STARTUP & ENTREPRENEURSHP

LAW

NAME: CHARU SINHA

PNR: 21010122106

SEMESTER: FOURTH

SESSION: 2021-24

CLASS: LL. B

TEACHER: PROF. SHIVANI RAJESH

PROF. SHWETA SINGH

WORDS : 1400
 TABLE OF CONTENTS
INTRODUCTION.............................................................................................2

ISSUES......................................................................................................................2

CRITICAL ANALYSIS..............................................................................2

CONCLUSION...................................................................................................2
INDIAN UNICORNS’ FAILURE IN INITIAL PUBLIC OFFERINGS-
THE AGENCY RISKS OF STAKEHOLDERS & SEBI’s ROLE

INTRODUCTION

In 2023, a sinister spectre haunts the start-up ecosystem in India- it is the association of
overvalued unicorn companies1 and their ubiquitous failure in IPO valuations. Investment in
technology startups in India declined by 17% in the first half of 2022 2

The frenzy that accompanies the subscription of the unicorn IPOs in undeniable with
statistics indicating 150-200x subscription. Retail investors have no idea regarding the Draft
Red Herring Prospectus or the business model or the fundamentals of the start-up as long as
they are backed in valuation by reputable hedge funds from US or China. Much to the
chagrin of these investors most of these unicorn IPOs have a 30-40% difference between
issue price and listing price. The difference was 55% for Zomato and 54% for Policy Bazaar. 3

The startup valuation process, in itself, involves complex and non-transparent methods of
valuation. The traditional valuation methods are difficult to deploy due to the novel and
nascent technology development which makes forecasts of profits onerous. Earlier valuation
meant either intrinsic or relative valuation through the present value of the future cash flows
by perusing growth models.4

1
Mazhar Mohammad , Beware! Unicorns have a habit of failing in public markers. Here’s why, ECONOMIC
TIMES, (7 March 2023 ; 6:45 P.M.)
https://economictimes.indiatimes.com/markets/ipos/fpos/beware-unicorns-have-a-habit-of-failing-in-public-
markets-heres-why/articleshow/84398461.cms
2
Ibid
3
Binu Paul, Zomato, Nykaa, Paytm led the IPO boom in 2021 but failed. Can the tide turn?, BUSINESS
TODAY, (8 March 2023, 11:45 A.M)
https://www.businesstoday.in/magazine/bt500-indias-most-valuable-companies/story/a-bevy-of-start-ups-
rushed-to-nab-sky-high-public-market-valuations-of-2021-but-flopped-what-lies-ahead-355358-2022-12-06
4
Kimberly Gleason, Yezen H. Kannan, Christian Rauch, Fraud in startups : What stakeholders need to know,
Vol 29 Issue 4, Journal of Financial Crime (2022)
Thus, when preparing for an IPO the focus is much more on getting a good price for the exit
of investors and minimal on whether the valuation will sustain post-IPO. Thus, VC firms can
can be dubbed as market opportunist rather value creators in terms of business. 5 Besides, the
incentive structure of a private equity investor and public market investor are in juxtaposition.
VC firms have deep pockets and they are, seldom comfortable writing off even hundred
percent of investments. Whereas, public market relies on financial statements for gauging
future earnings from their shareholdings. 6 The phenomenon of Poor IPO performance is not
limited to Indian startups but extends to foreign markets as well especially in the U.S. For e.g.
there was much hype before the listing of Uber, We Work, Door Dash etc. but their
valuations and stock prices tanked from supernormal highs to sub-normal lows. This prompts
a deeper structural problem in the way startups are re-financed successively in different
Series Rounds and finally through ‘pump and dump’ scheme, the public has to suffer from
the IPO reality check of losses. 7

CRITICAL ANALYSIS

RISKS TO STAKEHOLDERS : VENTURE CAPITALISTS, REGULATORS &

PUBLIC
VC FIRMS
Due to lack of cash flows/ profitability, high cash burn rate and investment in research and
development in the early stage of a start-up, paying dividend on equity or interest on debt is
not possible. This makes the exit of a Venture Capital(VCs) firm the only opportunity to
seize Return on Investment, which it can do through – a.) Initial Public Offering – VC can
sell their stake to public by stock market listing ; b.) Management Repurchase- The founder/

5
Game of IPOs : The sizzle and fizzle of internet companies, FORBES INDIA, (15 March 2023 ; 7:50 P.M.)
https://www.forbesindia.com/article/take-one-big-story-of-the-day/game-of-ipos-the-sizzle-and-fizzle-of-
internet-companies/78227/1

