ABSTRACT
The startup industry in India has become the third largest in the world and more and more new age technology startups are going for the Initial Public Offer (IPO) on the local exchanges. The disclosure framework under which these IPOs are being conducted however, is geared towards traditional, asset-heavy companies and was primarily developed in the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR). Startups with negative cash flows, no physical assets, intangible valuations, and unusual corporate governance structures create a somewhat different disclosure environment that is only partially covered by current disclosure rules. This article explores whether the disclosure regime in place by SEBI is sufficient for startups IPOs, what are the special obligations that startups need to comply with and what are the gaps in the regulatory regime. Finally, it offers a moral outlook and a vision for the future of capital markets in India.
KEY WORDS : SEBI, IPO, Startup Disclosure, ICDR Regulations 2018, DRHP, Risk Factors, Related Party Transactions, New-Age Companies, Investor Protection, Indian Capital Markets
INTRODUCTION
The Indian IPO market saw a historic occasion with the public offerings of companies such as Zomato (2021), Paytm (2021), Nykaa (2021), and Delhivery (2022). These listings revealed a basic contradiction: the policies designed for traditional companies that are having trouble characterizing the risk profile of loss-making, hyper-growth startups. Retail investors were attracted by the familiarity of brands and rarely provided with sufficient disclosure to help with investment decisions. Paytm’s post-IPO meltdown in which it lost value by almost 75% in a span of months proved to be a commentary of sorts on whether the prospectus presented the whole picture. The main regulatory authority for a startup looking to go public in India is the Securities and Exchange Board of India (SEBI), which requires the company to provide disclosure in the form of a Draft Red Herring Prospectus (DRHP) and the final prospectus. It’s not just about filing these documents, it’s about making them meaningful, completing them, and investor-friendly. This article is from the perspective of what a startup needs to do to just “do the right thing” and what it should do to do the “right thing.
REGULATORY FRAMEWORK
The SEBI (ICDR) Regulations, 2018, is the foundation of IPO disclosure in India, which is complemented by: SEBI Circular is a specific circular letter to address disclosure norms for new-age technology companies in light of the Paytm episode. The Listing Obligations and Disclosure Requirements (LODR) Regulations, 2015 — covering the post-listing continuous disclosure. The Companies Act, 2013, which gave the basic statutory guidelines regarding the contents of a prospectus under Section 26 and Schedule II. A startup may be required to mandate the following under ICDR: Objects of the issue and use of the proceeds; Financial statements of the last three years; Material litigations; Any related party transactions; Key managerial personnel details; Risk factors. SEBI’s 2022 circular introduced a new section for loss-making tech startups that called for disclosure of Key Performance Indicators (KPIs) that companies use internally to track growth, basis of valuation and a comparison of pre-IPO investor price with the IPO price of the company. This is a direct answer to the opacity seen in previous listings. Compliance is a process that really starts at least 18–24 months in advance of the listing date for a startup aiming to go public. The startup has to ensure that its financial statements are compliant with Ind AS (Indian Accounting Standards), appoint a merchant banker who is registered with SEBI as a Book Running Lead Manager (BRLM) and form an Audit Committee and Internal Financial Controls as per the Companies Act.
