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SME Exchange - Do small companies and startups have the ability to access public markets?

Raising capital from the public through a stock exchange is usually the most preferred way of financing the activities of large companies. While smaller companies will also love to be able to raise money this way, most of them cannot access the stock exchange route to raise capital as only companies with a high paid-up capital and a history of profitability were so far allowed to list on a stock exchange and source money from the public. This was based on the assumption that a company sourcing money from the public should have a certain scale and reputation, so that it does not run away with public money.

To understand why the concept of a special exchange for SMEs was introduced, we must understand how a company raises money for its operations. Startups could only take loans from banks or financial institutions, or they had to find investors who could invest large sums of money in the company and take an equity stake (which was not easy for them). As they could not source public funding, startups could not earlier compete with larger businesses on equal terms, which had cheaper sources of funding available to them. The financial crisis led to a slowdown in the growth of large companies, and an increased focus on small businesses and startups, as the latter had significant potential for growth.

Now SME’s can also raise money from the public through the SME exchanges – is it going to be viable

In India, SEBI came up with a special framework that existing stock exchanges can adopt for Small and Medium Enterprises (SMEs) in 2012, recognizing their systemic importance to the Indian economy and to help them to grow faster.  Under the new framework, existing stock exchanges can open a special segment called the SME Board for trading. The purpose of this framework is to provide special incentives for SMEs to list on public exchanges, and to provide them liquidity and access to cheaper sources of funding. The BSE and the NSE quickly set up separate segments for SMEs in compliance with these provisions. The SME Exchange is a new way in which small and medium enterprises (SMEs) can raise money from the public.

The terms for listing on the SME segment are different from those on the main stock exchange. In order to be eligible to list, companies must have a minimum of 50 investors and a paid-up capital (after listing) of at least INR 50 lakh.

Advantages of listing on the SME Exchange (as compared to listing on the main board)

Provisions related to listing on the SME Exchange of a stock exchange are contained under a new chapter introduced to the SEBI (Issue of Capital and Disclosure Requirements) Regulations (ICDR Regulations). Apart from the fact that the SME Exchange allows startups to access public funding which was not earlier possible, the SME Exchange offers various relaxations to them which would not have been available if they were simply allowed to list on the main board. These advantages are described below:

1. Financial results shall be submitted on half yearly basis instead of a quarterly basis. While this increases costs for a company which was earlier publishing results on an annual basis, it is less onerous than the requirement for companies listed on the main board, which must publish results on a quarterly basis. This reduces operational costs and hassles.

2. Cost savings on publishing financial results, such as the following:

i) SMEs need not print and send their financial results to individual shareholders, as required in respect of companies listed on the Main Board.  They can simply make it available on their websites.

ii) SMEs can send the abridged version of the annual report of few pages with the details of the profit & loss account and balance sheet to the shareholders instead of sending physical copies of full annual report.

3. Relaxations on compliance with certain procedural requirements, as compared to other listed companies (which are listed on the main board of the exchange)

i) Profitability record: The condition of having a track record of profit making for 3 years out of last 5 years as applicable for listing an IPO on the Main Board is not applicable for listing on the SME exchange.

ii) IPO Grading: For companies seeking listed, SEBI has made grading of the IPO mandatory. For SMEs, grading is not mandatory if they list on the SME Exchange.

iii) Tax advantages for shareholders when they dilute or exit: During the initial stages, promoters may have a huge shareholding in their startups. If the startup is performing well, promoters have the option of completely or partially selling their shares to an investor or acquirer.

For example, when the Redbus founders, who held around 15 percent stake in the company sold their shares to Naspers, an iBibo entity, Redbus had a total valuation of over INR 600 crores, and their shares would have been collectively valued at around INR 90 crores. They would have been subject to significant capital gains tax. Founders may not want their shares to be subjected to a high tax regime – for example, Eduardo Saverin, the co-founder of Facebook shifted to Singapore because he did not want his assets to be subjected to the heavy taxation regime of the United States.

If an SME is unlisted, its shares will attract short term capital gains tax upto 30% (the actual rate will depend on the income tax slab applicable to the individual shareholder concerned) or long term capital gains tax of 20% on the sale of shares, depending on the time period for which the shares are held. For listed securities, short term and long term capital gains tax rates are 15% and nil respectively – instead a different tax called the Securities Transaction Tax (STT) is applicable on sale of securities on the exchange, which is a very small percentage amount compared to capital gains tax. As the promoters of SMEs tend to hold a large percentage of shares of the company with them, they will benefit from lower tax rates if they sell their shares on the SME Exchange.

Considerations while listing on the SME Exchange
While there are attractive tax incentives and relaxations from detailed relaxations from compliance obligations (compared to listed companies on the main board) as explained above, the listing on the SME exchange has its own set of administrative and other troubles, as explained below:

1.  Inaccessibility for retail investors: The regulations do not prescribe an upper limit of investment by investors, but prescribe a floor of Rs. 1 lakh of minimum investment to keep retail investors at bay from the SME exchange. Further, the minimum trading lot for a transaction must also be Rs. 1 lakh. Since a buy or sell transaction on the exchange must comprise minimum of 1 lot on the exchange shares worth Rs. 1 lakh must be transacted in a single transaction.  Owing to the higher minimum transaction size, the SME exchange is likely to witness activity from high net worth individuals, institutional investors and banks (who are informed investors) only who are usually risk averse and will be very circumspect about investing in this new SME stock exchanges. In essence, the SME exchange has to compete with the main exchange to attract investors, and keeping retail investors at bay and having a minimum transaction size of Rs. 1 lakh can make it difficult for the SME exchange to find investors.