6
Sunil Sanghai, Two Caveats for start-up planning IPOs in 2023, THE ECONOMIC TIMES, (11 March 2023 ;
5:20 P.M.) https://economictimes.indiatimes.com/markets/stocks/news/2-caveats-for-startups-planning-ipos-in-
2023/articleshow/96851606.cms?from=mdr
7
Ibid
entrepreneur purchases VC stake c.) Mergers & Acquisitions d.) Refinancing – through sale
to a bigger institutional investor. 8

Therefore, there is an agency risk between VCs and the start-ups they finance due to the
information asymmetry. Thus, it is imperative to assess factors which have a strong
correlation for a successful exit such as syndication ( co-investing in alliance with other
VCs) and Specialization(e,g high technology/ FinTech)9

SEBI’s STRICTER IPO COMPLIANCE

SEBI has mulled over the prospect of amending rules for IPOs for greater accountability of
public fund deployment for non-specific purposes ; to limit the same. For e.g. many
companies propose to raise funds under object head of ‘Inorganic Growth Initiatives’, i.e. to
raise fund for unidentified future acquisitions and strategic alliances. However, SEBI
suspects this to mislead the retail investors by not providing full disclosure regarding usage of
IPO proceeds.10

A disconcerting trend has been observed in the non-observance of transparency in IPO

pricing, which is based on their valuation. Currently, there exist no third-party independent
institutions which can verify the underlying valuation of the company form which IPO is
priced.11 There have been serious doubts raised with respect to the pricing and valuation
methodology perused by banks of companies.12

8
Kshitija Joshi, Deepak Chandrashekhar, IPO/M&A Exits by Venture Capital in India : So agency Risks
Matter? Asian Journal of Innovation and Policy, 534-563, (2018)
9
Ibid
10
Samie Modak, SEBI proposes stricter IPO norms as startups listings gather pace, BUSINESS STANDARD,
(8 March 2023, 3:40 P.M.)
https://www.business-standard.com/article/economy-policy/sebi-proposes-stricter-ipo-norms-as-startups-
listings-gather-pace-121111601397_1.html
11
Rajeev Gupta, Why SEBI has failed to check IPO overpricing in India? (12 March 2023 ; 5:22 P.M)
https://timesofindia.indiatimes.com/blogs/myview/why-sebi-has-failed-to-check-ipo-overpricing-in-india/
12
Game of IPOs : The sizzle and fizzle of internet companies, FORBES INDIA, (15 March 2023 ; 7:50 P.M.)
https://www.forbesindia.com/article/take-one-big-story-of-the-day/game-of-ipos-the-sizzle-and-fizzle-of-
internet-companies/78227/1
 ISSUE SIZE, DEMAND & ‘WINDOW OF OPPORTUNITY’
Through empirical analysis of Indian companies’ IPOs, it has been established that IPOs
which are in high demand and carry reputed management teams have higher
survivability and are less prone to failure. Contrarily, companies with very high initial
returns have slim chances of survival. 13 Further, evidence shows that ‘issue size’ which is a
proxy for the resources at disposal, matters in survival of IPOs. Firms with deep pockets and
superabundant resources are shielded from the reverberations felt during private to public
ownership transformation.14

A market boom attracts a barrage of firms, with weak key performance indicators, as there is
an opportunity window fuelled by the ‘hot new issue’ euphoria. However, a reversal in
economic cycle, exposes weak links in the market to austere market conditions ; Ergo hazard
of failure is high.15

However, two caveats will assure a successful IPO in 2023 :

1. Companies which have robust fundamentals i.e. debt-to-equity ratio, financial
leverage, price-to-earnings ratio etc. will be spearheading the market such as high
technology companies.
2. Only those companies which have tenable valuations would be able to signal market
readiness for IPOs

CONCLUSION

The survivability and long term-success of a start-up IPOs depends on the sustainable
growth of the VC industry by deepening the existing ecosystem through a backward linkage.
Due to the high failure rate of early stage startups, there is a general disinclination of growth
in VC firms in India vis-à-vis global contemporaries. By virtue of, VC firms’ appetite to take

13
Garima Baluja, Balwinder Singh, The Determinants of Survival of Initial Public Offerings in India : An
empirical Study, Vol. 11 Issue 4, 7-30, IUP Journal of Financial Risk Management, (2014)
14
Ibid
15
Ibid
on a high risk- high reward investment they should be assisted by the regulator in exiting
startups through IPOs. 16

Additionally, a SEBI regulation related issue stems from the extremely arduous process of
listing of technology driven startups which have no track record of profitability as a metric
for their viability since their business model differs from traditional businesses.
Unfortunately, profitability is a measure roadblock for listing on Indian bourses. Further,
without listing in India they cannot access capital via overseas exchanges. 17 For comparison,
China allows direct listing of their VC backed national companies in foreign stock exchanges
which makes them more competitive. The overall sentiment for Ed-Tech, Fin-tech and
Enterprise Tech is positive and shall continue to attract investors but in the coming time
instead of an IPO, private companies may decide to alternate funding schemes such as
18
Venture Debt and Convertible Notes Most importantly, it is essential that all stakeholders
are apprised regarding the financing structure of the start-up as part of its market readiness
for an IPO.

