Investing in loss-making IPOs: A cautionary tale

The year 2021 has been witness to a raging bull market with the Sensex more than doubling since last year’s March lows. Unsurprisingly, we have also observed a flurry of IPOs this year, with 49 main-board IPOs so far, cumulatively raising a mammoth Rs. 1,01,053 crores from investors. This has also been a great opportunity for many start-ups to introduce themselves to the public. Tech start-ups like Zomato, Paytm, Nyka, PB Fintech have hit the market with a storm, raising a combined total of more than 38,000 crores which is 38% of all the issues so far this year. The street eagerly awaits upcoming IPOs of tech firms like MobiKwik, Ixigo, PharmEasy, and RateGain Travel. However, the key characteristic that differentiates most of these tech firms from other firms launching their IPOs is that they are loss making firms. For instance, Zomato, Paytm, and PB Fintech reported the loss of Rs. 356 crores, Rs. 381 crores, Rs. 110 crores respectively for the quarter ended June 2021. MobiKwik witnessed an 11% increase in its loss levels to Rs. 111 crores for the FY 2021. However, despite being loss making firms, retail investors are eagerly look forward to bidding and participating in these IPOs.

Such bizarre phenomenon poses many questions like (1) Why are tech firms with high growth potential and optimistic future outlook still incurring losses? (2) Why are investors showing keen interest in loss making tech IPOs?  and (3) What parameters should an investor look into before participating in the IPO of a loss-making firm? Let’s first understand why these tech firms are incurring losses. The key reasons for reporting such high losses are (i) high employee acquisition cost (ii) high sales promotion expenses, and (iii) high cost of acquiring the latest technology. Start-up firms have to pay higher salaries to hire skilled employees and offer better perks and benefits to retain them. RateGain’s employee expenses constitute 71% of its total revenue and these expenses grew by 11% from FY19 to FY20. Tech start-ups also have to undertake high sales and promotion expenses to tap different customer segments. MobiKwik spends almost one-third of its revenue from operations on its business promotions. Policy Bazaar disrupted the insurance industry by offering faster, convenient, and transparent digital solutions to handle claims and to offer ancillary financial services to customers. In India, the insurance industry has traditionally been an offline industry that heavily relies on human trust and interface.

Another key phenomenon that has to be deciphered is the retail investors’ keen interest in loss-making IPOs. According to the SBI report, 14.2 million new individual investors have entered the equity market as they no longer find fixed deposits and small savings schemes as attractive investment options. Their hunger for higher returns is driving them to tech IPOs. They don’t want to miss out on the Indian digital unicorns who use exceptional user interfaces to offer viable and convenient solutions to the untapped Indian market. Further, these tech start-ups have received progressive rounds of funding from venture capitalists, which has driven their valuation to peak levels. Some investors truly believe in the story of Digital India that enjoys increasing internet and smartphone penetration, and hence don’t want to miss out on being part of a valuable firm. Another chunk of investors simply aims to get listing gains and thus, aren’t truly bought into the company. Overall, it seems that the Indian retail investors are drinking a heady cocktail of FOMO (Fear-of-Missing-Out) and greed.

So, is there any logical way of evaluating a loss-making IPO? Traditional valuation methods are based on profits. The investors must understand that these tech start-ups are unlike the traditional manufacturing and services firms. They are asset-light firms that disrupt the industry through their innovative digital solutions. Though they are growing at a fast pace, they incur huge expenses to garner and sustain their growing market share. Hence, investors investing in loss making IPOs need to realize that they are investing in potential than profitability. For each Amazon like story, there are thousands of start-ups that have shut shop.  So how does one reasonably evaluate the potential of a start-up? The potential of a firm is defined by 3 M’s viz. Meaning, Management and Moat. First and foremost, the start-up’s business should resonate with oneself. One needs to gain knowledge about the industry in which it is operating and the innovative solutions offered by the start-up. A good grasp of the industry, firm, and the products will enable one to research it well and be passionate about investing in the same. As an investor, one must ensure that the management of the tech start-up is astute and trustworthy. Time must be taken to evaluate management’s background, their strategies, and past performance. Stable and progressive management ensures that equity investment is in safe hands.  Finally, the tech start-up must have a moat i.e., a unique strength that not only ensures its future growth prospects but also makes it difficult for the competitors to seize its market share.

In conclusion, while the investing journey in such loss-making IPOs is riddled with pitfalls, doing one’s homework properly and being prudent with both the quantum of investment and the time duration, should enable an investor to convert this into a successful endeavor. It seems fitting to conclude with Warren Buffet’s quote, “When you find a really good business run by first-class people, chances are a price that looks high isn’t high. The combination is rare enough, it’s worth a pretty good price”.