Ravi, who is otherwise a cautious guy, applied for an SME IPO just because he got a message in a friend’s WhatsApp group saying “Big GMP! Apply now, don’t miss this jackpot!”. Ravi could not miss the temptation of a quick profit on the listing day, and he invested close to Rs 1.47 lakhs in the IPO.
The stock listed 10% lower on the first day and by the end of the week was 35% down. Ravi’s 1.47 lakhs had become 95,550.
What went wrong? Let’s dive in and check the 5 SME IPO red flags you should analyse before you decide to invest in an SME IPO. So, next time you receive a message about Big GMP and hitting a jackpot, you will be well prepared to make an informed decision.
Red Flag #1: Unusual Profit Spikes Just Before the IPO
Have you noticed how many SMEs have suddenly turned profitable only one or two years before they went public? Companies that had shown losses or thin margins for years suddenly posted record profits right before the IPO.
Magic?…Hard work?…..or something fishy?
What to check:
- Check and compare the company’s last 3 years revenue and profit numbers
- If, for example, FY22 and FY23 were bad but FY24 was profitable, probe a little bit deeper for the reasons for this turnaround.
For example, a company went from a profit of 15 lacs in FY23 to a profit of 2.1 crore in FY24, just before its IPO. Looks suspicious, right?
Why does it matter?
Many promoters try to dress up their balance sheet before the IPO. This is a classic Red Flag. This is done to inflate the valuation or create an illusion of growth to attract unsuspecting investors.
Red Flag #2: Weak Promoter Background or Related-Party Dealings
Promoters are the heart and brain of any small business. Especially in SME IPOs, they are often everything; they are the CEO, the Founder, the marketing head, and sometimes the auditor’s best friend too.
So, if the promoters are of questionable integrity, that’s another SME IPO Red Flag. Check for any history of failed ventures, legal issues, or poor governance.
Related party transactions are the deals the company makes with the promoter’s relatives or businesses. While such dealings are legally legitimate, they become problematic if they benefit the other parties more than the company.
For Example
- Paying a large consultancy fee to the firm owned by the promoter’s relative
- Renting office space from the promoter’s property
- Giving unsecured loans to directors
Where to check:
Check the RHP under “Related Party Transactions” or “Notes to Financial Statements”.
Why it matters:
Such transactions can drain the company financially and also signal poor transparency. This is another major SME IPO Red Flag.
Red Flag #3: High Valuation Compared to Peers
Some SME IPOs are priced at lofty valuations without being backed by strong fundamentals that justify the valuation.
What to Check:
- Compare the company’s P/E and P/S ratios with the company’s peers from the same industry. For example, an SME IPO company from the textile industry has a P/E ratio of 45, but other listed companies from the textile industry have a P/E ratio of 15-20, which could indicate that the IPO is over-priced. It means you are paying more for a lesser-known company than what you would have otherwise paid for a proven, listed company.
- Look at revenue and PAT (Profit After Tax). The revenue tells us how much money the company is making by selling its products and services. If the revenue is stagnant or low, but the IPO price is high, it means you are paying a premium for a company that hasn’t grown. Similarly, if the profits of the company are negative or low, then the high IPO price isn’t justified.
Why it matters:
An overpriced IPO leaves little room for listing gains or long-term appreciation.
Red Flag #4: Low QIB/NII Subscription
A low subscription level from NIIs and especially from QIBs is a concern, as it means smart money is staying away from weak issues. This is another SME IPO Red Flag.
What to check:
- In the 2nd half of the last day of IPO subscription, check the subscription levels from QIBs and NIIs.
- High Retail participation but low QIB and NII participation means caution.
Why it matters:
QIBs and NIIs have more resources and are better equipped to evaluate an IPO than retail investors. High participation from these two groups could be perceived as a vote of confidence in the IPO.
Red Flag #5: Weak Use of IPO Funds
Check how the company plans to use the amount collected from the IPO. If the funds are going to be utilised for business expansion, R&D, or acquisitions, then it’s a sign of growth. The details are mentioned in the “Objects of the Issue” section of the RHP (Red Herring Prospectus). However, be cautious, if most of the funds are going to be utilised for:
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Loan repayment, especially loans taken from the promoters
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General corporate expenses. You will find this in most IPOs. It’s often a red flag when 40–60% is allocated here without details.
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Buying back promoter-owned assets like land, buildings, or equipment that already belong to the promoter or their relatives. It raises two issues. Firstly, it enriches the promoter more than the company, and secondly, the asset pricing might not be fair or transparent. There’s a conflict of interest here.
- Offer for Sale (OFS): In OFS, promoters or early investors are selling their stake to the public. The money from this sale goes to them and not the company. It could mean that they lack confidence in future growth and want to cash out.
Why it matters:
It could mean the IPO funds are going to be used to clean up debt or benefit the insiders, and not for growth.
Bonus Tip: Don’t Ignore Liquidity Risk
SME IPOs are listed on the NSE Emerge or BSE SME platforms. Another major issue for investors in the SME segment could be liquidity (low trading volume). You may get stuck even if your stock is in profit, because there are no buyers. This is another SME IPO Red Flag if you are looking for a listing day exit.
Conclusion – SME IPO Red Flags
Missing a bad IPO is more important than catching every good one. SME IPOs can offer good returns only if you can identify the red flags early. So, next time if you receive a WhatsApp message of GMP with fire emojis, pause, think, and check if the SME IPO has any red flags, and only after you are convinced, decide whether to invest or give it a skip.