What Varanium Cloud teaches us about spotting SME IPO traps

"Merchant bankers should learn to say no," Ashwani Bhatia, a whole-time member of market regulator SEBI reportedly said at an event a few months ago, referring to the lack of due diligence from auditors and market intermediaries on SME IPOs. "Nobody is saying no to SME listings, even when they inflate their balance sheets," he said as reported by the media.

These comments may have been inspired by the many fraudulent cases that SEBI has come to take note of in recent months. Varanium Cloud is one of them. The SME company that claimed to provide data centres, e-learning and payment gateway services saw its shares surge 11 times in just four months following its debut in September 2022.

Suggested watch: Should you bet on the SME frenzy?

Come January 2024, when the stock's one-way decline began as investors realised promoters had pared their stake to 36 per cent from 63 per cent earlier. The stock has now wiped over 95 per cent of gains from its all-time high.

A SEBI investigation later revealed the company had misused the IPO funds and furnished false financials. The regulator then passed an interim order in May 2024, barring the company and its promoter, Harshawardhan Sabale, from the securities market. The regulator has recently confirmed the order.

What SEBI found

• IPO proceeds misused: Varanium raised Rs 40 crore through its IPO to build three data centres and three digital learning centres. But during a site visit, NSE found that these facilities didn't exist. Instead, SEBI discovered that the promoter had funnelled the funds to related parties.
  
• Fabricated financials: According to Varanium's financial reports, its revenue had leapt from Rs 4 crore in FY21 to an astounding Rs 923 crore by December 2023. However, these numbers were found to be made up, generated by false accounting entries. Even massive expenses claimed for server and data centre charges towards Amazon Web Services were fabricated with no funds debited from the company's bank account.
  
• False announcements and share dumping: To keep investors excited, the company rolled out a string of enticing but misleading announcements—from launching an OTT platform to introducing jewellery and apparel lines. When the pre-IPO lock-in period expired, the promoters quickly sold their shares, walking away with profits of over Rs 140 crore.

Spotting trouble early

It is challenging to spot a fraudulent company early on, especially when it's fabricating its financials. However, Varanium had many glaring red flags even in its publicly available information. We have listed them below. These warning signs should serve as a guide for investors to spot potential traps, especially in SME public offerings, that lack stringent scrutiny.

Red flag 1. Profit without cash flow

Varanium Cloud reported Rs 178 crore in cumulative profit over 18 months ending December 2023, but its operating cash flow was a mere Rs 8 crore. This means the company had high receivables, which is unusual for a capital-light IT business.

Your lesson: Higher profits with poor cash flow may suggest that a company might be using accounting practices to inflate profits without generating real cash by recording fictitious revenue or overestimating receivables. In other cases, poor cash conversion also limits a business' ability to run operations smoothly. Hence, profits without actual cash generation provide no levers for growth.

Red flag 2. Frequent auditor changes

Before the IPO, Varanium Cloud switched auditors every year, cycling through Garg Goel & Co in FY20, APRA & Associates in FY21, and AK Kocchar & Associates in FY22.

Your lesson: Frequent auditor changes may suggest possible disagreements over financial practices and an attempt to cover irregularities. Always research an SME's auditor history to assess the reliability of its financial statements.

Red flag 3. High promoter share pledging

Following the IPO, the company's promoter began pledging shares aggressively. Promoter pledging jumped from 11 per cent 64 per cent from April to September 2023.

Your lesson: High promoter pledging often suggests that the promoter may be financially stressed or preparing to offload risk. In this case too, the company's promoter Harshawardhan Sabale was known to have defaulted on personal debt in the past.

Red flag 4. Promoter's troubling history

Sabale further had a documented history of financial misconduct. In 2009, he was arrested in Goa for allegedly misappropriating Rs 14 crore from a company under the pretext of arranging foreign direct investment of Rs 46 crore for the firm. Another fraud case where he allegedly duped a CEO of Rs 15 crore surfaced in Mumbai, indicating a pattern of fraudulent behaviour.

Your lesson: Investigate the background of a company's promoter or directors. Past financial misconduct is a significant red flag and may hint at a tendency for unethical practices.

The allure of making outsized returns in SME IPOs is tempting. But as Varanium Cloud's case illustrates, due diligence and a granular analysis is essential, especially since SME companies operate under lighter scrutiny.

Also read: 5 SMEs that made to the big league