[Abhishek and Ishan are students at NALSAR University of Law and National University of Advanced Legal Studies, respectively.]
Equity markets are often viewed as a reflection of the financial sector and a key indicator of the economy’s health. Consequently, thriving market for new issues of publicly offered equity securities, or the initial public offering (IPO) market, is perhaps the most direct and tangible evidence of an economy where new businesses have confidence in their future prospects. A significant stakeholder in a developing country such as India, are small and midsized enterprises (SMEs). Post the pandemic sluggishness, the Indian startup ecosystem witnessed a significant revival in 2024, strengthened by a series of successful IPOs by emerging companies, coinciding with a recovering funding environment. During the year, 13 startups, including prominent names such as Swiggy, Mobikwik, and Ola Electric, successfully entered the public markets, collectively raising over INR 29,000 crore (approximately USD 3.4 billion) from Indian capital markets. In this backdrop, investors expected the IPO frenzy to only strengthen in 2025. However, the decision of the Securities and Exchange Board of India (SEBI) on 18 December 2024, to tighten the reins on SMEs to go public, may inadvertently lead to an all-time economic slowdown albeit its intent to protect investors.
SEBI’s Initial Framework: Defining and Regulating SME Funding through ITP
Small scale industrial units, technically classified as SMEs, are defined as industrial establishments with a cap of one crore rupees on fixed, leased, or hire-purchase assets. Similarly, establishments with investments exceeding ten crore rupees fall under the category of medium scale industries. In 2013, the SEBI established the Institutional Trading Platform framework to facilitate SMEs to raise funds without the conventional IPO route. Notably, according to this framework, the investors need to have a minimum trading required of INR 10 lakhs, and the qualified companies were supposed to secure at least INR 50 lakh as their minimum investment requirement from several qualified sources such as venture capital funds or institutional buyers with a three-year lock-in period, etc. Capital raising is permitted only via private placements and rights issues without non-renounceable issues. The exit mechanisms included voluntary exit (90% approval) or mandatory exit in case of crossing thresholds of INR 25 crores of paid-up capital, INR 300 crores of revenue, or INR 500 crores of market cap.
Breaking Down the Regulatory Overhaul
A significant turn came in December, when SEBI through its 208th Board Meeting approved amendments to the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018 and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (LODR Regulations) to be implemented on all draft red herring prospectus’ (DRHPs) filed on or after 19 December 2024. SEBI has clarified that the revision is primarily intended to safeguard the investors. As per the amendments, companies must show INR 1 crore operating profit during two of the past 3 years prior to filing their DRHP. The regulation tightened the offer for sale (OFS) ceiling limit to 20% of issue size and 50% of shareholder holdings. Lock-in conditions now take a stepwise structure for holding of promoters above the minimum contribution with the release of holdings at one and two years. Further, if promoters of a company hold more shares than the minimum required contribution, these extra shares are “locked in” or restricted from being sold immediately. The restriction on these extra shares will be lifted in a phased manner; i.e., after one year, 50% of these additional shares can be traded, and the remaining 50% of the extra shares can be sold or traded after two years.
The regulation also sets forth clear financial parameters by limiting the amount for general corporate purpose to 15% or INR 10 crores, whichever is lower (general corporate purposes include such identified purposes for which no specific amount is allocated or any amount so specified towards general corporate purpose in the draft offer document filed with board). It also prohibits the amount issued to be directly or indirectly used for repayment of a loan of the promoter or any other related party. Further, SME companies are allowed to issue additional shares without necessarily moving to the main board, a platform for larger companies. However, they have to comply with the rules prescribed in LODR Regulations, which apply to companies listed on the main board. Similarly, the process of allocating shares to non-institutional investors (NIIs) shall also be in compliance with the same rules used for NIIs in main board IPOs. Moreover, SME companies listed on the stock exchange must also follow the same rules for related party transactions as main board companies. However, a transaction will be considered “material” or important enough to require shareholder approval if it is worth at least 10% of the company’s annual consolidated turnover or if it is worth INR 50 crores or more (whichever is lower). Also, if an SME plans an IPO, the DRHP of that particular issue should made available to the public for 21 days, with a QR code, so it can be reviewed and feedback or comments can be provided for it.
