Why is SEBI interested in ratings for startups in India?

The Securities Exchange Board of India recently asked private equity (PE) and venture capital (VC) funds focused on private market investments to disclose details of their valuation practices.

Over the past year, India has seen the creation of several unicorns as venture capital and personal capital owners have scrambled to fund start-ups in various sectors.

In 2021, India saw investments of nearly $39 billion, which is a fourfold jump from last year. India even beat China in the number of rhinos produced, with 44 rhinos created in 2021 versus 42 rhinos created in China. However, the total amount of funding for China was greater than the money raised by Indian start-ups.

The regulatory crackdown on Chinese tech companies has helped Indian companies attract more investor interest as well. Despite the much-reported funding slowdown in the first half of 2022, India created 14 new unicorns while China created 11 of them.

However, despite the optimism surrounding the Indian startup space, SEBI has requested funds to provide details on fund valuation methodologies.

There may be several reasons why SEBI may solicit funds about changes in fund valuation methodologies, qualifications of evaluators, the relationship of the appraiser to the fund, use of audited or unaudited data, etc.

Typically, PE and VC funds operate through closed-end funds known as Alternative Investment Funds (AIFs). These funds are closed with significant exposures to unlisted companies.

Startups are usually money-losers, have volatile earnings, unproven business models and have many other characteristics that make them difficult to evaluate. Unlike mature corporate valuation metrics such as earnings percentage, discounted cash flow, or multiple operating earnings are not easily applicable. As a result, valuation methodologies for start-ups vary greatly and require relatively more guesswork than valuation of mature firms.

By inflating portfolio companies’ valuations, fund managers can show higher returns, while companies can raise money in the next round with higher valuations.

Inflated valuations mislead investors about the manager’s expertise, and investors may not have an accurate idea of ​​the fund’s actual performance. However, apart from the management fee, the fund manager only earns money from the investment after selling the shares of the fund. Once the manager achieves returns above a certain threshold, he is entitled to a percentage of the investors’ returns.

Moreover, recent collapses in company valuations in the public market may have prompted SEBI’s move as well.

Most of the tech companies’ initial public offerings were made with buttery valuations, and eventually led to huge losses for public market investors.

Even the management of the technology company associated with the IPO has justified the valuations by saying that the valuations were fully justified because private market investors had given them a similar valuation prior to the IPO. Realistic valuation methodologies would have prevented these companies from the severe multiple pressures these companies faced.

A recent wave of corporate governance issues in startups may have prompted SEBI to look into valuations.

The use of unaudited numbers for valuation may allow companies to continue raising funds based on numbers that may not reflect reality.

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

Strict accounting allows companies to make their financial statements look better than they actually are. Sometimes management has to constantly adjust the financial statements in order to maintain the company’s valuations. In recent months, many startups have come under the radar for tax evasion, commissions, shell company payments, inflated revenue and other issues after auditors pointed out these issues.

While it is difficult to understand SEBI’s motivation for inquiring about assessment practices, there are possibilities about SEBI that suggest more consistent assessment practices. However, as we explained earlier, the value lies in the eye of the beholder.

Given the complexity involved in valuing companies, some insightful investors may be willing to pay higher valuations for some companies, while others are unable to see the opportunity. Moreover, all developed markets require a diverse set of participants who value companies differently in order to provide market liquidity and help discover true intrinsic value.

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