KPI DISCLOSURE AND VALUATION TRANSPARENCY — WHAT STARTUPS MUST DO
KPI disclosure is one of the most crucial practical duties of a startup after the SEBI circular 2022. Startups are often valued by metrics including Gross Order Value (GOV), Monthly Active Users (MAU), Customer Acquisition Cost (CAC), and Lifetime Value (LTV), which are different from the traditional metrics used in company valuation. Now SEBI has made it mandatory that: Any of the KPIs that are discussed prior to the IPO communication or media release should be covered in the DRHP. It is important that each KPI comes with a description, the way it is calculated and how it will be reconciled to audited financials. A price-Per-KPI comparison should be included, including the price paid by people invested pre-IPO compared with the IPO price. For startups, it means a thorough review of all metrics that have been conveyed to a potential V-C investor or publicly mentioned in a pitch deck. The company is liable under Section 34 and Section 35 of the Companies Act (civil and criminal liability for misstatements in prospectus) as well as under powers conferred on the securities and exchange board of India by section 11 of the securities and exchange board of India act, 1992 in case of any inconsistency between pre-ipo representations and disclosures in DRHP. In practice, the following steps should be undertaken by a startup to ensure that KPIs are certified by an independent chartered accountant, a disclosure committee is established at the board level, and there is a formal process to document how each KPI has originated and developed. Consistency of KPIs is a mandatory item to be checked at the DRHP observation stage as part of SEBI’s examination process.
RELATED PARTY TRANSACTIONS AND GOVERNANCE DISCLOSURES
There are several governance challenges that come with starting up, such as founder concentration, multiple VC firms holding stakes in the start up, ESPOPs, cross holding between group companies, etc. All Related Party Transactions (RPTs) including transactions with promoters, directors, KMPs/key management personnel and their relatives are required under the ICDR framework of SEBI to be disclosed under ASA 24. In fact, the multi-layered investment model makes this especially challenging for startups. A private equity-backed start-up may be required to have multiple rounds of VC funding, which means that investors will be on its board simultaneously investing in other businesses that are competing and/or complementary. Such a transaction, be it a licensing agreement, a shared service agreement, a preferential allotment, should be detailed in the DRHP with complete financial information. The LODR Regulations (2021-22) mandate shareholders’ approval for the material RPTs, where the turnover of LODR is more than ₹1,000 crore or 10% of the annual consolidated turnover. Thus, startups should restructure their RPTs prior to filing a DRHP, either renegotiate or terminate RPTs that would not pass through public eyes and be sure that all previous RPTs are in order and have been board-approved. If not, it is not just regulatory risk that is created, there is also reputational damage that could throw the whole IPO process into disarray.
MORAL ASPECT
There’s also a more basic fiduciary responsibility question: Once a startup becomes publicly owned, it puts millions of retail investors in a trust relationship, many of which are first-time investors who are tempted to invest in these brand-name companies. The moral responsibility of the founders and promoters is more than just complying with the SEBI checklist. Information gap between sophisticated investors before an IPO and the retail investors in India is high due to lack of financial knowledge among Indians and their increased participation in IPOs after the outbreak of the COVID pandemic. A start-up that discloses only what it is legally obliged to disclose and keeps material information that it does not need to willfully reveal may be “legally legal” but “morally wrong”. This moral ground is recognised by the shift in SEBI’s regulatory approach, which was previously generic risk factors to specific KPI certifications. Founders need to get this through their heads that the DRHP is NOT a marketing document. It’s a trust document that’s legally binding.
ROAD AHEAD
SEBI has demonstrated its flexibility with regard to changing the framework as per the market realities. The regulator has also taken initiatives to create a new platform for startups, namely, the Innovators Growth Platform (IGP) and is now mulling introducing a separate Social Stock Exchange, reflecting their sensitivity to the changing dynamics of Indian businesses. But there are some that have yet to be filled. The first is that Indian IPO legislation does not have much regard for forward-looking disclosures and projections/guidance, as compared to the PSLRA, 1995 which grants the ‘safe harbour’ provisions in respect thereof. Structured projections, like the other projections, will also be subject to an audit, and are likely to significantly improve investor decision making with loss-making startups. Second, SEBI needs to toughen up on post-listing compliance by the companies which were not able to achieve the KPIs mentioned in the IPO application. Thirdly, the so-called ‘gatekeepers’, merchant bankers ought to be held much more strictly to account. In the start-up world, disclosure should be considered a journey that begins long before the DRHP is filed and that doesn’t end after the listing bell.
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WRITTEN BY : ARNAV NAIK
