Understanding the Business and Its Path to Profit
Before you get into complex ratios, start with the basics: What does the company do and how does it make money? The Draft Red Herring Prospectus (DRHP) will have a detailed section on the company's business model. Many new-age tech companies are not profitable
when they go public. That's not automatically a red flag, but you need to understand their plan to become profitable. Look for trends in their financial statements. Are losses narrowing? Is revenue growing faster than expenses? A clear, sustainable business model is more important than short-term profits. A company that can't explain how it will eventually make money is a significant risk.
The Purpose of the IPO: Growth vs. Exit
The 'Objects of the Offer' section in the DRHP is one of the most critical for investors. It tells you exactly how the company plans to use the money raised from the public. An IPO can consist of a 'Fresh Issue' of shares, where the money goes to the company, or an 'Offer for Sale' (OFS), where existing shareholders (like founders or early investors) sell their stakes. A large OFS component can be a red flag, suggesting that insiders are cashing out because they believe the company's best growth days are behind it. Ideally, you want to see a significant portion of the funds being used for business growth, such as capital expenditure for new facilities, research and development, or market expansion.
Revenue Growth and Cash Flow
High revenue growth is often the main attraction of a startup IPO. However, it's essential to check if this growth is consistent and sustainable. Look at the year-on-year growth rate for the last three years, which is provided in the financial statements. More importantly, check the company’s cash flow statement. A company can show profit on paper but still have negative cash flow from operations, meaning it's spending more cash than it's bringing in from its core business. Consistent negative operating cash flow, especially in a company that's been around for a while, is a major warning sign about its financial health.
Assessing the Valuation
Valuation is a tricky subject for startups, as many don't have profits to apply traditional metrics like the Price-to-Earnings (P/E) ratio. Instead, analysts often look at the Price-to-Sales (P/S) ratio or other industry-specific metrics. A key exercise is to compare the IPO's valuation with its listed peers. The DRHP includes a section on the 'Basis of Offer Price' which can provide some justification. Be wary of excessively high valuations driven by market hype rather than solid fundamentals, as these stocks are more likely to see a price correction after listing.
Promoter Holding and Lock-in Periods
It is important to see who the key people behind the company are and how much stake they will hold after the IPO. In India, regulations from the Securities and Exchange Board of India (SEBI) mandate that promoters must hold at least 20% of the post-issue capital, which is locked in for a period, typically 18 months. This ensures they have 'skin in the game' and are committed to the company's long-term success. Also, pay attention to the lock-in periods for other pre-IPO shareholders, like venture capital funds. When these lock-in periods expire (often 6 months for non-promoters), there can be a large supply of shares hitting the market, which can put downward pressure on the stock price.
Risks and Legal Disputes
Every DRHP has a 'Risk Factors' section, which can be dozens of pages long. While some of these are standard boilerplate, many contain crucial information specific to the company. Read this section carefully. It will highlight dependencies on a single large client, ongoing major legal proceedings, or regulatory uncertainties that could seriously impact the business. A long list of significant legal cases against the company or its promoters is a definite red flag.