16
Kshitija Joshi, Deepak Chandrashekhar, IPO/M&A Exits by Venture Capital in India : So agency Risks
Matter? Asian Journal of Innovation and Policy, 534-563, (2018)
17
Ibid
18
Samie Modak, SEBI proposes stricter IPO norms as startups listings gather pace, BUSINESS STANDARD,
(8 March 2023, 3:40 P.M.)https://www.business-standard.com/article/economy-policy/sebi-proposes-stricter-
ipo-norms-as-startups-listings-gather-pace-121111601397_1.html
 REFERENCES

1. Michael Ewens and Joan Farre-Mensa, The Deregulation of the Private Equity Market
and the Decline in IPOs, Vol 33 Issue 12,The Review of Financial Studies, 5463-5509
(2020)
2. Rajas Saroy, Ashish Khobragade, Rekha Misra Sakshi Awasthy, Sarat Dhal, What drives
Start-up fundraising in India, RBI Bulletin January (2023)
3. Khanindra Ch. Das, Indian Startups (2016-2021) What lies ahead?, BIMTECH Business
Perspectives, (2022)
4. Kimberly Gleason, Yezen H. Kannan, Christian Rauch, Fraud in startups : What
stakeholders need to know, Vol 29 Issue 4, Journal of Financial Crime (2022)
5. Kshitija Joshi, Deepak Chandrashekhar, IPO/M&A Exits by Venture Capital in India : So
agency Risks Matter? Asian Journal of Innovation and Policy, 534-563, (2018)
6. Ravi Kiran and Rohini Inder , Price Performance of IPOs in Indian Stock Market, 2022,
Vol 30 Issue 4 Euro Economica, (2011)
7. Garima Baluja, Balwinder Singh, The Determinants of Survival of Initial Public
Offerings in India : An empirical Study, Vol. 11 Issue 4, 7-30, IUP Journal of Financial
Risk Management, (2014)
8. Mazhar Mohammad , Beware! Unicorns have a habit of failing in public markers. Here’s
why, ECONOMIC TIMES, (7 March 2023 ; 6:45 P.M.)
https://economictimes.indiatimes.com/markets/ipos/fpos/beware-unicorns-have-a-habit-
of-failing-in-public-markets-heres-why/articleshow/84398461.cms
9. Binu Paul, Zomato, Nykaa, Paytm led the IPO boom in 2021 but failed. Can the tide
turn?, BUSINESS TODAY, (8 March 2023, 11:45 A.M)
https://www.businesstoday.in/magazine/bt500-indias-most-valuable-companies/story/a-
bevy-of-start-ups-rushed-to-nab-sky-high-public-market-valuations-of-2021-but-flopped-
what-lies-ahead-355358-2022-12-06
10. Samie Modak, SEBI proposes stricter IPO norms as startups listings gather pace,
BUSINESS STANDARD, (8 March 2023, 3:40 P.M.)
https://www.business-standard.com/article/economy-policy/sebi-proposes-stricter-ipo-
norms-as-startups-listings-gather-pace-121111601397_1.html
11. Sunil Sanghai, Two Caveats for start-up planning IPOs in 2023, THE ECONOMIC
TIMES, (11 March 2023 ; 5:20 P.M.)
https://economictimes.indiatimes.com/markets/stocks/news/2-caveats-for-startups-
planning-ipos-in-2023/articleshow/96851606.cms?from=mdr
12. Rajeev Gupta, Why SEBI has failed to check IPO overpricing in India? (12 March 2023 ;
5:22 P.M) https://timesofindia.indiatimes.com/blogs/myview/why-sebi-has-failed-to-
check-ipo-overpricing-in-india/
13. Game of IPOs : The sizzle and fizzle of internet companies, FORBES INDIA, (15 March
2023 ; 7:50 P.M.)
https://www.forbesindia.com/article/take-one-big-story-of-the-day/game-of-ipos-the-
sizzle-and-fizzle-of-internet-companies/78227/1