What An IPO Prospectus Isn’t Telling You Clearly
The Securities and Exchange Board of India has gradually moved to a disclosure-based regime from a rule-based one as part of the regulator’s policy shift to manage the affairs of the capital markets.
In that time, issuers and bankers appear to have mastered the art of masking facts in a disclosure-based regime.
In the seven months of the current financial year, issuers raised Rs 69,848 crore through public issues, at a pace that would surpass the Rs 74,707 crore raised the last financial year. A highlight has been the listing of new-age companies in the current year.
Amidst this rush, IPOs are increasingly being used to facilitate exits for existing investors versus a dominant share of the issue coming in as fresh capital for the company. In July, SEBI Chairman Ajay Tyagi observed that the proportion of offer-for-sale is higher than primary issuances or fresh fundraising in recent issues.
While the market regulator is grappling with the issue of minimum public shareholding versus minimum public float requirement, there is a bigger issue with SEBI’s current disclosure-based regime. A process of merely ticking all the boxes is leading to a failure in ensuring SEBI’s policy intent is enforced.
These shortcomings are playing out even as the market witnesses meteoric valuations being assigned to new-age companies.
Do these new-age firms have a solid basis for the valuation they get in today’s market? It is the demand for these companies that is determining the IPO price, grey market price, and subsequent listing price. While there may be market forces at play in this process, what the investor ends up paying is a ‘fear of missing out’ premium for a new age company or platform that continues to make losses while its valuation jumps multi-fold between the time it files its draft red herring prospectus application and gets to the IPO, through fundraising done over in the previous 3-12 months.
To reiterate, the disclosures are present but not in a format that allows investors to easily understand the company and valuations.
The market value of the company is a product of its price and total outstanding shares. The price is determined by the investor feedback during roadshows undertaken by the company and its bankers in the run-up to the IPO.
The RHP approved by the market regulator requires a company to have its share capital history. All IPO prospectuses—whether draft or final—have this disclosure.
However, what is missing is a simplified disclosure by companies of funds raised either subsequent or close to the IPO, through complex instruments.
To illustrate, companies often issue quasi-equity instruments which require to be converted into equity shares at the time of an exit or an IPO. These convertible instruments are generally in the form of preference shares, subsequently converted into equity shares. In most cases, these preference shares (the exact kind could vary) are converted in a 1:1 ratio. So far, no issue. But that changes in the outcome of the conversion which is not disclosed fully. The final price arrived upon conversion is often not clearly disclosed in the prospectus. Complicating the investor’s valuation visibility further is a slew of stock splits and bonus actions by the company. These disguise the price and how the valuation of the company moved along with the share capital history.
Imagine a fund-raise via optionally-convertible redeemable preference shares that have a face value of Rs 100. These first get converted into equity shares at a pre-determined conversion ratio; then go through a stock split to bring down the face value to Rs 2 or Rs 1; then undergo a bonus which could be as high as 499 shares for every one share held. At the end of it, the price per share for the fundraise is not disclosed, nor is it clear what the company was valued at during that last fundraise.
After all that, the company runs a standard disclosure that it may have raised funds at a price lower than IPO in the last year, without disclosing the price.
Why shouldn’t the regulator direct all issuers to provide the price on an ex-corporate action basis that is comparable to the IPO price? Why should the regulator not insist on companies disclosing a company’s valuation at the time of a preference share issuance or primary issue to any party in the previous 12-18 months? Mere disclosure of ex-price history, along with share capital history, is a sufficient disclosure for investors to look at the issue price objectively.
Among the most important disclosures in the red herring prospectus are the risk factors. Companies mention a long list of risk factors but fail to disclose the materiality of those factors. Like in the case of a recent quick-service restaurant IPO, the company mentioned the renegotiation of its franchise agreement with the brand owner and the requirement of launching new stores in a financial year. However, what was not disclosed was how many stores the company is required to open every year, even though it mentions that they will receive concessions on achieving the store opening targets.
Many companies mention the absence of any long-term supplier agreements but fail to disclose the sensitivity analysis due to changes in raw material costs, etc. on their profitability.
ESOP Valuation Report
Most new-age companies have an employee stock option scheme in one form or another. The disclosure provides details of the scheme, the eligible employees, and at what price it is offered. But what is likely missing is the fair pricing of the ESOP shares and its impact on the company’s financials. As per the requirement, the fair price of the shares needs to be determined before providing the ESOP to the employees. A company can provide the ESOP to the employee at a discount to fair value, but it should then disclose the price differential on exercise price and fair value, and the impact that will have on its profit and loss statement. These disclosure exercises are often undertaken only after listing, to not impact the the profitability projects made in the prospectus. If that is the case, then the materiality of the ESOP accounting expense should be disclosed to the investors before listing. Why is the regulator not asking the issuers to disclose the fair value of the shares vested to the employees and material impact on financials during the period of exercise of ESOPs?
Fair Valuation Report
Almost every company has made a primary share placement in the run-up to its IPO filing, or during the transitory period of approval. This exercise not only provides funds to the company, but also serves as a hop, skip, and steep jump to a high valuation so that it doesn’t look optically appear as too steep a jump in valuation made without a proportionate rise in the company’s fundamentals.
Every time a company carries out a preferential issue before coming to the market, it is required to undertake a valuation exercise from a certified chartered accountant or valuation firm. These valuation reports are required to be submitted or uploaded on the website of the Ministry of Company Affairs / Registrar of Companies. In most cases, the valuation is undertaken on a discounted cash flow or DCF basis and the share value is arrived at based on this valuation.
Why is SEBI not asking the issuer to disclose the entire valuation report as part of the prospectus? Let investors know how these companies were valued pre-IPO by investors.
It has been observed that wherever the promoter stake is likely to fall below the 50% mark or the strategic benchmark of 26%, there is a likelihood of an issuance to the promoter ahead of the IPO. In some instances, this is being done on a rights basis at a discounted price. In this, the existing investors do not participate, and the promoter ends up acquiring the shares in the rights issue to either offload existing unlocked shares to earn a quick profit or raise fresh funds for the company without diluting much stake. In other cases, the company makes a preferential issue to the promoter at just half the IPO valuation just because promoter shareholding is required to be locked in as per SEBI mandate. The only disclosure that is available on this is the price at which the rights or preferential issue took place with details of the same, hidden in the ‘*’ as part of the fineprint.
It is observed that there is an increasing tendency to undertake small value transactions to push up the valuations ahead of the IPO and if it is disclosed, it is fine. Well, the regulator should say it is not fine and should not allow the existing investors or promoters to use the IPO route to exit easily.
The regulator needs to look closely at IPO disclosures because this new chapter being written—How to Get Away With IPO Valuations 101—is not good for the capital markets.
Sajeet Manghat is Executive Editor at BloombergQuint.