Explained: Why is SEBI concerned about Indian start-up valuations?

Explained: Why is SEBI concerned about Indian start-up valuations?

The Securities Exchange Board of India has recently asked private equity (PE) and venture capital (VC) funds focused on private market investments to disclose details of their valuation practices.

Over the past year, India has seen the creation of several unicorns as VCs and PEs rush to fund start-ups in various sectors.

In CY2021, India saw investments of nearly $39 billion, four times more than a year ago. India even beat China on the number of unicorns produced, with 44 unicorns created in 2021 compared to 42 unicorns created in China. Nevertheless, the total amount of funding going to China was higher than the funds raised by Indian startups.

The regulatory crackdown on Chinese tech companies has also helped Indian companies attract more investor attention. Despite the much-talked-about funding slowdown in the first half of 2022, India created 14 new unicorns while China created 11.

However, despite the optimism surrounding the Indian startup space, SEBI asked the funds to provide details on the fund assessment methodologies.

There may be several reasons why SEBI asks funds for changes in fund valuation methodologies, evaluator qualifications, the evaluator’s relationship to the fund, the use of audited or unaudited data, etc.

Usually, private equity and venture capital funds operate through closed-end funds called alternative investment funds (AIFs). These funds are closed with significant exposures to unlisted companies.

Startups are typically loss-making, have volatile earnings, unproven business models, and have several other characteristics that make them difficult to value. Unlike mature companies, valuation metrics such as earnings ratio, discounted cash flow, or operating profit multiple cannot be applied easily. As a result, methodologies for valuing start-ups vary widely and require relatively more guesswork than valuing mature companies.

By inflating the valuations of portfolio companies, fund managers could potentially post higher returns, while companies can raise funds in the next round at higher valuations.

Inflated valuations mislead investors about the manager’s expertise, and investors may not have an accurate idea of ​​the fund’s actual performance. However, aside from management fees, a fund manager only earns money on an investment after a sale of the stakes held by the fund. Once a manager generates returns above a certain threshold, they are entitled to a percentage of the investors’ returns.

Additionally, the recent slumps in corporate valuations in the public market may also have prompted SEBI to act.

Most initial public offerings for tech companies took place at frothy valuations and ultimately resulted in steep losses for public market investors.

The management of the IPO-linked tech company even justified the valuations by saying that the valuations were completely justified since private market investors had offered them a similar valuation just before the IPO. Realistic valuation methodologies would have spared these companies the severe multiple squeeze they faced.

The recent spate of corporate governance issues at start-ups may have prompted SEBI to take a look at valuations.

Using unaudited numbers for valuations could allow companies to continue raising funds based on numbers that might not reflect reality.

Recently, a prominent company came under scrutiny from investors and lenders after it failed to disclose its financials and allegedly delayed payments for a deal. According to reports, the company had used accounting practices that auditors were not comfortable with.

Aggressive accounting allows companies to make their finances look better than they really are. Sometimes management is forced to continually change financial statements in order to maintain company valuations. In recent months, several start-ups have gone under the radar for tax evasion, kickbacks, shell company payments, inflated earnings and other issues after auditors flagged the issues.

While it is difficult to understand SEBI’s motive behind the survey of appraisal practices, it is possible that SEBI is suggesting more uniform appraisal practices. However, as pointed out earlier, the value lies in the eye of the beholder.

Given the complexity of company valuation, some savvy investors might be willing to pay higher valuations for certain companies, while others are unable to see the opportunity. Additionally, all developed markets need a diverse set of participants who value companies differently in order to provide market liquidity and facilitate the discovery of true intrinsic value.

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