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The Economics Behind: A Startup’s Path to SME IPO

February 23, 2024
7 mins

From a modest 428 registered startups in 2016 to a remarkable tally of approximately 117,000 by 2023, the Indian startup ecosystem has seen an exponential surge representing a 267-fold growth, translating into a staggering Compound Annual Growth Rate (CAGR) of 122%. 

On January 16, 2016, Prime Minister Narendra Modi articulated a vision for India to solidify its position as a leading global centre for innovation and entrepreneurship. In pursuit of this vision, policies were introduced to cultivate a robust ecosystem conducive to nurturing innovation within startups and fostering investment within the country's startup landscape. This vision has clearly become a reality. Today, the significance of startups in the Indian economy transcends mere speculation, firmly establishing itself as a cornerstone in India's economy.

In this article, we will delve into the lifecycle of a typical startup's progression, elucidating how an SME IPO aligns with the exit perspective of early-stage investors. We will explore the rationale for listing an SME IPO and the criteria guiding the listing process, examine the migration trajectory of startups to the main boards, and analyse the valuation perspective at the listing juncture and beyond.

A Startup’s Transitional Journey

A startup diverges significantly from the lifecycle trajectory of a conventional promoter-backed enterprise due to several distinctive features:

- Disruptive/innovative business models

- Abundance of external equity financing

- Constrained timeframe for attaining product-market fit

- Expectations for investor exits

These defining attributes of a startup stand in stark contrast to the evolutionary path of a traditional business. Consequently, startups face a scenario wherein they lack the luxury of time to realise substantial outcomes concerning business expansion and meeting investor return expectations. 

To better understand the investor return expectations, let's look at the typical lifecycle of a Venture Capital firm.   

As illustrated above, venture funds commonly seek to divest from a company within 8-9 years of their initial investment in said company. The disparity between the lifecycle trajectory of a conventional company and that of a venture fund necessitates the establishment of a range of exit mechanisms to facilitate liquidity.

Traditionally, exit options for a venture-funded startup are typically confined to:

- Opportunistic secondary transactions involving incoming or existing investors

- Strategic mergers and acquisitions

- Buyback arrangements (though these are less prevalent in the industry due to negative cash flows and prioritisation of growth investments)

- Initial public offerings on major stock exchanges

However, a lesser-explored alternative exit strategy, yet one that has existed for some time, is the Small and Medium Enterprise (SME) Initial Public Offering (IPO).

The Rationale for SME IPO

SME IPOs furnish startups and small businesses with a channel to procure capital, gain entry into capital markets, bolster credibility, access liquidity options, augment visibility, and pursue sustained growth over the long term. Of paramount significance, SME IPOs afford companies the advantages of a conventional IPO without necessitating the scale, which is typically demanded to thrive on major stock exchanges within a constrained timeframe.

In addition to these advantages, the SME IPO has witnessed a notable surge in interest from companies seeking listing on the exchange, as well as heightened enthusiasm from investors eager to engage in these opportunities.

Experiencing an extraordinary surge of 1900% since the conclusion of 2019 [BSE SME IPO index], this index significantly surpasses its mainstream counterparts by a considerable margin. However, despite this remarkable ascent, the pinnacle of success is not devoid of challenges: 

Susceptibility to Price Manipulation: The notable instance where 35% (62 companies) of entities debuting on SME IPO exchanges in 2023 yielded returns ranging from 100% to 1000% has raised concerns regarding potential price manipulation, prompting regulatory scrutiny. Concentrated ownership among a select group of investors has, at times, facilitated fraudulent activities by promoters and traders. To address such concerns, regulatory authorities, such as the Securities and Exchange Board of India (SEBI), have bolstered surveillance capabilities through initiatives like the trade-for-trade settlement framework and short-term additional surveillance measures (ASM).

Profitability: The listing criteria stipulate that a company must demonstrate positive EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) for at least two out of the preceding three financial years prior to its listing. This requirement may present a challenge for many startups, as startups typically prioritize growth and execution during their initial years, with profitability often not being the primary metric of focus. This is not to diminish the importance of profitability for startups; rather, it reflects the reality that early-stage venture capital funding is typically allocated to facilitate growth, with profitability often viewed as a longer-term objective.

Restriction on Migration to the Main Board: Furthermore, according to the listing criteria, upon listing on the SME IPO board, a company is prohibited from migrating to the main board for a minimum period of three years. This restriction poses a challenge for companies demonstrating credible growth and profitability comparable to peer companies listed on the main board, as they are unable to migrate regardless of their performance.

Formalisation of the SME IPO Market 

Recognising the potential of an SME exchange, both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) institutionalized their respective sub-exchanges.

BSE SME, the foremost and most established SME exchange, has facilitated the listing of over 480 companies and raised INR 6.08K Cr in capital. The combined market capitalisation of all listed companies on the platform stands at INR 126K Cr, with over 180 companies transitioning to the Main Board (BSE and NSE).

NSE Emerge serves as a reputable and efficient marketplace, bringing together sophisticated investors and emerging corporates. With 349 listed companies and capital raised amounting to INR 7.8K Cr, the platform boasts a total market capitalisation of INR 100K Cr. Additionally, 138 companies have migrated to the main board from NSE Emerge.

In 2015, SEBI introduced further guidelines to facilitate the listing of new-age companies and startups through the institutional trading platform (ITP). Positioned as India’s counterpart to NASDAQ, the ITP platforms - NSE Innovative Growth Platform (NSE IGP) and BSE Institutional Trading Platform (BSE ITP) - focus exclusively on aiding startups in accessing capital with relaxed listing norms. This initiative expands the investor base, reduces compliance burdens, and offers cost-effective listing opportunities along with tax benefits.

