SEBI's New Rules For SME IPOs - A Contemporary Analysis
Author: LawSphereX
Category: Corporate & Insolvency
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SEBI'S NEW RULES FOR SME IPOS: A CONTEMPORARY
ANALYSIS
Prajjwal Chauhan, BBA LLB, University School of Law and Legal Studies (USLLS), GGSIPU, Dwarka, Delhi.
ABSTRACT
Small and Medium Enterprises (SMEs) play a crucial role in India's economic growth, by significantly adding to the country’s GDP and foreign exchange reserves through exports. However, the rapid expansion of SME IPOs has revealed many challenges, including misuse of public funds and insufficient regulatory oversight. To address these challenges, SEBI acknowledging the issues laid down sweeping reforms in December 2024. Key changes in the framework include stricter eligibility criteria for listing shares in capital markets, enhanced disclosure norms, restrictions on fund usage, and measures to regulate speculative practices. These reforms aim to protect investors, maintain market integrity and promote transparency which align with global standards such as the UK's AIM Rules and the SEC's Regulation A in the US.
Although the new stricter regulations improve market credibility, they also present certain challenges, more so for smaller SMEs with focus on long-term growth. Enhanced compliance requirements for merchant bankers, further increase operational complexities. Despite these possible downsides, the reforms strengthen India's capital markets, fostering a sustainable and investor-friendly ecosystem. They aim to pave the way for SMEs to transition into large-cap companies and ensuring balanced growth with global competitiveness. This article critically analyses these reforms, their implications for various stakeholders, and their potential to modernise India's SME IPO framework while maintaining a delicate equilibrium between growth and regulation.
Introduction
Small and Medium Enterprises (SMEs) are widely regarded as the backbone of India's economy, due to their significant contribution in Gross Domestic Product (GDP) of the country and exports. This rise in SMEs has resulted in employment generation, entrepreneurship development, and economic growth. 1 Acknowledging the expansion of the sector, the need for public funds was apparent, recognising the need for these enterprises to access capital markets, the Securities and Exchange Board of India (SEBI) established a dedicated SME platform under the SEBI (ICDR) Regulations, 20182.
For any SME to be listed on BSE SME and NSE Emerge, it has to comply with the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 20153 (LODR Regulations) and SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations) along with additional Listing Norms as have been devised by the respective Stock Exchanges. 4 As of October 2024, 745 companies are listed on SME exchanges with a combined market cap of ₹2 lakh crore. In FY23-24, 196 SME IPOs raised over ₹6,000 crore, and FY24-25 is close behind, with 159 IPOs raising ₹5,700 crore by October5. Amidst this exceptional sector growth, certain underlying issues went unchecked due to less stringent regulations. On December 18, 2024, SEBI introduced significant amendments to these regulations, aiming to enhance transparency, investor protection, and overall market integrity.
Context and Rationale for the Reforms These platforms were meant to ease the IPO ecosystem for SMEs to promote infusion of public funds into the growing sector. However, concerns regarding promoters cashing out using the 1 MSME industry in India – market share, reports, growth & scope: IBEF, India Brand Equity Foundation, https://www. ibef. org/industry/msme. 2 SEBI, Securities And Exchange Board Of India (Issue of Capital And Disclosure Requirements) Regulations, 2018, SEBI/LAD-NRO/GN/2018/31(Issued on September 11, 2018).
3 SEBI, Securities And Exchange Board Of India (Listing Obligations And Disclosure Requirements)
Regulations, 2015, SEBI/LAD-NRO/GN/2015-16/013 (Issued on 2, 2015).
4 Mondaq, Is Your Business Ready? Understanding SME IPOs (Dec. 7, 2024), available at
https://www.mondaq.com/india/securities/1559056/is-your-business-ready-understanding-sme-ipos. 5 SEBI to Overhaul SME IPO Framework, Raises Retail Application Minimum to ₹2 Lakh, Fortune India (Dec. 18, 2024), available at https://www.fortuneindia.com/macro/sebi-to-overhaul-sme-ipo-framework-raises-retailapplication-minimum-to-2-lakh/119200.
Offer for Sale (OFS), misuse of public funds by diverting funds showing them as vague transactions like general corporate purposes and other related party transactions, and insufficient regulatory oversight prompted SEBI to overhaul the existing framework. Other ancillary concerns included poor liquidity for investors and high-risk IPOs with speculative returns. The amendments approved in the December 2024 board meeting were notified by a consultative paper issued on November 19, 2024, which identified key areas of concern, including the need for stricter eligibility criteria and enhanced disclosure requirements. 6 These reforms align with SEBI's broader mandate to ensure a fair, transparent, and efficient capital market. By tightening the rules, SEBI seeks to strike a balance between fostering market growth and protecting investor interests.
