India ranks as the fourth largest digital start-up hub in the world, with over 3,100 start-ups in the country, according to figures by the National Association of Software and Services Companies (Nasscom). The domestic IT market grew 10% in terms of revenues during fiscal 2014/2015, to around $20.9bn.
The rapid growth of the sector means many of the start-ups are now multimillion-dollar companies that are looking to raise fresh capital for further growth, say observers. Tapping ECM investors is one of the best ways forward, but with regulations governing their IPOs highly constrictive, many are contemplating overseas listings.
In a bid to stem that outflow, officials at Sebi are understood to be holding a meeting with start-ups on March 27, with plans to issue a consultation paper soon after to discuss potential changes to rules governing their listings.
“This is a significant change as it shows Sebi expects that issuers from sunrise industries will seek listings,” reckons Manan Lahoty, a Mumbai-based partner at Luthra & Luthra law firm. “And these technology and e-commerce companies have their unique challenges and requirements.”
It’s not hard to see why start-ups want to make a beeline for an international listing. Among the roadblocks facing an Indian IPO are requirements to clearly identify the company’s promoters, who are then subject to a three year lock-up period for 20% of their share capital following the listing.
While this is easy enough to adhere to by conglomerates with a certain amount of family ownership, it doesn’t work in the favour of start-ups.
“Sebi wants companies to identify their promoters, which works from an old economy perspective where there are lots of family businesses,” said Juhi Singh, a capital markets partner at S&R Associates. “But now many start-ups have founders who have a very small stake because of private equity involvement. And PE firms are reluctant to be classified as promoters due to the liability issues and lock-in restrictions that apply to a promoter.”
Divvying up proceeds
That’s not the only factor forcing Indian start-ups to go overseas. Sebi also has restrictions on the ways companies can use their IPO proceeds.
At the moment, not more than 25% of the proceeds can be put towards general corporate purposes. On top of that, Sebi has also taken it upon itself to reject draft offer documents by companies if a big chunk of the issuance is not allotted to creating tangible assets.
If that wasn’t enough, if a start-up wants to change the use of proceeds following a listing, it has to offer investors a put option for their shares if they are against the tweaks.
“Sebi likes a fair bit of clarity and details on the use of proceeds,” said Lahoty. “In a 2012 circular, Sebi said that if IPO proceeds were used for the creation of intangible assets or brand building, it may not approve the application. But most of the time, these sunrise companies need funds for brand building. And if they can’t use funds for that, it defeats the purpose of their capital raising.”
Losing out
Bankers are hoping that the March 27 discussion between Sebi officials and start-ups will pave the way for more a more straightforward regime, especially as the country’s equity capital market has little to show for in terms of new tech IPOs.
The last such listing was in May 2013, when search engine company Just Dial raised $170m from a domestic deal. The company had set up shop in 1996, but only launched its website in 2007. Its IPO was multiple times oversubscribed by both retail and institutional investors, keen to get their hands on a company with impressive growth potential.
More recently, e-commerce company Flipkart is understood to be mulling a US listing, while online marketplace Snapdeal is also thinking of selling shares either domestically or overseas.
“[New rules are] very important because India is losing out a lot,” added S&R Associates’ Singh. “There’s talk of Flipkart going abroad for its IPO, and typically start-ups that have listed abroad have seen big-bang deals.
"Sebi needs to attract them to stay here and needs to make the regulations more palatable for them.”
Adding to start-ups’ woes is the regulator’s tight grip on profitability. Firms need to show a profit record for at least three of the previous five years before getting the nod for an IPO, say market watchers. If a firm fails to meet all the profitability requirements, it could still go ahead with its listing, provided that 75% of its shares are allotted to qualified institutional buyers (QIBs), who are considered more sophisticated than retail investors.
While this rule certainly lacks flexibility, bankers reckon the biggest task for Sebi will be to put in place rules to appease both issuers and investors.
“We need regulations that will protect the widow on the street, while encouraging start-ups and entrepreneurs to raise capital,” said an MD of investment banking at an Indian bank. “Finding the right balance will be key for Sebi.”
Demand for flexibility
This balance will only be obtained if the regulator opts for as much flexibility as possible for tech start-ups, while not lowering the standards of disclosure.
For instance, the banker reckons that restrictions on using IPO proceeds could easily be solved by changing the terminology being used in the Issue of Capital and Disclosure Requirements (ICDR) Regulations that govern equity-raisings in the country.
Rules can also be tweaked to be in line with US regulations, especially when it comes to disclosure, say legal experts. For instance, Indian companies need to disclose pending litigation extensively at the IPO stage, including those targeting not just promoters but even companies associated with them.
The US, on the other hand, only has materiality thresholds, which can be easily navigated.
These layers of disclosure and adherence make the listing process in India very prolonged and cumbersome, say sources.
“There are lots of e-commerce/technology companies thinking of their IPO strategies, so the pipeline is there,” said Singh. “There are reports that Sebi may issue a consultation paper [afterwards] and this will be relevant because it will help us understand what Sebi is thinking and how serious it is in attracting these companies.”