[Tejasvi is a student at NALSAR University of Law.]
The Securities and Exchange Board of India (SEBI) has recently proposed changes to the pre-listing and post-listing framework for small and medium enterprises (SME) through its board meeting dated 18 December 2024. Through this, SEBI has approved changes in the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018 (ICDR) as well as the applicability of corporate governance provisions under the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 to SMEs. The measures approved by SEBI are in furtherance of its consultation paper (Paper) dated 19 November 2024, although it diverges from it in many respects. Out of all the changes approved, the author will focus on those which raise certain concerns.
SEBI, in its Paper, has elaborated on the rationale behind these changes, primarily aiming to curb the misuse of SME IPO proceeds. In many instances, funds raised through SME IPOs were being diverted through related parties or shell companies, facilitating artificial inflation of revenues via circular transactions. A recent example is Trafiksol ITS Technologies, whose INR 44.87-crore IPO was cancelled after SEBI uncovered plans to divert funds to a shell entity. This case, along with others, highlights the pressing need for changes in the SME IPO process, especially given the growing retail participation in such issues.
This piece explores whether SEBI’s recent reforms are enough to rebuild trust and drive sustainable growth in the SME-IPO space. It breaks down key changes from the latest board meeting, looks into its broader implications and suggests the necessity of further steps. While the reforms tackle important areas like profit eligibility, disclosure standards, and post-IPO governance, there is still work to be done to bridge the gap between policy and informed practice.
Introducing Profit Requirement as an Eligibility Criteria
SEBI has recently updated its eligibility criteria for SMEs planning to launch an Initial Public Offer (IPO) by introducing a fixed profitability threshold. Previously, SMEs only needed to show a positive operating profit at least twice over the past three years. Now, the updated rule requires these companies to report an operating profit of INR 1 crore at least twice in the past 3 years. This stricter requirement may overlook companies' growth potential, especially when considering examples like Amazon, which became profitable only after a considerable period since their IPOs. For many SMEs, a high profitability bar alone does not fully capture their long-term promise, potentially leaving promising companies without the funds they need to grow.
Just as SEBI provides two pathways for mainboard IPOs under Section 6 of ICDR—one for companies that are profitable and another for those that are not—it could adopt a similar approach for SMEs. SEBI has done this for mainboard IPOs because it realizes that the potential of companies is not always perfectly reflected in fixed profit benchmarks. Instead of relying solely on these rigid profit benchmarks, SEBI could offer alternative criteria, such as revenue growth over recent years, positive cash flows, solid return on investments, or healthy return on capital. These alternatives would allow companies with high initial capital requirements to attract public investment if they demonstrate other signs of financial strength and future potential.
Alongside these alternatives, to provide better protections for retail investors, SEBI could follow the pathway of Mainboard IPOs under Section 6(2) of the ICDR, in that it limits a very small amount of the IPO subscription for retail investors. This approach would balance the need for the financial protection of retail investors with the recognition of potential growth, ensuring that promising SMEs are not unfairly excluded from accessing public funds. SME IPOs were primarily introduced to address funding challenges, and any rigid profit criteria undermines this purpose.
Monitoring of Funds Collected
SEBI has capped the allocation for general corporate purposes (GCP) at 15% of the raised amount or INR 10 crore, whichever is lower. Reducing the limit under Regulation 230(2) of the ICDR from the previous 25% of the raised capital, enhances oversight and ensures better monitoring of fund utilization. GCP as defined under Section 2(r) of ICDR, refers to funds raised from the public without a specific designated purpose, giving SMEs significant flexibility in their use. This threshold reduction aligns with SEBI’s broader goal of preventing the diversion of public funds. This unrestricted access creates the risk of funds being utilized for purposes beyond what investors intended, making SEBI’s changed threshold a necessary move.
While SEBI has revised the GCP threshold, it has rejected certain other proposals made to achieve a similar aim of monitoring the fund utilization. The rejected proposals to achieve this aim are (a) appointment of a monitoring agency when the fresh issue size exceeds INR 20 crores, and (b) mandatory quarterly disclosures of shareholding patterns, statements of deviation or variation, and financial results.
SEBI's rejection of the first proposal risks hindering its goal of ensuring the productive use of SME funds. At the same time, this rejection was crucial, as lowering the threshold for mandatory monitoring to INR 20 crores from the present INR 100 crores under Regulation 262 of the ICDR, would have imposed undue financial burdens on SMEs striving to raise capital with minimal obligations. While SEBI should rightly change the threshold to make it proportional to the SME platform instead of just applying the mainboard threshold to the SME platform. In changing this threshold, it should also take into account that the SME companies will have to pay monitoring fees. The threshold should not be reduced so much such that it would end up discouraging smaller companies from accessing public funds, counteracting the purpose of the SME platform.
