Pre-Ipo Investing: A Guide To India's Private Markets

Investing in pre-IPO shares in India is an option for those looking to get in on the ground floor of a company's public offering. Pre-IPO investments are a way for companies to raise funds and mitigate the risk of an unsuccessful IPO, and they offer institutional investors the chance to get involved in governance matters and help the company get 'institutionalised' before going public. While pre-IPO investments are typically restricted to high-net-worth individuals with sophisticated knowledge of financial markets, they can be a way to get shares at a discounted price.

Pre-IPO share price and how to find them

Pre-IPO shares are stocks or equity shares that are available for purchase by investors before a company goes public with an initial public offering (IPO). These shares are typically offered to institutional investors, high-net-worth individuals, or select groups through private placements. There is no set price for pre-IPO shares as they are not traded on public exchanges. However, there are various methods to evaluate the price of these shares. Here are some commonly used methods:

Book Value Method

This method takes into account the company's tangible assets and liabilities. It is important to ensure that the company's assets and liabilities are revalued annually and are fair. The formula for calculating book value is:

> Book Value = Sum of all tangible assets - Sum of all tangible liabilities

Last Transaction Price Method

This method considers the last price at which the pre-IPO share was traded. However, this method is generally not used as the previous trade price may not be apt for the current trade, and the shares could be overvalued or undervalued.

Price-to-Earnings Ratio or Discounted Cash Flow Method

This method is commonly used for companies with stable business operations. It involves using recent earnings to anticipate future cash flow, and then discounting these future cash flows with a discount rate derived from the same sector or listed companies on the stock exchange.

Net Asset Value (NAV)

Net asset value is similar to the book value method, but it uses current share market prices instead of previous prices. There are two methods to calculate NAV:

Including Only Tangible Assets

> NAV = Sum of all tangible assets with current market value - Sum of all tangible liabilities with current market value

Including Both Tangible and Intangible Assets

> NAV = Sum of all tangible & intangible assets with current market value - Sum of all tangible & intangible liabilities with current market value

When looking to invest in pre-IPO shares in India, there are a few platforms and services that can assist you. Sharescart.com is one such platform, offering unbiased advice and tools for in-depth analysis. Another service is provided by Planify, which brings "Private Equity for Retail investors", allowing individuals to invest in companies before they are listed on the stock market. Additionally, UnlistedZone provides a platform for buying and selling unlisted and pre-IPO shares.

Benefits of using a merchant banker

Investing in the pre-IPO market in India can be a complex process, and enlisting the services of a merchant banker can offer several benefits.

Firstly, merchant bankers play a crucial role in facilitating connections between companies and investors. They have extensive networks and relationships with both issuers and prospective investors, which can help in marketing the issue and reaching the right investors.

Secondly, merchant bankers are responsible for conducting due diligence and ensuring legal compliance. This involves thoroughly evaluating the issuer's eligibility, including their financial health, regulatory compliance, and disclosure requirements. They also assess the capabilities and independence of intermediaries involved in the IPO process. By doing so, merchant bankers help protect investors from potential risks and ensure that all necessary regulations are met.

Additionally, merchant bankers provide essential financial and advisory services. They guide corporate clients through the complex process of structuring and executing international transactions, including cross-border mergers and acquisitions. Merchant bankers can also assist in fundraising, private equity, and business loans, especially for companies that may not be large enough to raise funds through a public offering.

Furthermore, merchant bankers have expertise in managing the currency exchanges and regulatory issues associated with international business operations. They can facilitate the transfer of funds across borders and help companies navigate the legal and regulatory landscape of different countries.

Lastly, merchant bankers are well-versed in the technical aspects of IPO management. They assist in preparing and submitting the necessary documentation, calculating requisite fees, and coordinating with various intermediaries involved in the IPO process, such as registrars, monitoring agencies, and underwriters.

Overall, engaging the services of a merchant banker can provide valuable expertise, connections, and guidance when navigating the complex world of pre-IPO investments in India. Their role is crucial in ensuring a smooth and compliant process, ultimately benefiting all stakeholders involved.

