Pre-IPO market in tizzy as SEBI flags 200-investor cap; merchant bankers look at workarounds

The boom in shares of SMEs over the last couple of years has led to a scramble among HNIs to buy a piece of the company ahead of the listing.

The booming market for pre-IPO placements, particularly in small and micro cap companies, has been delivered a jolt by SEBI. That is making merchant bankers and high networth individual (HNI) investors anxious.

At the heart of the turmoil is the belated realisation of a clause in the Companies Act, 2013.

Under section 42 (2), an unlisted company cannot offer shares to more than 200 investors in the same financial year, except through a public offering. Earlier this week, Moneycontrol reported that SEBI has delayed the approval for Mobikwik and some other companies’ IPOs after finding that they had allotted shares to over 200 investors in a single year.

Also read: Mobikwik, other IPO-bound companies face approval delay

Simply put, an unlisted company cannot privately place shares with more than 200 investors. Violation of this rule invites a penalty or having to buy the securities back from the buyers.

HNI investors queue up for pre-IPO allotment in SME stocks

The boom in shares of SMEs over the last couple of years has led to a scramble among HNIs to buy a piece of the company ahead of the listing. Because of the strong demand, merchant bankers have been able to find enough takers for pre-IPO rounds of funding.

“It operates like a cosy clique,” said an HNI who invests in these issues.

“In some cases, the merchant banker corners a sizable chunk through fronts, knowing that the stock will sell like hot cakes upon listing. In other cases, large investors having a huge following persuade the companies to allot shares to them and their associates,” the HNI said.

Many HNIs have been borrowing funds to invest in pre-IPOs because until a couple of months ago, the approval process for SME IPOs was quite smooth. As a result, many HNIs have been able to even double their money within 6-8 months.

With the regulators now taking a hard look at Section 42 (2) of the Companies Act, merchant bankers and HNIs are in a tizzy.

Merchant bankers look for workarounds to allot pre-IPO shares to HNI clients; but will it work?

Some merchant bankers are suggesting a workaround where the IPO-bound company allots shares to a front, which in turn sells those shares to HNIs looking to invest in pre-IPO rounds.

But this solution is unlikely to work. In April, the Registrar of Companies fined crowdsourcing platform Planify and some companies for violation of Section 42 of the Companies Act. The companies had allotted shares to Planify Capital or its group company and later using the online platform, the securities were sold in the open market.

An HNI told Moneycontrol that he had refused at least two pre-IPO proposals and insisted that the merchant banker get an undertaking from the company that it has not allotted shares to more than 200 investors in a year.

“The companies may be able to find workarounds, but there is a lack of clarity on how the rule can be interpreted,” the HNI said.

There is another arrangement that merchant bankers have been suggesting to prospective investors in pre-IPO rounds.

“The HNIs pool the money and make a loan to the company, on the condition that the company gets an approval for the IPO within six months,” the above HNI said.

“Once the approval comes, the loan will be shortly converted into equity,” he said.

In the case of SME IPOs, the approval is given by the stock exchanges on whose platforms the companies plan to list. Market sources say that after SEBI flagged the froth in SME stocks, exchanges have been approving IPOs at a slower pace than before.

Moneycontrol reached out to both exchanges asking if they were looking at compliance with Section 42 of Companies Act while giving the approvals for SME IPOs. The story will be updated once Moneycontrol gets a response from them.