SEBI's rejection of the second proposal for mandatory quarterly disclosures of shareholding patterns and financial results is a prudent decision, given the high compliance costs such requirements would impose on SMEs. Such disclosures are undoubtedly valuable for ensuring compliance post-IPO in mainboard companies. However, applying the same requirements to SMEs as the mainboard could place an undue burden on these smaller entities. Thereby, SEBI was right in rejecting this proposal as it would have added pressure, ultimately discouraging SMEs from accessing public markets.
While both of the rejections are cost-effective for SMEs, more balanced and nuanced criteria could have been brought, balancing the investor-required transparency with SME-required cost-effectiveness. Such a balanced approach would involve taking into account specific risk indicators while asking to comply with either the appointment of monitoring agency requirement or requiring quarterly disclosures. Such risk indicators include things like not meeting the profitability requirement etc. SEBI should also require mandatory monitoring when the issue funds are allocated for specific purposes such as funding a subsidiary, repaying loans for a subsidiary, investing in a joint venture or subsidiary, or acquisitions.
Pre-IPO Disclosure Requirements
SEBI has now made it compulsory for SME companies undertaking an IPO to file a draft red herring prospectus (DRHP) to be open for public comments for 21 days from the date of release of the DRHP. This move aligns SME IPO requirements with the Main Board's DRHP norms as mentioned under Regulation 26(1) of ICDR. While SMEs did publish DRHPs, there was no fixed window for keeping it open for public comments. This allowed SMEs to release red herring prospectus (RHP) in very short durations, without even getting or acting on any public input. As per the earlier requirement, releasing a DRHP became a mere procedural requirement to be checked off the list before bringing out an RHP. Now, with SEBI’s newly added mandate to keep DRHPs public for 21 days, it is no more just a box to tick but a genuine opportunity for public engagement before finalizing the RHP. This increases transparency by enabling public scrutiny and feedback, ensuring that the process becomes more democratic and SMEs could not just bring out a quick RHP.
While a good step has been taken in mandating DRHP filings, SEBI has also rejected certain other pre-IPO disclosure proposals which can turn out to be a little problematic. In the Paper, SEBI had proposed to make it mandatory to disclose senior management personnel (SMPs), details vis-à-vis compliances regulated by Employees' State Information Corporation / Employees' Provident Fund Organisation viz. number of employees registered on the said portal, amount paid, delay in payment of due for past 3 years. All these proposals have been rejected by SEBI.
For SMEs in their formative stages, leadership is decisive in shaping growth and stability. Investors do not rely solely on financial metrics; they also scrutinize the caliber of those steering the company. Disclosure of SMPs not only enables investors to form a complete outlook of the SMEs but also equips them to provide more informed and complete feedback on all the disclosures and information given in the offer documents. Disclosure of other details like social security contributions helps the investors know about the financial capacity of the SME and the regularity of its financial payments. Declaring details like such help investors gauge the capacity of the SME to keep up with regular mandatory payments, which helps ensure their future growth. These disclosures would have given investors deeper insights into an SME’s financial discipline and leadership quality, aiding more informed decision-making.
Conclusion
While SEBI's recent reforms seek to address key issues in the SME IPO space, they risk falling short by relying too heavily on fixed and rigid profit criteria as the primary measure of eligibility. A singular focus on profitability fails to account for the diverse growth trajectories and potential of many SMEs. This narrow approach overlooks the fact that several high-potential companies may not immediately meet the profitability threshold, even though they exhibit solid future potential. Rather than relying solely on these inflexible profit requirements, SEBI should pivot towards a more dynamic and nuanced regulatory approach as discussed by the disclosures suggested above. Incorporating additional disclosure requirements—such as demonstrating revenue growth, providing clear cash flow projections, and offering transparency about senior management personnel—would offer investors a complete and more informed picture of an SME’s financial health and future prospects. Such disclosures would better protect retail investors, allowing them to make decisions based on a broader range of financial signals rather than just short-term profitability. Another step to strengthen the regulatory framework is to refine post-IPO fund monitoring requirements, ensuring a balanced approach that addresses investor concerns while considering SME cost constraints.
SEBI’s primary goal should be to create a regulatory framework that balances financial discipline with the need for flexibility, enabling SMEs to access capital without being stifled by rigid profit constraints. Having a better regulatory framework would ensure that only companies with genuine potential—whether immediately profitable or not—can tap into public funds, while safeguarding investors from undue risk. In doing so, SEBI can foster a more inclusive, transparent, and sustainable growth environment for SMEs in India.
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