Risks of an IPO

Risks of an IPO

  • Reading time:5 mins read

An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Owners and partners in privately held firms consider an IPO as the road to riches and get enticed by huge run-ups in the stock prices of companies. The choice can bring a huge influx of cash that the company can use to grow its business without incurring as much debt, to better compensate investors and employees, and provide stock options or other kinds of compensation. But before undertaking this complex, expensive, time-consuming preparations and incurring the risks involved, the downside of this move must be fully assessed. There are many bumps, detours, and dead-ends on this public path to thousands of crores of financing for companies.

For IPOs to succeed businesses have to have a sustainable and profitable model. If the market does not find the business viable in the long run, or if the company’s debts outstrip earnings or show similar negative indicators, the IPO will very likely fail. Experts have pointed out that start-ups’ lack of profitability is a hurdle to going public. Even bigwigs such as OYO and Ola are still burning cash. “Almost no Indian company, unicorn or otherwise, is in a position to make its financials public, let alone chart a clear path to profitability,” acc. to Karthik Reddy, co-founder of Blume Ventures.

Once a company goes public, its finances and almost everything about it, including its business operations, is open to government and public scrutiny. Periodic audits are conducted, and quarterly and annual reports are required. The company is subject to strict legal oversight and regulations, including strict disclosure requirements. These things sometimes work against company interests. A careful reading of these reports can accurately determine a company’s cash flow and credit-worthiness, which may not be perceived as positive.

Another critical factor in an IPO is the timing. Preparation for the IPO is expensive, complex, and time-consuming. Lawyers, investment bankers, and accountants are required, and often outside consultants must be hired. It can take a year or more to prepare for an IPO. Business and market conditions can change radically in this time, and it may no longer be a propitious time for an IPO, thus rendering the preparation work and expense useless.

These apprehensions were evident in the Indian market in 2019 as the number of IPOs fell from 41 in 2018 to 18. The average listing day returns of the 18 companies that debuted in financial year 2019 was a meagre 2%, as against 21% the year before, and 20% in financial year 2017. Another worrying statistic was that 47 Indian companies which had gone through the painstaking process of getting their IPOs approved from SEBI decided to shelve their listings which were worth around ₹51000 crore

The WeWork IPO saga follows hot on the heels of IPOs from taxi hailing apps Uber and Lyft earlier in 2019. Founders, early investors and investment banks have hugely overpriced a number of IPOs in the last few years, which means new investors could not profit from them. Appetite for technology IPOs is waning fast, as a result. An immediate consequence is the withdrawal of some planned IPOs and deferral of others such as AirBnb. What is becoming clear is that investment banks cannot value loss making technology start-ups for an IPO. While Uber had huge potential, its intense price wars with its competitors were heavily subsidised. This pushed them further into the red. Uber was originally claimed to be worth US$120 billion, its IPO was valued at US$83 billion, and its current valuation is around US$55 billion. Many believe even that is excessive. Similarly, WeWork was originally claimed to be worth US$70 billion, then US$47 billion but failed to reach even US$15 billion before withdrawal.

Another interesting IPO failure is that of the Anil Ambani owned Reliance Power way back in Jan 2008. When the company debuted in the capital market, it seemed to have depended more on external factors to ride on the Reliance brand and the appeal of the energy sector – rather than strong fundamentals. Thus, despite profits of only Rs 16 lakh, it had a price band of Rs 405-450. The issue was sold out within the first minute of its opening on January 15, 2008, a record for a mega offering of Rs 11,563 crore. The IPO had received a record over 50 lakh bids worth Rs 7.5 lakh crore, and the issue got subscribed by more than 72 times. Yet, in the end, the Reliance magic failed – a first in the history of the Indian stock markets. On the opening day, the stock spiralled up 19% to trade at Rs 538 for all of four minutes before plunging to Rs 355 and never recovering enough to even close to the issue price. By the close of trading, investors’ wealth in hundreds of crores had been eroded. Today, the stock that had once opened at ₹430 trades at less than ₹3. While many stocks might have fallen from grace on Dalal Street, what sets Reliance Power apart is the strong optimism that surrounded the IPO at the time of its launch. From rickshawallahs, to HNIs and foreign investors, people came in droves to invest in the IPO. Record demat accounts were opened during that period. A few sold out their entire portfolio, while some borrowed money to buy units in the IPO, but all in vain!

Warren Buffet also holds a straight forward stance towards IPOs. In an interview to CNBC before Uber made its maiden issue, Buffett explained why he had decided to pass it; it was because he had never bought an initial stock offering!

From a distance, an IPO may look like a perfect means of making money. Close up, the many flaws become apparent. These should not dissuade a company from going public, however. Providing all the pros and cons have been understood and evaluated, and all the inherent risks assessed, if circumstances are right, an IPO may open profitable new opportunities for a company ready to be publicly traded.