How Indian startup IPOs are altering the market for valuation

18 Nov. 2021, Paytm comes up with IPO. Happiness all around and there is only one name on everyone's mouth - Paytm. People invest, and the stock which was trading at 2150 rupees in 2021, it had dropped to 530 rupees after dropping by 70%. And not just that, if you look very closely, from Zomato to Nykaa every startup who got listed on stock market, their stock has crashed today. Startup founders made a lot of money.

 ipo overlaue by the angel investors

• VCs made money even more than them, infact investment banks also made a lot of money, but who suffered in all this? Common people like you and me. We watch media or influencer tells us, and we invest money in any IPO without thinking much, and then we loss money. But the question is, how all this happens? Every Indian startup that came with IPO, today, how has its stock crashed? Is this a scam?
• Or is there something going on inside the startup world which most of the people don't know? Paytm IPO valuation - $20 billion, Zomato IPO valuation - $12 billion, Nykaa the only profitable startup back then IPO valuation - $13 billion. You know what, Paytm, Zomato, Nykaa all of these companies have one thing in common. And that is when all these companies brought IPOS, their stocks were over valued assets, and that is the reason, within 2 years of IPO, their stock value has reduced by 50%-60%. Now in order to understand, how all this happens, first of all we have to understand why the stock prices of all these loss making start-ups comes with over priced value? This is where the game of venture capitalism starts!

The Players of the Startup IPO Game: Maximizing Profit

• To understand this, first of all we need to know the players of this game. If you look very closely, there are four types of players in this game. No. 1 - the founders of the company, No. 2 - the venture capitalists, those invest money in company, No. 1 - the investment banks, those who raise and give money to these companies, and infact bring their IPOs.
• And last and most importantly, common people like you and me. And the fact over here is, every person who is involved in this game, all have one goal and that is to maximize their money. Founders make money when they dilute their equity. VCs make money by selling and purchasing the equity. Investment banks make money in terms of service fee and that service is under-writing. When a bank lends money to a company by raising they charge a fee on the amount they raised.
• And last, the general people like you and me we make money by selling and buying the shares. Now see, the main goal of founders and VCs, all their wealth is paper wealth, so their goal is to convert their paper wealth into liquid wealth. Means that the wealth which they can use to do something. Now the question is, how would this happen? Now, pay very close attention. Me and my friend Vaibhav, starts a company named Divine Media.

Startup Valuation Multipliers: Understanding the Factors

Suppose, its revenue is 3 crore rupees and now we have to raise funding, so first of all, we will approach an investment banker, that investment banker will ensure that we get maximum valuation multiplier on this revenue. For an example, we get multiplier of 20x. So technically, 3*20x means 60 crores. The market valuation of our company would be 60 crore rupees. So what's the benefit of investment banker in it? Well, whatever the funding we will raise this investment bank will charge 3-7% under-writing fee.

Suppose we raise our Series-A round from Lala ventures. And we raise 6 crore rupees from Lala Ventures. To raise this 6 crore rupee amount according to our valuation in the market we will have to give 10% stake to Lala Ventures. So in that case, we will dilute 5% each. And we will give this 10% stake to Lala Ventures in the return of which, we will get 6 crore rupees. Many of you must be having this question in your mind, on what things this valuation multiplier depends?

• These are some factors on which this valuation multiplier depends! No. 1 - Industry growth rate, what is the growth rate of the industry you are working in? No. 2 - TAM(Total Addressable Market Size) Means how big your market is? No.
• 3 - Serviceable Market Size. How much markets do you have the capacity to serve, or in future, you would be able to serve this no. of people. No. 3 - Scalability. On what level is your startup scalable?
• Is it that your startup is not scalable at all? And last and most importantly, Operational Leverage. In very simple words, How much do I have to increase my cost to increase my revenue? For an example, if I am software company and I make softwares, then it would cost me one time to make that software, but now I can scale it as much as I want, I don't to bear its cost again and again! So technically, my our operational leverage is very high. Now see, when you multiply that multiplier with your revenue, then comes your startup market valuation, and the fun fact over here is in most of the cases, the multiplier is not in the hands of start-ups.
• Only revenue is in their hands. That is the reason, the key focus of the majority of the startups that is their revenue metrics. But the question is, why? What will happen to profits? Well, let me tell you! VCs are in the business of entering and exiting the business.
• They don't care about profits. Every investor of startup want a good exit. And how would they get that exit? By increasing the valuation. See, if you really want to invest in the stock market, then it is very important for you to take care of little expenses which take a bigger form later! Such as brokerage, whenever you buy or sell stock, you will have to pay brokerage, and what if, that brokerage become nil for lifetime.

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So if you liked this idea, then you should definitely try out mStock. Now coming back, I know what are you thinking how does the valuation of those startups increase so much? Now taking the same example, Divine media raised 6 crore rupees they will use that money to boost their revenue figures. For which we will give customers to our customers, and will do other marketing activities. So by burning 6 crore rupees we increased the revenue of Divine Media from 3 crore rupees to 9 crore rupees.

In that scenario, even if we get the same multiplier, in that case also, 9*20 equals to 180 crores. Our valuation which was 60 crore rupees earlier, now it has increased to 180 crore rupees. Because our revenue has increased three times. So technically, Lala Ventures who put 6 crore rupees in our company today, their stake is worth 18 crore rupees. And this is where the next funding round comes in place. Now I, Vaibhav and Lala Ventures we go again to raise funding round of Series-B.

