds to the startup's woes before getting a nod for its IPO.
Lock-in restrictions: Under regulation 36(a) of the ICDR Regulations, the promoters are required to offer a minimum 20% of post-issue capital as lock-in for a period of three years. The lock-in provision ensures promoters' skin in the game for at least three years. However, many start-up companies that have flourished in recent times, and several which have also achieved scale, have a lower founding members' holding (often less than 20%) and a large institutional investors' holding.
Objects of the issue and basis of issue price: The ICDR Regulations require disclosure of the objects of the issue and the basis of the issue price, including the purpose of the issue, means of financing the project for which monies are proposed to be raised, proposed deployment status of the proceeds at each stage of the project, interest of promoters and directors, earnings per share, diluted earnings per share, price-earnings ratio, pre-issue average return on net worth, etc. Start-up companies are often loss-making and belong to sectors for which there are no comparable financial ratios available, which acts as a process limitation.
End-use restrictions: SEBI has prescribed restrictions on the ways companies can use their IPO proceeds and retains discretion to reject offer documents if a big chunk of the issuance is not allotted to creating tangible assets. Startups require funds for brand building (an intangible asset) and any regulatory restriction on this would defeat the purpose of their capital raising exercise.
Minimum post-issue paid-up capital requirement: The BSE (Bombay Stock Exchange) prescribes a minimum post-issue paid-up capital of the startup of `100 million for an IPO on the exchange. This may restrict the access of some startups to the BSE as a listing platform to raise capital.
The best alternative
One of the primary questions with regards to listing of startups concerns their ability to attract institutional investors and valuation issues. Given that technology companies have soaring valuations with deeper liquidity requirements, the debate revolves around whether a separate exchange for such start-up companies is needed or whether they should be allowed to list on the main board of the stock exchanges with easier norms. The issue is critical to address in view of the negligible activity in other specific platforms such as SME exchanges (for small and medium-sized enterprises) and institutional trading platforms, which have been unable to attract significant interest from the investor community.
The better approach would be to allow listing on the main board of these "alternative" companies with certain regulatory relaxations as against proposing an alternative platform.
A constructive move on this front in the nature of the proposed Startup Act which would address issues on delayed incorporation, cumbersome documentation, single window clearance would hopefully arrest externalization plans of the startups and take the government's ease of doing business initiative notches higher. The framework should ideally provide for adequate analyst coverage for the startups to target suitable investors for their stock.
In the US, the average tech company has around 20 analysts covering its stock. The aim should be surpass that number and provide an even better capital raising platform to Indian startups than Nasdaq. The proposed startup listing platform should ideally take this opportunity to address the entire gamut of issues from incorporation to exit listing.
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