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Investors Should Be Wary of the Coming Startup Markets

Despite the excitement around SEBI's new startup IPO rules, individual investors should be wary

It seems to be the modern consensus that there are two kinds of businesses--startups and just businesses. Everything about startups are different and now, as per new regulations announced by SEBI, they will different kind of IPOs as well. I'm sure there are lots of investors who read headlines about hot new startups and the pot of gold that awaits those who have put money in them. Soon, thanks to the changes being brought about by these new regulations, startups can launch IPOs in India, and a lot more people can invest in them.

Under the new rules, startup IPOs and trading will be will be on a separate platform within the stock exchanges, institutional investors (QIBs, in the official nomenclature) and non-institutional investors will be able to invest, but retail individual investors won't. Non-institutional investors include individual investors who can invest more than a certain amount, which is generally ₹2 lakh but in this case has been set to ₹10 lakh. Basically, individuals can invest in startup IPOs, but the minimum ticket size is ₹10 lakh.

If you've been following this news, you probably appreciate the logic behind this move. Existing Indian rules are pretty hostile to startups, which has resulted in many such businesses to domicile themselves outside the country. IPO rules that effectively bar such businesses also limit funding and exit options for entrepreneurs. Such points are as they are, but the general focus on them means that we are not looking at the issues from potential investors' point of view.

It hardly needs to be pointed out that investing in startups will be a very different business than the kind of equity investing that even a seasoned investor might be used to. There won't be any conventional track record of profitability, nor will any normal methods of equity research or analysis be of much use. Nor, indeed, will you have company managements saying the kind of things that you are used to. Instead, you could have, someone like one of the Flipkart founders who said some months back that they had no plans for becoming profitable soon. This company, feted by everyone as Indian ecommerce's poster child, had losses of ₹10,289 crore on sales of ₹29,377 crore in 2014-15. If it meets its target of ₹70,000 crore sales this year, it could well have losses of around ₹20,000 crore. As an investor, do you feel equipped to evaluate such a business?

The problem with all this is that startups are not permanently immune to the normal laws of business, nor are richer investors immune to getting swept along by stories of imminent world domination that startups like to spin. Almost without exception, all Indian startups who have captured any market share have done so on the strength of unsustainable cash burn. This is considered normal for all tech startups, but there is a difference. When Google was burning money back in 1999-2001, it was using the cash in building its technology and its infrastructure. The same is true of Facebook or Twitter at the equivalent stages of their history. This was even true for Amazon at one stage.

In contrast, much of the startup scene in India today seems to consist of businesses that are literally giving away money to gain customers. I know there's the whole last man standing theory that these businesses are being built on and I won't get into arguing against that. Maybe, a day will come when except for one in each category, all web-based businesses will shut down and my best of luck to all of them.

However, all this does mean that the startups that do IPO in this new exchange will be a poor match for the individual investor, even one who can invest ₹10 lakh and above. Unless the amount you invest is genuinely an irrelevant 'fun money' allocation, investors should stick to businesses that can be evaluated by conventional measures of profitability and track record. Every startup has a story about growth and potential and maybe some will turn out to be true but as an investor, you will have no reasonable way of predicting which is true. Equally likely, it may be that by the time these startups reach the IPO market, they will either be massively over-valued and/or the IPO will just be an exit just before failure for the earlier investors. Examples of all these exist in abundance in other markets.

Effectively, the startup IPO market will be a combination of an opaque and risky future with high valuations. Which is really not what the individual equity investor in India needs.