Bottomline | Understanding SME IPOs and risks

SEBI (Securities and Exchange Board of India) has issued a warning on SME (small and medium enterprises) offers and listings to investors and there are reasons for such caution even beyond the manipulation of shares by promoters. Here is why.

Comparing an SME to a large company is like pitting David against Goliath. And in the real world, very few Davids manage to defeat Goliaths.

This needs to be taken into account when evaluating investment in SMEs.

What’s more, investing in certain asset classes requires different types of experience and ingenuity.

Therefore, you need to decide what you are qualified to do before deciding whether SME investments are right for you or not.

But first, let’s understand the risks.

THE SCALE OF RISK

Only one in ten startups survives. This means that if you invest in a startup, chances are only one in ten bets will succeed.

In terms of risk, SMEs may be a little better off. And while I have not been able to find definitive data on SME insolvencies alone, banking sector data shows that 6-7% of SME credit becomes non-performing each year.

Read also: Small IPOs become bigger in subscription as investors ignore risks to make a quick buck

This means that around seven out of every hundred SMEs experience financial difficulties every year. In comparison, very few large listed companies become insolvent within a short period of time.

Therefore, when evaluating SMEs, a higher risk premium should be assigned to expected returns and, consequently, lower valuation multiples compared to their larger peers.

So, on a peer-to-peer basis, my guess is that an SME should be trading at a 30-40% discount to a large, established peer.

ACCESS AND CAPACITY

The most important thing when investing in a startup or SME is access and experience to evaluate the prospects of said business.

You know very well that investors in startups go through several interactions with the promoters and perform due diligence before investing money. They are also involved in helping grow the business and guiding the management team, especially if it is led by young professionals.

This access, combined with the experience and involvement of investors, creates probabilities that help investors make money. Without this, 10 out of 10 investments could end up failing.

In the case of SMEs, the risks are also high. Therefore, access to management, knowledge of their reputation and market position, knowledge of their financial strength as promoters and of their business capabilities and strategy are important factors in order to make an investment with a reasonably good chance of making a profit. Without this, the odds are against you.

QUESTION OF SCALABILITY

In any equity investment, the potential of the company being invested in to grow and scale is extremely important. This is what separates the men from the boys.

For every Amazon and Flipkart, there are thousands of startups that fail. The reality of business success is that only a few will manage to grow and thrive.

The big issue with Resourceful Automobile’s recent IPO that attracted a lot of attention on social media is the issue of scalability.

Read also: Resourceful Automobile, the SME that has subscribed 419 times its IPO, is listed at issue price

The key issues to be analyzed by way of illustration in this case and in all IPOs of this type are: the nature of the business, scalability, profitability, expansion and diversification potential, peer business models and competitive intensity.

In the case of Resourceful Automobile, it must be noted that the company is a Yamaha 2-wheeler dealer with a small presence in a locality in Delhi.

The first thing to consider here is Yamaha’s prospects in this segment in India. It currently has the lowest market share among non-pure EV players in the country. And dealer growth depends on Yamaha’s success as the OEM handles all the marketing.

The listed company is the one that houses the Yamaha dealership. As a general rule, no original equipment manufacturer (OE) will allow a corporate group to sell products from any other brand in a company.

This, therefore, limits the expansion of business with other brands of this company. This is unlike Landmark Cars, a larger listed company which has 11 subsidiaries under the listed entity for partnerships with 11 OE brands including Mercedes, Jeep, Honda, VW, BYD, KIA, MGM, M&M and Ashok Leyland.

Resourceful Automobile therefore has no future beyond Yamaha, although the developer could create another company to sell another brand.

Furthermore, margins in the dealership business are around 7% and that is in line with the company’s historical figures and last year’s numbers seem like an aberration, so any valuation model should attribute a multiple accordingly.

The big question here is, can Resourceful Automobile be among the top 5 two-wheeler dealers in the country? Currently, that seems impossible, unless Yamaha does some magic.

GOVERNANCE IN QUESTION

Another major risk is the lack of knowledge of the promoters and the quality of governance, which makes it extremely difficult to distinguish between the good and the bad.

SEBI has clearly warned that promoters have been making announcements and using corporate actions to influence share prices for their own benefit in several SMEs. This poses a huge risk.

Read also: A report on greed and fearlessness in India’s frenetic IPO market

Furthermore, you never know what the published figures are hiding. It is not difficult to falsify the accounts and you can never know if they reflect reality unless you know the auditor and his ethical standards.

SMEs are better off being left alone

For the retail investor, venturing into the SME segment is generally a no-no for all the reasons mentioned above.

It is better to earn a little less profit than to lose capital. Leave investments in the SME segment to investors who know the subject.

Happy investing!