The Dark Truth And The Reality Of The Tech Startup’s IPO Game In India

At the end of FY22 and right at the cusp of welcoming FY23 in December, the markets were abuzz with the record number of tech startups in India lining up at the doorstep of SEBI to get approval for launching their respective IPOs in the new year.

For many, this came as excellent news, especially since the word recession was gaining ground globally, and it seemed that India might scrape through.

Why not? If so many tech startups were making a beeline seeking SEBI’s approval, then it may just be the case, right?

Instead of answering this question right away, there is a need to understand and decode the actual game of IPOs and do some reality check instead.

Firstly, who are the groups standing behind startups when they are readying to make their debut in the market?

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

Having made this clear, many of us retail investors are advised by financial advisors, planners, bankers, etc. or even by ourselves if we do our financial planning to jump on the IPO bandwagon. It is a good bet, they say!

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

Examples of the same are many – Paytm, Zomato, Nykaa, Policybazzar- these four new-age tech stocks wiped out 55% of investors’ wealth in 2022. 

Now each of the four companies mentioned above, the stock crashed almost by 60-70% after their respective IPOs.

Hence, what is the common thread that is visible between these companies – they are all unicorns, they all launched their respective IPOs, each of their stocks crashed almost 50-70%, and their founders are one of the most visible personalities commanding a cult following. 

But this is where the common thread ends, and the dark truth emerges unknown to the typical retail investors is that at the time of the IPOs, many of the founders and the insiders of the company sold their stakes or subsequently and hence ended up making a massive amount of money for themselves. 

Hence in this crazy game of IPOs, who in reality benefits?

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

But what happens to the retail investors, one may ask?

Well, they are the ones who take all the risk and end up with pittance to show for investing in these overhyped, overvalued IPOs. 

Here is yet another very wired but crucial fact – if one were to check the PE valuation of any of these loss-making companies and the outlook given by fund managers. 

One would find that the view in terms of the startup’s growth potential is still rosy, and the PE Ratio is high.

Let us take the example of Nykaa, the stock has crashed substantially from its peak, and yet it commands 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 yes, then how is the game actually put on board?
3. What can retail investors do to protect their wealth?

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

Any startup has early-stage investors; for example, in the case of Mamaearth, which recently came out with its IPO and was overpriced, Shilpa Shetty is one of the early-stage investors. 

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

Early-stage investors are drawn to invest at the conceptualising stage of a startup. Since they see the potential of doubling, if not tripling, their money investing in these companies makes sense to them. Staying invested for a couple of months or over a few years, the icing on the cake is if the company debuts on the stock market through an IPO.

The Journey From Seed Money, Rounds of Fundings and IPO debut.

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

Returning to the example of Mamaearth, in January 2021, it was valued at, say, “X” number.

Today assume the valuation has become “3X”, so at the time of filing the papers for an IPO, Mamaearth – Rs. 400 crore IPO on an Rs. 24000 crore valuation, which is the valuation given to Mamaearth by a company called Sequoia, which is also their early stage investor. 

Now companies like Sequoia or other early-stage investors are roped in to invest and also throw in the mix of celebrities who back the company and make them more visible by acting as brand ambassadors, all to play the number value game which increases exponentially. 

Thus, with each round of funding, the company’s valuation keeps going up. Finally, it becomes an overinflated asset, and after the launch of its IPO, it is dumped on retail investors.

Now coming to the second question – how do Venture Capitalists play the game?

The world economy, between 2006 to 2021, was growing reasonably well, and the VCs were also pumping in a lot of money into companies. 

Hence, during this time, VCs became prominent, but what do VCs do, and what is their business model?

Let us retake the example of Mamaearth – one is seed funding, and as the rounds of the funding increase, new investors are brought in.

Hence, the valuation bubble keeps growing over and after each round of funding. 

Now a question may pop into the mind: why are new investors brought in each time, and why do they buy and invest in such pumped valuations of a company? 

The reason is that they know that newer investors can be brought in and that the existing investors either have a choice to exit in the next round of funding or they can wait for the IPO, which is when they can offload their shares onto the unsuspecting retail investors. 

Another critical point is that most of these companies focus on revenues, not profits, which is an essential aspect of this IPO game.  

If you take a look at the DHRPs of these companies, you will find several highlighted aspects of the company – such as the company has become profitable and hence commands higher premiums etc.

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

The model is relatively simple, no matter how much cash the company may be burning, it is not a problem, just as long as the company keeps its focus on revenues.

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

Hence, to further substantiate this point, companies like Byju’s, Zomato and Paytm pre-2020 were only focusing on revenues and had absolutely no intention of making any profits; why?

Since the only intention was to keep growing the bubble of overvaluation.

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

Secondly, by the last round of funding by VCs, the bubble would have grown to massive proportions, and that is when they need to exit and make their money. 

Now, what is the role of investment banks? 

The investment banks bring a privately listed company to become publicly listed on the stock market, where the stocks can be bought or sold- and this process is called IPO.

Big investment banks like Morgan Stanley, JP Morgan, and Goldman Sachs do 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 straightforward example of how the overall game is played is this – the founder of policy bazaar Yashish Dhaiya was all set to sell his stocks in the company, and he was asked at the time why he was doing so.

He responded that he had put all his funds into the company and needed the money for “kharcha paani”.

Now the fact is that most founders, when they work in their company, command huge salaries running in crores; hence the above answer is not adequately portraying reality.

Finally and the last stage is the Mutual Fund Managers, who are brought in by Investment Banks to sell the IPOs. They do so by advising their clients to pick up stocks of the launched IPO of a company. 

Hence, now, we have got a much clearer picture of how the so-called loss-making tech startups are not only dumping their stocks on retail investors but, in the process earning vast amounts of money for all parties- the founders, the VCs, the early stage investors, the investment banks and finally the stock/ mutual fund managers. 

 Hence what can retail investors do?

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