Assessing the Possible Impact
Historically, the SME IPO segment has been prone to manipulative practices, with pump-and-dump schemes becoming alarmingly common. Empirical data reveals that between 2018 and 2023, nearly 40% of SME IPOs experienced stock price manipulation within their first year of listing, often orchestrated by promoters offloading significant stakes post-IPO. The restriction on OFS, limiting it to 20% of the issue size, addresses this vulnerability by essentially curbing short-term exits. Additionally, the prohibition on using IPO proceeds to repay promoter loans or for excessive general corporate purposes, capped at 15%, ensures that funds raised are directed toward sustainable growth and operational development, reducing the likelihood of financial mismanagement. The prescribed minimum EBITDA threshold of INR 1 crore over 2 of the preceding 3 financial years, further strengthens the market by screening out unstable entities.
This is crucial, as data from NSE SME indices highlights that SMEs with stronger financial metrics at listing consistently deliver better post-IPO performance, with returns averaging 12% higher over three years. Moreover, enhanced disclosure requirements, such as the public comment period for DRHPs, has been empirically shown to improve investor confidence. This aligns the Indian SME framework with global best practices, such as those observed in the UK’s alternative investment market, where stricter entry norms have been shown to correlate with lower instances of post-IPO volatility.
However, this decision came in light of the recent amendment to the Companies (Compromises, Arrangements and Amalgamations) Rules 2016, which eliminated the mandatory approval of the National Company Law Tribunal for “reverse flip” mergers, drastically reducing the timeline for such processes from 12-18 months to 3-4 months. This measure was hailed as a breakthrough, particularly for Indian startups domiciled abroad, as it facilitated their return to participate in the domestic listing boom. The immediate results proved promising with IPO fundraising in India nearly doubling to USD 9.2 billion in the first 9 months of 2024. However, SEBI’s decision to tighten the rules on SMEs to go public may prove to be a double-edged sword for the economy.
As seen in China’s tightening of IPO norms, such shifts in regulatory frameworks can inadvertently introduce systemic risks. In China, stricter scrutiny of IPO processes caused firms to abandon listing plans, compelling venture capitalists to activate redemption rights en masse. Data from consultancy Zero2IPO revealed that redemption exits surged to 641 in 2023, a threefold increase, as over 14,000 startups faced liabilities worth approximately USD 1.2 trillion. While redemption rights ostensibly safeguard investors, their large-scale activation aptly displays the balancing act required to build trust among stakeholders without destabilizing startups. The China startup economy parallels the potential outcomes of SEBI’s reform if unintended consequences, such as overregulation, are not pre-emptively addressed.
The implications of such regulatory shifts extend beyond individual startups to the larger economic role played by SMEs. As highlighted by the International Finance Corporation, a USD 5.2 trillion financing gap affects 40% of formal SMEs in developing countries, half of which lack access to formal credit. Among the 64 million MSMEs in India, only 14% have access to credit. The MSME sector's overall financial demand is dire, standing at roughly USD 1,955 billion, driven by a debt-to-equity ratio of 3.8:1. Of this, $1,544 billion represents the demand for debt-based financing, yet nearly 47% of this debt demand remains unmet and un-addressable.
Conclusion
While SEBI’s decision is to ostensibly protect investors and boost investor confidence, it holds the potential to essentially break the startup bubble that has built up over the past decade. As shown earlier, India’s economy is heavily reliant on the FDIs brought in to the country by such firms. The Indian startup ecosystem attracted over USD 140 billion in FDI, a testament to its pivotal role. Given that India’s economic landscape has increasingly relied on the innovation and FDI inflows driven by these firms, the implications of these reforms extend far beyond investor confidence. The question remains whether startups will adapt to this new regulatory environment, perhaps shifting their business models towards slower, more sustainable growth, or whether the pressures imposed by these changes will cause the startup bubble to burst.
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