Opportunities for Startups

E2E: Cloud HPC Platform Soars Post-IPO

E2E operates as a Cloud-based high-performance computing platform, catering to a range of applications, including machine learning, artificial intelligence (AI), and deep learning. Its functionalities encompass the scheduling of snapshots, automation of backups, and real-time data storage and access. Key features include load balancing, deployments, object storage, automated backups, API interfaces, auto-scaling, and Database as a Service (DBaaS), among others.

In November 2014, the company secured its seed round of investment amounting to INR 2.85 Cr, with a valuation of INR 13 Cr. Subsequent to this initial seed funding, the company did not pursue further rounds of financing prior to its public listing on the NSE Emerge exchange.

On May 15, 2018 [9 years post its incorporation], the company officially debuted on the stock market, listing its shares at a price of INR 57 each, with an overall valuation of INR 81 Cr [6.2 times its initial seed valuation]. Despite being valued lower than typical benchmarks for publicly traded companies, E2E garnered substantial interest from investors, leading to an oversubscription of 70 times its initial offering.

Early investors in the company experienced a significant return, estimated at approximately six times their initial investment at the time of the company's listing.

Currently, the company’s market capitalisation stands at INR 1,140 Cr [~14 times its SME IPO valuation] with a share price of INR 788 and a TTM PE multiple of 65, whereas the sector PE stands at 37.

Migration Journey

For Small and Medium Enterprises (SMEs) or startups, listing on SME IPO exchanges signifies not the culmination but rather a significant milestone in their journey. Beyond the advantages of accessing public capital, achieving faster time to market, and navigating relatively lighter compliance burdens, these entities possess the opportunity to transition seamlessly to the main bourses of the market.

It is important to note that certain criteria must be met for successful migration, as outlined in the accompanying table for BSE and NSE.

However, by diligently adhering to the prescribed protocol and compliance requirements expected of a publicly listed company, SMEs and startups can utilize their time on the SME IPO exchange as a preparatory phase. This period serves as a valuable trial run, enabling them to acclimatise to the demands associated with the main boards while concurrently benefiting from the prestige and expanded public visibility enjoyed by entities listed on these premier platforms.

Here are two instances of companies that have undergone this migration process:

A-1 Acid Limited engages in the trading of a diverse array of chemicals and acid products, catering to various industrial applications. The company's product portfolio encompasses a wide range of chemical offerings that are utilised across different sectors within the industrial domain.

Upon its initial public offering (IPO), A-1 Acid Limited raised INR 18 Cr and debuted on the BSE SME platform, with an issue price set at INR 60 per share.

During the IPO subscription period on October 1, 2018, the offering garnered considerable interest from investors, with an overall subscription rate of 1.81 times. Specifically, the public issue saw a subscription rate of 1.25 times in the retail category, times in the Qualified Institutional Buyer (QIB) category, and 2.37 times in the Non-Institutional Investor (NII) category.

The company was able to transition to the main board within 4 years of its listing on the SME IPO exchange.

Established in 2008, Bhatia Communications & Retail (India) Limited operates as a Surat, Gujarat-based entity primarily engaged in the retail and wholesale distribution of mobile handsets, tablets, data cards, mobile accessories, and related products. The company specialises in the sale of smart mobile handsets across various brands.

In its initial public offering (IPO), Bhatia Communications & Retail (India) Limited successfully secured INR 24.75 Cr in funding and debuted on the BSE SME platform, with an issue price set at INR 150 per share.

During the IPO subscription period, the offering garnered a subscription rate of 1.36 times overall. Specifically, the public issue witnessed a subscription rate of 0.73 times in the retail category and 1.98 times in the Non-Institutional Investor (NII) category.

The company transitioned to the main board within 3 years of its debut on the SME IPO exchange.

The Valuation Focus

There exists a prevalent perception within the industry that valuations of initial public offerings (IPOs) for small and medium enterprises (SMEs) are relatively subdued in comparison to those of companies listed on the main board. Typically, entities make their debut on the SME IPO platform with valuations ranging from 5 to 25 times their Profit after Taxation (PAT) at the point of listing.

To assess the validity of this perception, we conducted an analysis focusing on a specific cohort of recent SME IPOs spanning diverse sectors:

*Revenue and PAT figures are as of the latest financial statements prior to the listing date

The median valuation aligns closely with the prevailing industry viewpoint, registering at approximately 27.29 times the Profit after Taxation (PAT). Nonetheless, for an overarching view of value realisation, it is advisable to evaluate the growth trajectory of these enterprises from their listing date to the present market prices.

*Revenue figures are as of the latest available financial statements - March’23

Evidently, the median valuations for both Revenue and Profit After Tax (PAT) have experienced significant growth from their initial listing prices.

Attaining Mutually Beneficial Outcomes

As the startup ecosystem undergoes continual transformation, claiming an increasingly significant portion of the economic landscape, the imperative to furnish a steady stream of capital, whether in the form of equity or debt, to a segment of India characterised by scarcity in cash and credit becomes paramount.

The SME IPO market facilitates startups in procuring capital from a broader spectrum of investors possessing pragmatic expectations regarding returns. Additionally, it furnishes liquidity to founders, whose primary remuneration often comprises stock-based compensation rather than consistent cash withdrawals during the nascent stages of the company's growth trajectory.

Moreover, it offers timely exit opportunities to early-stage investors, enabling them to realise returns and reinvest these funds into the ecosystem. This cyclical process not only aids investors in achieving financial gains but also rejuvenates the ecosystem, fostering the growth and prosperity of subsequent cohorts of startups.

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