Fraudulent IPO Practices and SEBI's Corrective Actions Instances of fraud in SME IPOs have become increasingly common, with companies exploiting regulatory gaps to mislead investors. These include misrepresenting IPO objectives, diverting proceeds for unrelated purposes, and inadequate financial disclosures. For Example, the SEBI cancelled the IPO of the Trafiksol ITS Technologies Ltd. , a company specialised in intelligent transportation systems and automatic solutions. The investigation was based on a complaint by Small Investors’ Welfare Association (SIREN) alleging that the object of the IPO to be misleading, specifically financials regarding purchase of a software, other allegations were related to non-disclosure of important information by the company. SEBI directed the SME to refund the raised fund amount to the investors under surveillance of BSE.
This is just one of many such cases which have become prevalent in the SME IPO sector. 7 Another instance is where the SME was held guilty of misusing the IPO proceeds, SEBI held while passing an interim order banning the company form accessing the capital markets until further notice, that the funds raised by the issue were not used for the specified intended purpose of the issue, instead certain promoters of the company transferred some funds to a related entity for unknown purposes. Cases like these called for stringent regulatory changes 6 NSE Implements Stricter Eligibility Criteria for SME IPOs Following SEBI's New Rules, Business Standard (Dec. 23, 2024), available at https://www. business-standard. com/markets/capital-market-news/nse-implementsstricter-eligibility-criteria-for-sme-ipos-following-sebi-s-new-rules-124122300378_1. html.
7 SEBI, Order in the Matter of Trafiksol ITS Technologies Ltd.,
https://www.sebi.gov.in/enforcement/orders/dec-2024/order-in-the-matter-of-trafiksol-its-technologiesltd_89239.html. in the SMEs IPO framework.8 Key Amendments in the SME IPO Framework
1. Eligibility and Disclosure Requirements
One of the major changes to the previous framework is introduction of a more stringent eligibility criteria and comprehensive disclosure requirements for SME IPOs. According to new regulations the SMEs at the time of filing their Draft Red Herring Prospectus (DRHP) are required to demonstrate a minimum amount of operating profit (earnings before interest, depreciation, and tax -EBITDA) of INR 1 crore in the two of the last three financial years. This new regulations will ensure that only financially sound SMEs are listed on the platform which will give confidence to the investors in their investments. This step is crucial to create a balanced approach which maintains integrity of the market through strict entry barrier while facilitating public funding in the SME sector.
2. Restrictions on Offer for Sale (OFS)
The amendment aims to restrict Offer for Sale (OFS) portion at 20% of the total issue size by the SMEs and shareholders selling their shares are prohibited from selling more than 50% of their shareholding. These restrictions will ensure that the promoters and early stage investors do not dump majority of their shares post issue for listing gains. This step will provide fair opportunity to establish the SMEs in the capital market and will also favour minority shareholders of the shares.
3. Use of Issue Proceeds
The proposed amendments also intends to address another major issue in the SMEs IPO market which is misuse of public funds by the SMEs. The SMEs in absence of any restriction used the public funds collected through IPO listing for purposes repayment of loans from promoters or other related parties and for other unknown purposes in the veil of General Corporate Purposes (GCP). The SEBI has mandated that SME IPO shall not be issued for the purpose of repayment of loans from the issue proceeds, whether directly or indirectly. This change will ensure that 8 SEBI, Order in the matter of Varanium Cloud Limited, https://www.sebi.gov.in/enforcement/orders/may- 2024/interim-order-in-the-matter-of-varanium-cloud-limited_83309.html. the capital raised from the market is deployed for business growth and operational needs of the SME.
Further, In order to limit showing the object for issue as General Corporate Purposes (GCP) for diverting funds. SEBI under the new changes has capped the amount to be used for GCP as object of the issue. It states that only up-to 15% of the total issue size or Rs. 10 Crores, whichever is less could be used as GCP. This ensures that funds are primarily utilised for specified objectives, reducing ambiguity.
4. Public Access to Draft Red Herring Prospectus (DRHP)
In order to promote transparency and accessibility, SEBI has mandated that the DRHP shall be made public for 21 days for public to make comments regarding the contents of the DRHP. The DRHP shall be published in the newspapers with QR code. This will allow potential investors to raise concerns and seek clarifications regarding the IPO, enhancing the overall credibility of the IPO process. 9 Impact on SMEs While there are multiple upsides of the new changes they may pose certain challenges to the vision of promoting SME sector in India. Focus on profitability can inadvertently exclude and disproportionately affect smaller SMEs seeking public funds for growth. This may undermine the objective of establishing such platforms aimed at growth of SMEs in India.
