Investing in an IPO? 10 warning signs to look for before placing your bet

IPO activity is heating up ahead of a new wave of listings, as the one-year validity of approvals from the Securities and Exchange Board of India (Sebi) for several companies nears expiry. With IPO-bound businesses lacking a track record of exchange disclosures or trading history, investors rely on pre-listing disclosures, primarily in the Red Herring Prospectus (RHP).

A closer look at key sections of this lengthy, technical document can help investors spot risky investments, assess a company's financial quality and gauge valuation. Analysts say investors should watch for warning signs before committing capital to avoid poor-quality offerings.

Beware of these 10 warning signs before investing

• Complete Circle Capital Vice President and partner Aditya Kondawar said, “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,” as reported by Mint.
• According to Aditya Kondawar, investors should study the prices at which shares changed hands in the months leading to the IPO. Implying that examination of shares is essential to assess the company's financial quality, Kondawar added, “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?”

• Move beyond the latest period and evaluate the employee and marketing costs of companies issuing IPOs over several years. This will give a clearer picture of the company's financials as businesses often pull back on advertising and staff costs before an IPO to make losses seem minimal or move closer to break-even, Kondawar pointed out.
• Segregate short-term from long-term debt, as heavy dependence on short-term borrowing can be a sign of working-capital stress, Kondawar advised.
• Anand Rathi Shares and Stock Brokers' head of fundamental research–investment services, Narendra Solanki, suggested that investors should evaluate “what fundraising took place shortly before the IPO, at what valuation and under what circumstances”. The details are available in the RHP.

• Another red flag highlighted by Solanki is the compensation of promoters and top management, which should be benchmarked against industry standards. In addition, contingent liabilities disclosed in the RHP warrant close attention. A large liability relative to net worth could weaken the balance sheet if those obligations materialise.
  
  Contingent liabilities typically include guarantees issued on behalf of others, disputed tax demands, pending legal claims and discounted bills. These represent potential obligations that are not recorded as debt on the balance sheet but could materialise as liabilities in the future.
• Head of retail research at ICICI Direct, Pankaj Pandey, cautioned against companies whose promoters have a history of frequent business changes or large related-party dealings. He also advised investors to examine auditor remarks indicating weak internal controls. “The RHP discloses information about the promoters, their track record, related-party transactions and any pending litigation," Pandey said.
• Pointing to another alarm bell, Pandey said, “If the company shows profits on paper but negative cash flows year after year, that is a red flag."

• Carefully examine financial statements to spot over-dependence on one or two customers or suppliers, which is a warning sign.
• Repeated equity issuance is a major concern, as it can dilute existing shareholders.