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Understand risks well before you decide to hop on to the IPO bandwagon

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It is IPO (initial public offering) season again, and many of India’s unicorns are now looking to list on the market. These IPOs have gotten a lot of investor interest because funds are being raised for startups that many investors are very familiar with. It is tempting when you see a company go from zero to hero to want to participate in that story.

But just because these flashy new startups have shown tremendous growth in the past does not mean they will show similar growth in the future. It is important to remember a few things when thinking about these companies.

Listing day: Purely because of the unbelievable amount of retail interest, you might see these stocks move up on listing day. However, if you look at the history of many IPOs, the gains on listing often do not necessarily translate into long-term performance. And, because of the way the IPOs are allocated, retail investors might not actually get many shares in their account to create a significant amount of wealth. Nonetheless, when they see the stocks move up sharply on the first day, they can get swayed into believing that this stock is on its way up and therefore can get tempted to buy more in the secondary market—and this is something to be cautious about. It is better to buy based on fundamentals rather than looking at the fact that someone else might have made money in a stock.

Pricing: There is a reason that a company is raising money. Sometimes, the funds raised is for the purpose of expanding the underlying business. But in many cases, particularly for the new unicorns, the reason for going public is to give an exit to existing investors and shareholders. These shareholders typically are large institutional funds and employees of the company. These are some of the smartest investors on the planet and have a very deep understanding of their own company. No outsider would know as much as they do about the business prospects of the firm being listed. Every person wants to maximize his/her profits and, therefore, these IPOs are priced to perfection—to make maximum money for the current shareholders as well as merchant bankers. Sure, they could be wrong, but an investor must ask himself/herself what edge they are bringing to the table and what insights do they have which the promoters and existing shareholders have missed. And, more important, is this edge enough to give the new investor profits on their investments?

Growth and profits: Many new unicorns that have come up in the past few years have become big on the back of burning money and on discounts. Many a time, profits are on the back-burner and, in fact, the companies are loss-making. However, public market shareholders have very different expectations from private investors. Public shareholders expect both profit and growth. But for many of these startups, it is difficult to transition to a business model away from freebies and towards profitability. Moreover, when you take away discounts, it will have a major impact on growth. Investors don’t have to look very far for examples such as Uber in the US where we have seen this play out time and again. Although this is not true of all startups, it is important to be aware about this change in dynamics from going private to public and the impact it can have on a company.

Timing: Why is it that all these IPOs are coming at roughly the same time? Each unicorn has a different business model. Is it a coincidence that suddenly all these unicorns realize that right now is the time to go public with their company? Or is it that many of their existing investors see that the overall stock market is frothy, and they can therefore extract maximum gains now compared with a few months down the road? They may be wrong, but it is something to be cautious about.

Startups have a huge novelty factor, and it is tempting to want to participate in their story. After all, many of us have heard about knowing what you invest in. But there is a difference between knowing a company and being able to fundamentally judge if you can make money by participating in its story. And, therefore, a retail investor should really question where his/her edge lies. Some might still feel that they have a deep understanding and can make money. But for most, it is better to avoid the hype, diversify and leave the role of investing either to professional managers or to the simple low-cost passive funds.

Rishad Manekia is founder and managing director, Kairos Capital Pvt. Ltd.

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