This time we raise, suppose from Ritik Venture and Amit Ventures at a valuation of 180 crores. The question is why would Ritik and Amit Ventures invest money in our startup? Because they take a risk that when the company will raise money in Series-C it is going to be higher valuation than 180 crore rupees. At that time, we will dilute our stake and make money and will our stake later when the valuation goes high. So it is very very simple, Series-A, Series-B, Series-C and other funding rounds in all of these, a bubble gets formed on the valuation of the startup. All these VCs and founders forms a bubble and at the end of the day this bubble comes in the stock market in the form of IPO.

So that by taking money from common people like you and me, they can take money to their home. I know what you are thinking, if this game of valuation goes like this then why do common people like you and me invest money in these startup? Why the stocks of these IPO are crashing after we invest money in them? The answer to this is hidden in this, strategies to make you invest in an IPO. Whenever a startup comes with IPO they use different form of strategies so that more people invest money in their IPO, and the fun part is many players play their role in it. So again, four players play their role in IPO marketing strategy.

• No. 1 - the founders of the company! No. 1 - the brokers i. e. brokerage companies.
• No. 1 - the traders. Last and most importantly, the influencers. Founders do interviews, podcasts, public appearances, get a lot of articles published about them and their company. Brokers run ads, create content, publish newsletters related to that IPO, so that more and more people show interest in that IPO. And then comes, traders and influencers.
• Now see, what they do! So see, majority of traders and influencers they will give you these two information about IPO. No. 1 - Profit and Loss. If there is profit, then maybe you should invest, and if there is loss, then you shouldn't invest. Basically, they talk about profit and losses of the company.
• No. 1 - A lot of good traders and influencers they compare the industry P/E ratio to the company P/E ratio, to form a clear picture in the mind of people, and because a few people have got advanced, they talk about ROAS. Return on Ad Spend, that how much return is the company getting by running an ad. After that you make a decision of investing and not investing. But wait a second, at the time of IPO, for founders and VCs there is a lock in period of 6-18 months, so technically, they can't sell their stocks before that. But in a lot of cases, it has been seen that price starts declining before that.

So how all this happens? Well, it is super simple. The way VCs want this bubble to grow bigger with each funding round in the same way, when the startup comes with IPO the retail investors also wish that the bubble should be even bigger. So that we can sell share and book profits. People invest in startup IPOs for short term listing gains not long term gains. Now the thing is when this happens one out of these two things happens.

Either they face listing gain or listing loss. If there is listing gain, they sell their shares, to book their profits. Suppose, if there is listing loss so in that case, they panic sell their shares. They panic sell their stocks to avoid more loss. So in both scenarios, as soon as the IPO launches, after some days shares start floating more in the market. Why?

Because majority of the retail investors start selling the stock As a result of which, in no times the stock price starts declining. Because of which until the lock-in period of the founders and VCs expires till then that stock value has declined so much that they can hardly make any profit. That's why they already dilute their most of the stake they earn already what they want to earn. Because they know that this thing will happen with their startup! But you know what, they are so smart that they have figured out another way to make money. See, they sell stocks before lock period expiry because they know that the company is loss making.

So they figured out a way that how we can show our startup as profit making through financial engineering, so that people don't sell their stock till expiry of lock in period, people keep holding that stock, because they know a fact that if they show company profitable, then people keep holding their stock for long time, And this is what these guys want. When lock in period expires they get an excellent opportunity to sell their stocks and get an exit. But, but, but who faces loss in this? Common people like you and me. And this thing takes us to the most important question, as a retail investor, what are those things which we should consider? Well, it is very simple.

Find out the hidden things. Whenever any IPO comes, whether it's of IPO or not, there would be definitely something which is hidden from you. And if you find out that thing the actual reality of that IPO is hidden in that thing. Let me make it very simple for you, whenever any IPO comes, before investing in it you need to figure out four things. No. 1 - Why IPO?

Why is that company coming with IPO?

No. 1 - Fund utilization? What would it do with the money it is raising? Isn't it that the major portion of IPO if OFS i.e. Offer For Sale, in which the founder would take the money to their home. Or does the company genuinely need money for its growth? Technically, find out what would be the utilization of the fund it is raising, and you will this whole information easily. No. 1 - Unusual profits.

What is the core reason behind that IPO?

See, when the IPO comes, there is some kind of financial engineering involved. To show the profit of that company more and more. Your job is to find out the unusual profit of the company. Means that the profit of the company is coming from revenue from operations or the profit they have shown is coming from somewhere else? Because if there is no profit from revenue from operations that means it an an unusual profit, and company can't sustain that profit, Last and most importantly, intangible assets. Just read the balance sheet of the company and the worth of intangible assets.

And what are those intangible assets? In most of the cases, companies use intangible assets to make balance sheet powerful. And especially goodwill in those intangible assets. Because goodwill is such a thing, you can't question about! Using that they make their balance sheet more strong. And please, it is my humble request, while investing in any IPO, never invest money after getting influenced.

Do your own research and if you don't understand most of the things, and if you want to learn, you can checkout our second Artcile. Because here I teach all those things which will help you in taking smart investment decisions.

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