Why cash-hungry start-up giants turn to IPOs for sustenance

Food delivery platform Zomato that has just launched its initial public offering (IPO) saw its shares sell like hot potatoes. As soon as the IPO opened on Wednesday, July 14, the retail portion was almost fully bought up within an hour.

Earlier this week, the start-up raised ₹4,196 crore — around half its total IPO size of ₹9,375 crore — by allotting shares to anchor investors. There were media reports of the Life Insurance Corporation of India (LIC) buying shares in the Zomato IPO, breaking its decades-old investment norms.

Zomato is no outlier. Several Indian start-ups are making a beeline to the stock market to raise funds. Topping the list is digital payments start-up Paytm, which is set to launch an about ₹16,600 crore IPO around November 2021.

Other start-ups said to be in the IPO queue include last-mile logistics operator Delhivery, insurtech firm Policybazaar, CRM (customer relationship management) SaaS (software-as-a-service) provider Freshworks, and online retailers Flipkart and Nykaa.

Zomato’s rival Swiggy, as well as other start-ups such as edutech operator Byju’s and furniture e-tailer Pepperfry, are said to be considering IPOs, though the companies themselves have not announced plans yet.

What’s feeding the trend?

Start-ups —particularly unicorns, or those that are valued at $1 billion or more — are increasingly turning to IPOs for a multitude of reasons.

The main, of course, is money. In a world that is digitising at a rapid pace, the pandemic has only  hastened the transition. Online service providers and enablers such as Zomato, Paytm and MobiKwik have seen business boom since the COVID onslaught. To leverage the opportunity, they require funds in copious amounts.

The landscape is dotted with bootstrapped (self-funded) start-ups, but these are quite rare. Also, they invariably need external funding once they become big enough to move out of the garage.

Debt is an option too, but the interest component often deters young entrepreneurs from this route. Also, raising debt from the formal route when all they have to show lenders is an unproven proposal can be daunting.

Angel and venture capital funding

The preferred funding path for start-ups has for long been via private equity. The very early start-ups seek angel funding, from individuals or collectives such as the Mumbai Angel Network. These ‘angels’ not only offer cash and, sometimes, premises, but also turn mentors, guiding the first-time entrepreneurs through the nooks and crannies of running a business.

Once bigger, the start-ups typically go for venture capital (VC) funding, where the cheque sizes are bigger and the investor-investee relationship more formal. After attaining critical mass, the start-ups often raise private equity (PE) funding, where the amounts are much larger. PE funds are often global investors with strong sectoral or geographic focuses.

It’s when they grow even larger in size that start-ups go for IPOs. By then, they become well-known entities and, often, leaders in their markets.

Willing investors

An investing public that wants a pie of start-up ownership is perhaps the biggest draw for the companies. Rags-to-riches stories, as well as day-to-day examples of how tiny enterprises have taken on bigger rivals have helped convince investors to bet on start-up IPOs. Never mind that the start-ups are often unprofitable — the belief that their valuations will continue to be robust is promising enough for potential investors.

The Zomato IPO is a case in point. Brokers say its valuation appears rather expensive at 25 times FY21 enterprise value-to-sales (EV/sales). For domestic quick service restaurants, the EV/sales ratio stands at 11.6.

“We feel that this IPO is not for retail investors,” said Choice Broking in a note. “But investors with a higher risk appetite with a long-term investment horizon can apply. We assign a ‘Subscribe with Caution’ rating for the issue.” However, the retail demand seen on Day 1 of the IPO suggests there have been few takers for this line of thought.

Exit route for institutional investors

Institutional investors — both global and domestic — that put money in the start-ups have pre-agreed timeframes for exits. When a company’s valuation zooms, so does the value of the investors’ stakes. Hence, for them to exit with substantial returns, IPO proceeds come in handy. (The other typical options are buyout by the company itself, purchase of shares by some other investor, or a strategic acquisition).

In the Zomato IPO, shares worth ₹375 crore are an offer-for-sale (OFS) by Info Edge, which holds an over 18% stake in the firm. Other investors in the start-up include Antfin, Uber, Alipay, Squoia Capital, Temasek and Tiger Global.

Investors in Paytm include T Rowe Price, Alibaba, SoftBank, Elevation Capital and Berkshire Hathaway. They are all said to be looking at a complete or partial exit from the firm.

Eased norms

If IPOs are now a more viable option for start-ups, it’s also because the regulatory norms have been eased. In March this year, the Securities and Exchange Board of India (SEBI) rolled out measures to make it easier for start-ups to go public on the Innovators Growth Platform (IGP). The new norms were also designed to ease exit for early-stage investors in the start-ups.

One, SEBI trimmed to one year from two years, the shareholding period for investors with a 25% stake in the start-up pre-listing.

Two, it suggested a higher share of allotment of up to 60% of issue size to anchor investors, with a lock-in of 30 days. Three, it allowed the listing firms to issue superior voting rights to promoters, to prevent a dilution of their sweat equity.

Will more and more start-ups hit the IPO path?

Market experts say much hinges on how the early birds — Zomato, Paytm, et al — fare in the stock market over the medium term, once the short-term euphoria settles down. If their market capitalisation stays robust over a period, it may urge more of their peers to take the IPO route.