Why you should approach the SME IPO market with extreme caution

According to data from primedatabase, as many as 104 SMEs (small and medium enterprises) have used BSE and the National Stock Exchange’s (NSE) SME platform to raise ₹3,405 crore in FY25 so far. This figure already surpasses half of the total funds raised by SMEs in FY24.

Most of these IPOs are heavily oversubscribed, driven by “heightened momentum in the primary markets and and lot of liquidity floating around,” according to Deepak Jasani, head of retail research at HDFC Securities. However, Jasani warns that many SMEs can trade below their issue price within six months to a year after listing.

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Concerns are shared not only by market analysts but also by the Securities and Exchange Board of India (Sebi), which has issued cautionary advisories regarding the frenzied activity in the SME markets.

Risks investors need to be aware of

SME platforms on both NSE and BSE were created to help smaller companies raise capital through stock markets. Unlike large firms, SMEs may lack the resources to meet the rigorous compliance and regulatory requirements of a mainboard listing. Consequently, SME platforms have lower eligibility criteria and fewer disclosure requirements.

For instance, a company pursuing a mainboard IPO must have at least ₹15 crore in average operating profit over the last three years. In contrast, an SME IPO requires operating profits in just two of the last three financial years.

The compliance thresholds also differ. Companies listed on the SME platforms are only required to submit half-yearly earnings, while mainboard-listed companies must report quarterly results.

Despite the relaxed regulations, both SME and mainboard IPOs share the same lock-in requirement, mandating that promoters maintain at least a 20% stake in the company for three years post-listing.

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Additionally, on both platforms, SMEs must maintain a positive net worth. For the BSE platform, the company must also have net tangible assets of at least ₹3 crore. The exchanges may also impose additional criteria as needed.

Key factors to evaluate

Before investing in an SME IPO, it’s crucial to assess the quality of disclosures in the company’s draft red herring prospectus (DRHP) alongside its fundamentals. Important financial metrics to consider include the company’s debt-to-equity ratio, total debt, and profit growth. If the company shows negative growth, the DRHP should provide a clear justification.

“If there is any sudden jump in profits of 30-60% in any one of the three years preceding the IPOs, that is a red-flag. Why would company be needing capital if it is doing so well on its own. It could just be to generate investor interest. A quick background check also helps. Look up for the products of the company, are they legit, any cases or outstanding dues pending. And of course, valuations are most important. What’s the market cap the company is seeking as against its profits,” explains Anuj Agarwal, an investor tracking the SME segment.

Equally critical is the purpose of the IPO. “Investors should prioritize issues where funds are being raised for capital expansion or business growth rather than for working capital needs or debt repayment,” advises Jasani.

Evaluating the quality of disclosures is also essential. Check if the company provides sufficient product-wise or segment-wise details if it is into multiple products.

Jasani acknowledges that assessing SME IPOs can be challenging for retail investors, given limited disclosures and corporate governance practices may not be the best. “If you’re unsure about the company’s long-term prospects, it may be prudent to exit shortly after listing whether with gains or losses,” he suggests.

What Sebi says

Sebi recently issued a cautionary advisory regarding the risk of misrepresentation by SME promoters.

“It has come to the notice of Sebi that, post listing, some of the SME companies and/or their promoters have been resorting to certain means that project an unrealistic picture of their operations. Such companies/promoters have been seen to make public announcements that create a positive picture of their operations. These announcements are typically followed up with various corporate actions such as bonus issues, stock splits, preferential allotments, etc,” the regulator warned.

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It added that such actions can artificially boost investor sentiment, prompting them to buy shares at inflated prices, allowing promoters to offload their holdings at elevated valuations. Sebi has advised investors to exercise extreme caution in these cases.