💵 IPOs can be tricky

Planning to buy a firm through IPO? Read more to know how firms and VCs can trick you with Initial Public Offering.

🤔 Why IPO?

One of the buzzwords in the equity market in recent times was IPO.

As many as 63 companies floated IPOs this year (2021), raising 1.19 crore INR, according to Prime Database.

- The Economic Times, Dec 2021

So let's try to understand what and why an IPO is.

For that, you need to know how startups or corporates raise funding. Initially, when you start a business, it's usually you or most probably your co-founder (if there is one), who would have bootstrapped the business.

But as when the firm grows, you might need more funds to expand your business. That is when your bootstrapped business turns into a VC-funded business wherein you seek investment from VCs, financial institutions and Angel Investors. The initial investment is generally called Seed Investing and the further raised funds are respectively termed Series A, Series B, …

Also, that is when you eventually value a firm. For instance, if a business named Kart Corporate has a single founder and has raised Series A funding for 1M for a 1% stake from Sequoia Capital, then the Kart Corp is valued at 100M. If 1% of Kart Cop’s shares is bought for 1M, then 100% of the stake is valued at 100M. (Price-Demand-Supply Graph).

Assuming Series B from another investor XYZ VC was 5M for another 1% stake, now the company valuation has increased to 500M. But the founder currently holds only 98% of the stake, i.e. he holds 98% of 500M. Technically, no investor can impulsively sell this stake as it is just paper wealth. Of course, XYZ VC can sell their stake to another investor and exit, but most of the time these VCs look for GRAND exit.

That is where the company goes Public i.e. IPO - Initial Public Offering. Until then, Kart Corp was a Private company but the moment it launched the IPO and the moment it entered the share market, the firm became public which means common people like you and me (i.e. Retail investors) can invest in the company.

This is when the investors will sell all/part of their stake in the company and exit the firm to make a return on their investment.

🏦 Price of a share

So now the billion-dollar question - How much will the price of a single share of Kart Corp be in the public share market?

As I said before, the Investors want a grand exit and are desperate for a good return. For instance, XYZ VC wants a 40% return on its investment of 5M i.e 7M (incl. initial investment) so the new valuation of the firm has to increase by 2M, and financial institutions will calculate the number of shares that needs to go to the public and at what price a single share should be is calculated based on the returns required by the VCs. This is where a lot of VCs become over-greedy and start to value a firm higher leading to overvaluation.

🗑️ Pump and Dump scenario

This is where the real problem starts. So why do most of the share prices fall/correct post-IPO?

Before that, what are the similar views you get from these companies - Paytm, Nykaa, and Zomato?

Too much media attraction, high valuation, unicorns, and visible founders. Right?

Apparently, companies tend to overvalue so that they can get a maximum return. To avoid this, regulations have stated lock-in periods that usually range from 6 months to 1 year and when the lock-in period is over for the investors, they try to make a grand exit as I said before. Mass selling by investors occurs then and eventually, the prices plummet. This hurts the market sentiments which affects the retail investors and the 'Pump and Dump' scenario is executed by the VCs.

I am not trying to paint a negative picture here. IPOs can be great if firms are valued based on their balance sheets and Cash flows and not on media attention. For instance, Paras Defence which became public in 2021 was highly successful for the firm as well as the investors. But the issue is with the recent startups which are being valued at crazy prices.

Check out how Mamaearth has been valued insanely.

🚀 My experience with IPOs

I have targeted a lot of IPOs without even doing these valuations and calculations, just because I was having FOMO and wanted to try out all kinds of stuff in the equity market and get my hands dirty.

In fact, I was so much worried when I wasn’t allotted shares of Nykaa. But fortunately, now looking at its share price, I am glad I haven’t lost my money. But there are a few other IPOs that were successful for me - SJS Industries and Policy Bazaar (PB Fintech) and I was lucky enough to exit them at the right time with good returns.

Newly listed companies outperformed the Nifty 500 in only 4 years from 2010 to 2021

- Windmill Capital

Also, a few companies try to save their investors by the bonus share strategy like the one Nykaa did recently. Let me know in the comments how this strategy can avoid the pump and dump by the VCs. (Hint💡: Think about the capital gain tax and the lock-in period)