Due diligence responsibilities

Due diligence is a critical aspect of the pre-IPO process. It involves a thorough investigation and analysis of a company's financial, legal, operational, and business factors to assess its viability for a public listing. Here are the key due diligence responsibilities and considerations:

Financial Due Diligence:

• Reviewing financial statements and performance: Analyzing profitability, liquidity, solvency, and operational effectiveness.
• Evaluating the accuracy and reliability of financial statements: Ensuring integrity and trustworthiness through external audits.
• Analyzing revenue, profitability, and cash flow trends: Identifying positive and negative trends for deeper insights into the company's performance.
• Scrutinizing projected financial performance: Assessing the company's future prospects and investment value.
• Evaluating assumptions and growth forecasts: Assessing the accuracy of forecasts by examining data sources and identifying potential biases.
• Identifying potential risks and sensitivity analysis: Understanding internal and external risks and their impact on the company's projects and decisions.
• Examining capital structure and debt obligations: Analyzing the company's financial situation, risk profile, and debt management.
• Analyzing the capitalization table and ownership structure: Reviewing the company's securities, including common and preferred stock, warrants, and options.
• Assessing debt levels, terms, and repayment obligations: Evaluating the entity's financial leverage, risk exposure, and repayment capabilities.

Business and Market Due Diligence:

• Evaluating the business model and competitive landscape: Identifying strengths, weaknesses, opportunities, and threats.
• Understanding the company's value proposition and competitive advantage: Assessing the sustainability of the company's position and profitability.
• Assessing market size, growth potential, and industry dynamics: Conducting regular market analyses to account for dynamic markets and sectors.
• Identifying potential threats and barriers to entry: Analyzing the specific sector and market to effectively address risks and challenges.
• Assessing intellectual property and legal considerations: Reviewing patents, trademarks, copyrights, and trade secrets to ensure protection.
• Analyzing management team and corporate governance: Understanding the management team and governance practices to make informed decisions about the company's prospects and risks.
• Assessing the experience and track record of key executives: Evaluating the leadership and performance of senior executives.
• Evaluating the board of directors and governance practices: Assessing the board's performance and adherence to best practices.
• Identifying potential management risks and conflicts of interest: Maintaining transparency, integrity, and effective decision-making within the organization.

Operational and Technical Due Diligence:

• Assessing the company's operational processes and efficiency: Identifying areas for improvement and optimizing workflows.
• Identifying opportunities for cost optimization and productivity improvements: Analyzing spending, resource usage, and business operations to enhance competitiveness and growth.
• Evaluating scalability and capacity for future growth: Ensuring that the company's infrastructure and systems can handle increasing demand.
• Reviewing technology and IT infrastructure: Collaborating with IT professionals, stakeholders, and business leaders to align IT investments with organizational goals.
• Assessing technology assets and IT systems: Understanding the health of the company's technological infrastructure and identifying risks and vulnerabilities.
• Evaluating cybersecurity measures and data protection protocols: Ensuring the security and integrity of sensitive company information.

Legal Due Diligence:

• Ensuring compliance with laws and regulations: Verifying that the company adheres to all relevant Indian laws and regulations.
• Reviewing legal aspects: Conducting a legal audit to identify any pending legal actions, suits, or liabilities.
• Verifying real estate properties and transfers: Checking for any objections from secured creditors and reviewing court documents.
• Reviewing customer/service information: Analyzing interactions with customers, service practices, products, services, and legal approvals.

Organizational Items:

• Requesting Articles of Incorporation and business records.
• Asking for resolutions of directors and governing board information.
• Obtaining a list of shareholders and committees.
• Understanding share ownership among shareholders.
• Collecting annual business reports for at least the last 3 years.
• Identifying states where the company is permitted to do business.
• Reviewing business and strategic plans for the previous 3 years.
• Visualizing the organizational structure, including board members, directors, and employees.

License and Tax Items:

• Collecting operating and business licenses from relevant countries.
• Reviewing tax agreement data.
• Analyzing Local, State, Federal, and Foreign taxing data for the last 3-5 years.
• Identifying governmental licenses and permits.
• Examining income tax reports and employment tax filings for the last 3 years.

Company Employees and Board Information:

• Obtaining employment lists, including employees, managers, and board members.
• Understanding employee status, positions, salaries, benefits, and bonuses.
• Reviewing personnel policies, problem-resolving procedures, and leave policies.
• Analyzing employee health insurance and other insurance offerings.
• Collecting resumes of leading personnel.
• Reviewing employee audits for the last 3 years.
• Examining previous investment banking arrangements.

Service and Customer Items:

• Analyzing reports on products, services, and customer complaints.
• Reviewing legal approvals for products and services.
• Understanding the company's best customers and their benefits for the last 3 years.
• Examining trading policies, marketing plans, materials, and future strategies.
• Reviewing customer supply or service agreements.

Property-Related Items:

• Identifying business locations.
• Collecting real estate agreements and franchise licenses.
• Inventoring claimed property subjects.
• Visualizing trademarks, copyrights, and patents.
• Reviewing trademark complaints or issues.
• Examining real estate purchase contracts.

The role of timing and sizing in IPO success

The timing of an IPO is a complex dynamic game in the stock market. The decision-making process is influenced by a multitude of factors, including the enterprise's intrinsic value, information asymmetry, market investor sentiment, and regulatory factors.