2. Higher costs because of increased obligations of merchant bankers: The costs for a company listed on the SME Exchange may shoot up because of increased compliance obligations on merchant bankers in respect of its shares.

A company whose shares are listed on a stock exchange is required to appoint its own merchant bankers, who must be compensated by the company for their services. Although the terms of appointment of the merchant bankers are contractual, the merchant bankers’ obligations are as per the applicable SEBI Regulations (in this case, the Issue of Capital and Disclosure Requirements Regulations) and stock exchange bye-laws and rules. Merchant bankers have more onerous duties in case of a company listing on the SME exchange (as explained below), and since the issue size will be much smaller, their compensation will be much lower too, and it is apprehended that merchant bankers may not be really interested in this market at all. Appointing Merchant bankers is likely to be very expensive for SMEs even if possible. The following will be the role of the merchant bankers:

i) Merchant Bankers in the main board assist the company in raising equity capital only through the primary market (that is, at the time of issue of shares only), but in the SME Exchange, they have to continue market making for a period of 3 years in the SME’s stock, after listing. Market making involves holding a certain percentage of the shares at all times and providing quotes (for both buyers and sellers) for a specified percentage of the trading hours each day. Merchant bankers are likely to charge a higher fee for this.

ii) The issue must be 100% underwritten, that is, the merchant banker must agree to buy all the shares in the issue if insufficient subscriptions are received. He must also underwrite 15% in his own books of accounts, that is, he must agree to subscribe to 15% of the shares himself, under all circumstances. There is no such responsibility cast upon the merchant bankers in respect of scrips listed on the Main Board. Again, since these obligations impose additional risks and costs on the merchant bankers, such services may be available to SMEs only at a premium fee.

3.      Increased compliance requirements due to applicability of listing agreement: 
Clause 49A of the Listing Agreement on Corporate Governance will be applicable to the SME Segment. There has to be 50% independent directors on the Board of listed SMEs. They need to appoint various Committees as stipulated in Clause 49 of the Listing Agreement.

What is the listing cost on the SME Exchange?

As per a circular of the BSE dated 27 March 2012, annual fees will be charged at Rs. 25,000 or 0.01% of the full market capitalization (not issue size), whichever is higher.

Note that market capitalization of a company fluctuates over a wide range depending on how the company’s shares are valued in the market. It does not correlate with the money actually raised by the company. Unless the shares are sold, the value represented by the market capitalization cannot be realized. The question is, in case of highly valued companies, will the listing fee be too expensive?

Let’s take an example. Imagine that a company issues 1 lakh shares of face value INR 50 at a premium of INR 450 (at a total price of INR 500 per share), thus raising INR 5 crores (paid-up capital will be INR 50 lakhs - premium is not counted towards paid-up share capital).
If the market value of each share is INR 5,000, the company will have to pay INR 25,000 or INR 50,000 (0.01 percent of INR 50,000,000 is INR 50,000). INR 50,000 per year may not be too much for actually raising INR 5 crores. 



Evaluation of the working of the platform

The SME Exchange is fast emerging as an important venue for raising equity capital by small and medium sized companies. Note that after raising necessary capital to list, the minimum paid-up capital of the company should be INR 1 crore (this does not include the premium paid on the shares). This is a huge sum - early stage start-ups may need to raise smaller amounts of funding, and hence may not be able to access this mechanism for raising growth capital. The magnitude of this sum can best be appreciated through an example. Assume a company wants to raise INR 2 crores. It may issue 200,000 shares of face value INR 10, at a premium of INR 90 (i.e. a total issue cost of INR 100 per share). In this case it will raise INR 2 crores but its paid-up capital will only increase by INR 20 lakhs.

Therefore, the SME platform is more suitable for companies which have already achieved a minimum scale of operationsAlthough it was earlier believed that operational issues such as finding a merchant banker who would be willing to underwrite 100 percent of the issue or lack of investors ready to make big investments in this sector may be the reason why the SME Exchange would not be a serious option, the reality may soon be different. Due to the above issues, it took a while for small companies to start listing on the SME Exchange with only a handful of companies getting listed in the initial year, but now more SMEs are applying to list under this option as promoters and bankers are getting more familiar with the process and fees are getting standardized and competitive. As of April 2014, approximately 60 companies are listed on the SME Exchange – compare this with the virtual disappearance of IPOs on the main segment.

Is the SME required to migrate to the main board from the SME platform?

As an SME listed on the SME segment grows it may want to migrate to the main board – migration offers higher liquidity (note that shares can be sold in single units which could even be a few hundred rupees, instead of transaction sizes of INR 1,00,000) thus allowing a wider category of investors to take part and increasing liquidity (i.e. or the ease with which shares can be bought and sold) of the shares. Further, fees paid to merchant banks may also reduce as continuous market making is not required.

Note that migration is optional when the paid-up capital is between INR 10 crores to INR 25 crores. However, if the paid-up capital exceeds INR 25 crores then migration to the main board is compulsory.



A company has 1 crore shares of face value INR 10 each, which are issued at a premium of INR 90 to investors. What is the paid up capital of the company? Is it mandatorily required to migrate to the main board? 


Although the company has raised a total of INR 100 crores (1 crore shares x (90 + 10)), the premium amount is not counted towards paid-up capital. The capital of the company is INR 15 crores – migration to the main board is optional for the company as its paid up capital is less than INR 25 crores. 

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