The current regulatory framework for initial public offerings is incompatible with today’s venture capital-backed start-ups. It’s time we removed these hurdles
June 02, 2015
As we soak in endless hours and pages of acrimonious cacophony on the state of the nation after one year of a new government, perhaps all of the raging rhetoric can be capsuled down to one core issue – the ability to generate jobs. A foreign direct investment in retail debate is a debate about jobs. A land acquisition problem is a problem of lack of jobs. That sweeping phrase “economic reform” in its roots is about jobs. That India needs legitimate jobs of all shapes, sizes, colours and origins is an incontestable idea. It is well established that nearly 60 million micro and small enterprises employ 120 million people but is still not enough. On a smaller but a very crucial scale, the venture capital asset class has been slowly and quietly de-clogging capital constraints to create hundreds of thousands of direct and indirect jobs over the past 15 years. Now, this asset class runs the risk of wilting away.
Nearly 3,000 small and new companies have received more than Rs 3 lakh-crore ($60 billion) in funding between 2006 and 2014 from venture capital funds. To put that in context, that is three times more than the funding that 350 companies have received through our stock markets via initial public offering (IPO) in the same period. It is nearly half of all money invested by foreign investors in big companies in the stock markets. If we assume that these 3,000 companies on an average employ 100 people directly and an additional 50 indirectly, that is 450,000 (0.5 million) new jobs in the economy. Most of these are innovative companies with disruptive technologies that create new markets. The business models of these companies are unique, tend to be revenue-focussed rather than profit-focussed in its first decade of existence and do not fit the traditional valuation frameworks. All of this has been fuelled predominantly by foreign venture capital and private equity flows. These venture capitalists traditionally generate their returns through public listing of these companies in the stock exchanges. These returns then typically get routed back to funding newer start-ups and the cycle continues.
The bottleneck for this virtuous cycle in the Indian context has been the near demise of the IPO markets. Illustratively, one company, Ola Cabs has received Rs 4,200 crore ($700 million) in venture capital funding to provide jobs to more than 200,000 drivers across 100 cities and towns of India in less than two years. This is more than what the entire IPO market raised over the last two years put together, which was Rs 2,500 crore ($400 million). This bizarre imbalance between large amounts of venture capital and a drought of IPOs over the past decade has been bubbling up and threatens to blow over if not addressed imminently. There are both regulatory and market factors contributing to this malaise.
The current Securities and Exchange Board of India (Sebi) framework for IPOs requiring definition of promoters, profitability conditions, detailed articulation of use of IPO proceeds, long lock-in periods, textbook justification of valuation and so on is incompatible with today’s venture capital-backed fast growing start-ups.
There is an immediate need to relax these harsh requirements for today’s knowledge economy businesses nurtured with venture capital to enable them to access the IPO markets, provide exits to their investors, which in turn can be funnelled into newer companies. This is best done on an experimental basis through a new market segment or an exchange rather than changing the rules for everyone immediately. This new segment should lighten up rules regarding promoter definition, profitability, valuation rationale, market making restraints and let market forces determine these.
While some could argue that existing SME exchanges should suffice for these purposes, these exchanges tend to cater to small companies that have not been able to attract venture capital funding. This new platform for venture capital-backed new economy businesses should continue to be overseen by Sebi and limit participation to institutional investors without exposing retail investors overtly to the high-risk nature of such companies. Sebi had put out a discussion paper on this concept.
We acknowledge that the regulatory maze is not the sole reason for today’s lacklustre IPO market. IPOs have performed terribly over the past decade, with nearly 80 per cent of the 350 IPOs since 2000 under-performing the broader index, which can be attributable to lofty valuations, poor diligence by merchant bankers and greedy entrepreneurs. But these are market factors that are to be addressed by market forces. It is time to at least ease the regulatory hurdles to uncork the pent up venture capital-backed IPO demand bubbly. And if we need further motivation, China just announced setting up a new Strategic Emerging Industries Board, a new exchange along similar lines.