How to spot IPO red flags before you invest

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Initial public offering (IPO) activity in Indian markets is heating up, with companies raising about ₹ 22,400 crore this month through 26 August. More IPOs are expected before 30 September, when the one-year validity of approvals from the Securities and Exchange Board of India (Sebi) for several companies is due to lapse.

For investors, that raises a more important question: how do you tell a promising IPO from one best avoided?

Unlike established listed companies, IPO -bound businesses have no track record of exchange disclosures or trading history. Investors instead have to rely on what the companies disclose before listing, chiefly through the red herring prospectus (RHP)—a lengthy, technical document that can run across several sections.

You do not need to read every page. A closer look at a handful of sections can reveal potential red flags, help test the company's financial quality and, importantly, determine whether the valuation being sought is justified. Here is what to look for.

“If existing investors are simply using the IPO to exit, that may not augur well, because the basic premise is that the company should make productive use of the capital,” said Aditya Kondawar, partner and vice-president at Complete Circle Capital.

Investors should examine the prices at which shares changed hands in the months before the IPO. “If an investor received shares at a particular price six months before the IPO and the issue is priced at twice that level, did something materially change in those six months to justify the increase?” Kondawar said.

Narendra Solanki, head of fundamental research–investment services at Anand Rathi Shares and Stock Brokers, said investors should also study “what fundraising took place shortly before the IPO, at what valuation and under what circumstances”. The RHP contains these details.

Companies can sometimes make their financials look better around an IPO. Kondawar pointed to instances where businesses pull back on advertising and staff costs to make losses appear smaller or move closer to break-even. Investors should therefore examine employee and marketing costs over several years rather than focusing only on the latest period.

“The RHP discloses information about the promoters, their track record, related-party transactions and any pending litigation. Promoters with a history of frequent business changes or large related-party dealings should make investors cautious. And are there any auditor remarks suggesting weak internal controls?” said Pankaj Pandey, head of retail research at ICICI Direct.

Solanki said investors should also examine promoter and top-management compensation against industry levels, as well as contingent liabilities that may not be immediately apparent. The risk factors section of the RHP is where many such liabilities are disclosed.

Contingent liabilities are potential obligations that do not appear as debt on the balance sheet but could crystallize later, including guarantees given on behalf of others, disputed tax demands, pending legal claims or bills discounted.