Insider Selling in IPOs: Find the Red Flags

Investing in Initial Public Offerings (IPOs) is an exciting prospectus for new as well as experienced investors. Owning the shares of a company at the start of its journey in the stock market and seeing the stock prices go up could be an exhilarating experience for many. However, investing in IPOs is not without its share of risks, and one of the critical factors an investor has to consider is insider selling. It means when founder, executives, or early investors sell their shares during or after the IPO process.

In this article, we will discuss the significance of insider selling in IPos, its potential impact on stock prices, and the steps an investor could take to analyze such activity and thereby stay informed.

What Does Insider Selling in IPOs Mean for Investors?

Insider selling as mentioned above is when individuals or entities closely associated with the company, such as founders, executives, or institutional investors sell their shares or portion of their shares during the IPO process or shortly after the IPO.

For an IPO investor, insider selling could signal two points

Normal and Expected Activity: Insiders could sell the shares for legitimate reasons such as diversification or liquidity.
Potential Red Flag: It may well indicate doubt about the company’s future growth or overvaluation at the time of listing.

Knowing the difference between the two is critical for an IPO investor, who can accordingly align his investing strategy.

Why Do Insiders Sell During or After IPOs?

For an investor, it is important to know the reasons for insiders selling their shares. Here are the common reasons.

Wealth Diversification

The founders and early-stage investors may have a substantial portion of their wealth invested in that company. Selling the shares helps them to reduce concentration risk.

Business or Personal Needs

Insider selling might be for funding personal projects, philanthropic reasons, or business diversification among others.

Exit Strategy

An IPO usually marks the culmination of the investment cycle for venture capitalists and private equity firms. They can then sell their shares and realize returns during the IPO process.

Optimizing Market Timing

Insiders may sell shares during the IPO if they feel that the company has reached peak valuation, thereby ensuring maximum returns.

Although, these reasons may seem reasonable. For an investor, it is very important to evaluate whether this selling aligns with the company’s long-term vision.

How does Insider Selling Impact Stock Prices ?

Insider trading can have a significant impact on stock prices if the selling of shares is perceived negatively by the markets. Let’s explore the potential scenarios.

1. Negative Impact: Lack of Confidence

If there is large-scale selling of shares it may signal to the market that the insiders lack confidence in the company’s future growth performance. This can trigger a sell-off by other investors leading to a decline in share prices.
Example
When Zomato, came with its IPO, it was met with a lot of enthusiasm. However, after the lock-in period for the pre-IPO investors ended, there was significant insider selling by venture capitalists, which led to a sharp decline in Zomato’s stock prices.

2. Neutral Impact: Selling Well-Explained

When the insiders sell the shares for diversification or liquidity, and if such actions are well explained and communicated to the markets, the markets may not react negatively.
Example
In the past Infosys founders had sold their shares for philanthropic purposes. A clear communication from the company helped minimize negative market reaction.

3. Positive Impact: Increased Free Float

In some cases, selling by the insiders will increase the liquidity as more shares will be available in the market. This can attract institutional investors who may buy the shares and thereby stabilize the stock price in the long run.

How IPO Investors Can Analyze Insider Selling?

Understanding and evaluating insider selling is critical for IPO investors because it provides insights into the confidence levels of company insiders regarding the business’s future. Below is an elaborate explanation of how investors can evaluate insider selling and where they can find relevant information.

1. Scrutinizing the Red Herring Prospectus (RHP)

The RHP is the most reliable and comprehensive document detailing all the information about the company. It is filed with the Securities and Exchange Board of India (SEBI).

Here’s how you as an investor can find and interpret insider selling details in the RHP.

Where to Find Insider Selling Information in the RHP?

Shareholding Pattern:

Find the “Shareholding Pattern Before and After the Offer” section.
This section mentions the percentage of shares held by promoters, management, early investors, and other shareholders before the IPO and the expected shareholding after the IPO.
Large declines in the promoter or key insider shareholding might reflect a lack of confidence.

Objects of the Offer

Find the section “Purpose of the Offer” (or Objects of the Issue) in the RHP.
Companies disclose here, whether the funds raised from the IPO will be used for growth, debt repayment, or for existing shareholders exit.
If a large portion of the IPO is allotted to Offer for Sale (OFS), wherein existing shareholders are selling their stakes, then investors must evaluate if this sale aligns with the company’s growth prospects.

Lock-in details of Promoters

The RHP discloses lock-in requirements of SEBI for promoters.
The promoters will hold at least 20% of the post-issue capital (total share capital after the IPO) for 18 months after the IPO.
Any excess holding by the promoters above the minimum requirement of 20% is locked in for 6 months.
Heavy selling by promoters after the lock-in period must be watched closely by the investors as it may signal concerns about the company.

Management’s Discussion and Analysis (MD&A)

This part offers information on the company’s financial performance, strategies, and risks. Compare these with insider selling activity to help uncover any potential inconsistencies or red flags.

Example: The RHP of Paytm IPO revealed that a substantial portion of the shares sold were by pre-IPO investors. This high degree of insider selling was flagged by analysts as an area of concern, and the stock faced significant post-IPO challenges.

2. Evaluate Insider Intent

Analyze the justifications given by the company for insider selling. The fact that the company communicates transparently about its insider actions is a positive indication.

3. Track Post-IPO Insider Activities

After the IPO, there are periodic disclosures of insider activities. Follow the insider trading reports on reliable platforms or financial websites for these activities. Any activity that does not fit in with the company’s growth prospects should be a red flag.

Red Flags for IPO Investors

As an investor be cautious if you notice the following patterns.

High Insider Selling Proportion: If you notice that insiders are selling a large portion of their holdings, then this may indicate a lack of confidence in the company’s future growth.
Repeated Selling Post-IPO: Frequent sales of shares by key people in the company may suggest that they are cashing out at the expense of other investors.
Lack of Transparency: If the company fails to clearly communicate the reasons for inside selling, then it should raise a red flag for an investor.

Balancing Risks and Rewards in IPO Investing

As an IPO investor, it is prudent to maintain a balance between short-term opportunities with long-term. Here are a few strategies to consider:

Diversify Your Investments

Don’t invest heavily in one IPO, especially if there’s heavy insider selling. Invest across different companies and sectors to reduce risk.

Have Realistic Goals

Although IPOs can bring short-term gains they are often volatile. Understand your risk tolerance before investing.

Use Expert Insights

Rely on trusted and reliable sources to evaluate insider selling and company valuations.

Conclusion

Insider selling by and large during or following IPOs should not be viewed as a red flag but it is an important aspect that needs a close scrutiny on the part of IPO investors in India. Evaluating the company’s RHP, tracking insider selling, and the reasons for insider selling will help an investor to stay informed.

Whether it is your first IPO or you have invested numerous times, staying well-informed and watchful will guide you through the intricacies of IPOs and help build a solid investment portfolio.

Happy IPO Investing!