One key consideration in the timing of an IPO is the pricing constraint, which refers to the upper limit set on the IPO price. In some markets, such as the Chinese stock market, regulatory authorities may impose pricing constraints to maintain market stability and alleviate the "three highs" phenomenon (high issue price, high price-to-earnings (P/E) ratio, and high issue financing quota). Pricing constraints can impact the timing of an IPO by reducing the exercise value of the real option of IPO timing, thus encouraging an earlier listing. Enterprises with high trait factors, such as technology enterprises, may be more affected by pricing constraints and could consider going public earlier.

Another factor influencing the timing of an IPO is the market trend. If the enterprise anticipates a negative market trend in the future, it may opt to go public as soon as possible to avoid potential losses. On the other hand, if the enterprise expects a positive market trend, it may delay its IPO to take advantage of higher expected utility (valuation).

The sizing of an IPO is also an important consideration. The median deal size for IPOs over a five-year period ending on July 31, 2024, was around $200 million, with some companies raising well in excess of that amount. While large IPOs attract attention, smaller deals are also prominent, especially in certain sectors such as consumer markets and TMT. The sizing of an IPO will depend on the company's cash needs and profitability projections.

In conclusion, the timing and sizing of an IPO are crucial factors in its success. Enterprises must carefully consider their own characteristics, market fluctuations, regulatory factors, and market trends when deciding on the timing and sizing of their IPO.

Guidelines for marketing the IPO

Marketing an IPO in India involves a series of steps and guidelines that must be followed to ensure compliance with the regulations set by the Securities and Exchange Board of India (SEBI). Here are some detailed instructions and guidelines to consider when marketing an IPO:

• Appointment of Merchant Bankers: The first step is to appoint one or more merchant bankers, who will act as lead managers. These merchant bankers are financial intermediaries that facilitate equity and debt capital market transactions. They play a crucial role in pricing and executing the IPO, as well as managing shareholder relations after the shares are listed on the stock exchange.
• Filing of Draft Red Herring Prospectus (DRHP): The DRHP is a critical document that outlines the company's business plan and financial projections. It must be filed with the SEBI at least 21 days before the IPO's launch and made available to potential investors. The DRHP should contain accurate and up-to-date information, as any misstatements can lead to regulatory action.
• Obtaining SEBI Approval: Once the DRHP is filed, the SEBI will review it and provide comments or suggestions within 60 days. It is important to address any concerns raised by the SEBI and make necessary revisions to the DRHP. The SEBI plays a vital role in ensuring the fairness and transparency of the IPO process.
• Finalising the Offer Size and Price Band: After receiving feedback from the SEBI, the company can finalise the offer size and price band for the IPO. The price band is typically a 20% range within which the final price is determined.
• Launch of the IPO: At this stage, the company publicly announces its intention to launch an IPO. The lead merchant banker(s) will then contact potential investors and provide them with a copy of the DRHP.
• Pricing of the IPO: The lead merchant banker(s) will decide on the final price for the IPO within the specified range. This decision is based on the expected performance of the issue and prevailing market conditions.
• Book Opening and Allotment: The IPO subscription is open for eligible investors for a specified period. The lead merchant banker(s) will arrange the opening of the issue in accordance with SEBI guidelines.
• Compliance with SEBI Guidelines: It is essential to adhere to the eligibility criteria and conditions set by the SEBI. This includes requirements such as a minimum net worth, years in business, profit history, public ownership percentage, clean financial statements, minimum paid-up capital, positive net profit, and no loan defaults.
• Accuracy of Information: Ensure that all financial statements and disclosures are accurate and transparent. The company's management team should also be solid and capable of handling the IPO process.
• Sufficient Cash Flow: The company should have sufficient cash flow to repay debts and meet operating expenses. This demonstrates financial stability and reduces investment risk.
• Timeline and Cost Considerations: The IPO process in India typically takes 4-6 months, but it can vary depending on the size and complexity of the offering. The cost of going public can range from Rs. 2-5 crore.
• Marketing and Investor Relations: While not specifically mentioned in the regulations, effective marketing strategies and investor relations are crucial for a successful IPO. This includes promoting the IPO to potential investors, roadshows, and building relationships with institutional and retail investors.
• Restrictions on Communications: It is important to adhere to the restrictions on public communications, advertisements, and research reports outlined in Schedule IX of the SEBI ICDR Regulations. All promotional materials must be truthful, fair, and not misleading.

By following these guidelines and working with experienced professionals, companies can effectively market their IPO and navigate the regulatory landscape in India. A successful IPO can provide the necessary capital to fuel business growth and expansion.

Frequently asked questions