Valuing growth

Start-up listings will open up opportunities

Food-delivery platform Zomato is the first digital start-up to opt for an initial public offer (IPO) in India. Many others are waiting in queue, including Paytm, Mobikwik, Delhivery, and Flipkart. The Zomato issue, which on Tuesday got an enthusiastic response from anchor investors comprising marquee foreign portfolio and domestic institutions, followed the Securities and Exchange Board of India's (Sebi) decision in March to remove several restrictive stipulations that hampered start-ups.The changes included reducing the mandatory holding period for pre-issue investors to one year (from two years) and allowing discretionary allotment to eligible investors. Up to 60 per cent of IPO proceeds can be raised through allotments to “accredited investors”, although these shares would have to be issued at a price equal to or higher than that offered to others.

The IPO values Zomato at Rs 60,000 crore, and the grey market is pricing the share at some premium. This explains the sudden rush of IPOs by other digital start-ups. This is an opportune moment to tap the primary market. The stock market is riding high on plenty of liquidity and optimism. Many of these companies are unicorns, going by valuation in successive rounds of private market funding. Going public will give retail investors and institutions the chance to fund growth. It also gives early investors like Info Edge (which is selling part of its 18.5 per cent stake in Zomato) a chance to book handsome profits and perhaps redeploy cash in other start-ups.

The metrics for evaluating such companies are different. In evaluating conventional businesses, investors seek sound balance sheets and a record of profitability, alongside growth. In digital businesses, investors seek just growth. Zomato lost over Rs 816 crore in the last financial year on revenues of Rs 8,703 crore. It has accumulated losses of over Rs 4,000 crore in the last three years. However, revenues have grown 50 per cent in the last three years and the issue can help fuel more growth. Most digital start-ups have similar records of high cash-burn and sustained losses for long periods. Investors are willing to wait and assign high valuations on the basis of high growth prospects, rather than current profitability.

The underlying logic is simply that it has worked in the case of Amazon, Facebook, AliBaba, Twitter, and many others. All these businesses grabbed market share and absorbed losses for several years before turning profitable. By analogy, India may be adopting this investment model late, but the optimists will believe in history repeating. It is worth noting, however, that growth in the key segment which Zomato services may be flattening out. While India has about 550 million smartphone users, most are not high-value “targets”. Zomato has an average monthly user base of only about 10 million. These are high net-worth individuals at the very apex of the digital pyramid. In that same income segment, Amazon Prime has 7 million users, while Netflix has about 3 million subscribers. Further growth in this income segment may depend on macro factors such as broad-based gains in per capita income.