Another nuance is related to exclusion of important matrix other than profitability as a criteria for market access, this approach can pose as a challenge for SMEs pursuing long term growth over short term profitability. This step may lead to promoters and early stage startup investors to give preference to short term revenue generation over long term growth of a startup. There is a need for a more balanced approach that considers other important matrix of financial stability and return potential like Debt to Equity Ratio, Customer Acquisition Cost etc before listing of new shares. Impact on Merchant Bankers Intermediaries are an important part of the SME IPO ecosystem, Merchant bankers are one of 9SEBI, SEBI Board Meeting (Dec. 18, 2024), available at https://www. sebi. gov. in/media-andnotifications/press-releases/dec-2024/sebi-board-meeting_90042. html.
such key intermediary and their job range from due diligence and DRHP preparation to display of offers and underwriting. With the new changes merchant bankers are now subject to enhanced due diligence and operational restrictions. The incorporation of regulations such as phased release of promoter shareholding and public comment on DRHP through newspaper publications adds to their responsibilities. This will significantly raise compliance costs, and further amplify the importance of the role played by a merchant banker in IPO process of SMEs. 10 Implications for Investors For the investors the changes are welcoming except the concerns regarding profitability criteria pointed out above. SEBI has prioritised investor protection by introducing stricter disclosure norms and addressing and limiting fund misuse by the SMEs. Comparative Analysis: India vs.
Global Practices SEBI's regulatory approach aligns with global practices for SME IPOs, emphasising transparency, investor protection, and market integrity. The SMEs IPO procedure in UK is regulated through Alternative Investment Market (AIM) Rules for Companies11 formulated by the London Stock Exchange which lays down comprehensive disclosure norms, under the Rule 10 of the rules lays down principles of disclosure by the issuer, Rule 11 provides for General disclosure of price sensitive information and Rule 12 provides for Disclosure of Corporate Transactions. In addition to these rules the Rule 26 further requires the AIM company i. e. the issuer to maintain a website containing important information regarding the business and its listings.
Similarly, In the United States, SMEs seeking to access public markets through IPOs must adhere to eligibility criteria and disclosure requirements governed by the SEC, primarily under frameworks like Regulation A and Regulation Crowdfunding. 12 To qualify, companies must be U. S. or Canada-based and free from regulatory disqualifications, such as past fraudulent 10NSE, Emerge SME Merchant Bankers: Roles & Responsibilities, available at https://www. nseindia. com/products-services/emerge-sme-merchant-bankers-roles-responsibilities. 11London Stock Exchange, AIM Rules for Companies, available at https://www. londonstockexchange. com/ (2024). 12Regulation A—Conditional Small Issues Exemption, § 230. 251–230. 263 (Dec. 20, 2024), available at https://www. ecfr. gov. activity.
Regulation A allows SMEs to raise up to $20 million under Tier 1 or up to $75 million under Tier 2, with Tier 2 requiring audited financial statements and ongoing reporting obligations, including annual and semi-annual reports. Disclosure requirements include the submission of an offering circular, which details the business model, financial performance, risk factors, and intended use of funds. Regulation Crowdfunding further mandates filing Form C, which provides information about the company’s financial condition, target funding amounts, and use of proceeds. By adopting these best practices, SEBI positions India as a competitive and credible investment destination. Broader Implications for India's Capital Markets These reforms are not just about SMEs; they reflect SEBI's commitment to enhancing the overall regulatory ecosystem.
Through encouraging transparency and safeguarding investors, SEBI enhances market confidence, which is vital for the influx of domestic and global capital. The reforms aimed at SMEs have an impact beyond the direct target. They also indicate SEBI’s resolve to update India’s financial infrastructure to be in line with international developments. Not only would the SMEs have access to easier funding, it will also create a pool of some of the most lucrative and successful small business ventures transitioning into Large-Cap companies. This symbiotic interaction bolsters the core of India’s capital markets and fortifies its status as a global economic juggernaut. In doing so, through their innovation, vision and approach to governance, SEBI are not just enabling SMEs but actually strengthening the overall financial ecosystem for long-term sustainable growth.
Conclusion These changes to SME IPO regulations by SEBI are the first systemic step from the institution to bring the much-required harmony between the growth of SME sector of India while also filling regulatory gaps leading to the sustainable growth of India’s SME ecosystem. With stricter eligibility and disclosure requirements, the proposed regulations intend to weed out enterprises that are not financially sound before entering the market, thereby promoting the interest of the investors and market integrity. The limitations in use of funds and more stringent control on Offer for Sale elements protect the investors from speculative practices. The reforms bolster credibility but not without its own challenges.
While promising SMEs focusing on longterm growth instead of immediate profitability may face challenges in accessing public funding, this situation may also result in creation of an unintended barrier for new players. Likewise, increased compliance requirements will be quite demanding for merchant bankers and SMEs, making operations more complex, however, improving the quality of listings. These implications stretch far beyond the SME space. These reforms enhance investor confidence and encourage greater participation in India’s capital markets, making them more attractive to global investors. Even better, they form a pathway for SMEs to become large-cap beasts, and thus a vibrant, sustainable market structure.
Through advance consultation with industry, addressing key issues, and finally establishing high benchmarks, SEBI careful step to modernisation of India’s capital markets to be at par with global standards while achieving inclusive growth.