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Explained: Why Is SEBI Concerned About India’s Start-Up Valuations?

The Securities Exchange Board of India recently asked private equity (PE) and venture capital (VC) funds focusing on private market investments to disclose detail regarding their valuation practices. Over the last year, India has seen the creation of multiple unicorns as VCs and PEs rushed to fund start-ups in various sectors.

In CY2021, India saw investments of nearly $ 39 billion, which is a four-fold jump from a year ago. India even beat China on the number of unicorns produced, with the creation of 44 unicorns in 2021 versus 42 unicorns created in China. Nevertheless, the total amount of funding to China was larger than the funds raised by Indian startups.

The regulatory crackdown on Chinese technology firms helped Indian firms garner more investor attention as well. Despite the much-talked-about funding slowdown in the first half of 2022, India has created 14 new unicorns while China has created 11 of them.

However, despite the optimism surrounding the Indian start-up space, SEBI has asked funds to provide details about the funds’ valuation methodologies.

There could be several reasons behind SEBI asking funds about the changes in fund valuation methodologies, qualifications of valuers, the relationship of the valuer with the fund, the use of audited or unaudited data etc.

Usually, PE and VC funds operate through close-ended funds known as alternative investment funds (AIFs). These funds are close-ended with significant exposures to unlisted companies.

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

By inflating the valuations of portfolio companies, fund managers could possibly show higher returns, while companies can raise money in the next round at higher valuations.

Inflated valuations mislead investors about the manager’s expertise, and investors might not have an accurate idea of the fund’s actual performance. However, apart from a management fee, a fund manager only makes money from 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.

Further, the recent collapses in the valuations of companies in the public market might have prompted SEBI’s move as well.

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

The management of the IPO-bound technology 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 prevented these companies from the severe multiple compression that these companies faced.

The recent spate of corporate governance issues at start-ups might have prompted SEBI’s move to look into valuations.

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

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

Aggressive accounting allows companies to make their financials look better than it is in reality. Sometimes, management is forced to continually modify financials in order to sustain the company’s valuations. In recent months, several start-ups have come under the radar for tax evasion, kickbacks, shell company payments, inflated revenues and other issues after auditors flagged these issues.

While it is challenging to understand SEBI’s motive behind enquiring about valuation practices, there are possibilities about SEBI suggesting more uniform valuation practices. However, as highlighted earlier, the value lies in the eye of the beholder.

Given the complexity involved in valuing companies, some insightful investors might be ready to pay up higher valuations for certain businesses, while others are unable to see the opportunity. Further, all developed markets require a diverse set of participants who value companies differently in order to provide liquidity in the market and to aid the discovery of true intrinsic value.


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