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An In-depth Analysis of Unlisted Shares

by tavaga

What are Unlisted Financial Instruments? 

Unlisted financial instruments are securities that do not trade on a formal stock exchange like NSE or BSE because they do not meet specific listing requirements. Unlisted securities are traded on the over-the-counter (OTC) market and are commonly referred to as OTC securities. Market makers, also known as dealers, facilitate the purchase and sale of unlisted securities on the OTC market. 

Common stock is the most well-known type of unlisted security. Other instruments include government securities, corporate bonds, and certain OTC derivative products such as swaps.

The normal risks of investing are heightened when dealing with unlisted securities. The basic requirements of the listed company like the company size, market capitalization are eliminated in the unlisted companies. Some entities may have highly risky business plans, and be nothing more than an idea with no plan for success. Other risks include liquidity risk, interconnection risks, and counterparty risk.

What are Listed Shares?

If a company’s shares are traded on an official stock exchange it is called Listed Shares. Companies such as HDFC Bank, Nestle, and ITC, are all listed on the Bombay Stock Exchange and the National Stock Exchange. Through the broker or online brokerage account, we can buy and sell your shares on these stock exchanges.

What are Unlisted Shares?

Unlisted companies are those that are privately held and have not yet gone through the IPO process. Companies like Paytm, Ola, LIC, OYO, etc. Investing in unlisted stocks helps you gain access to new-age businesses that are highly innovative.

Types of Unlisted Companies

1- Companies that are subsidiaries of well-known parent companies. Examples include HDB Financial Services (a leading NBFC which is a subsidiary of HDFC Bank), Reliance Retail (a retail initiative of Reliance group), Hero Fincorp (financial services company and an associate company of Hero MotoCorp).

2- New-age business in technology, e-commerce, medical technologies, finance, gaming, etc. Examples include OYO, OLA, Razorpay, Zerodha, Dream11, etc.

How to Invest in Unlisted Companies?

Pre-IPOs and Start-ups 

A pre-IPO company is the one that is currently unlisted but plans to go public in the future. The shares from the unlisted company will be directly delivered to the Demat account, even if the transaction is off-the-record and the exchange is not involved. The important criteria when investing in unlisted companies is to choose a trusted intermediary (someone who can successfully help you close the transaction) while avoiding any counterparty risks (counterparty risk is the risk that we may transfer the money, but there is no guarantee that we will get the shares).

We can also invest in start-ups that are unlisted which have huge potential for multi-fold growth in the future. These companies might not be popular right now, but they have the potential to bring profits and growth in the future. The minimum investment amount in most start-ups is around Rs 50,000 and stocks will be transferred to the Demat account.

Buy from existing employees with ESOPs

Companies provide stock ownership plans to employees by allowing them to purchase a predetermined number of shares in the company at a predetermined price after a predetermined period. Brokers help you connect you with employees of organisations who are ready to sell their shares at a predetermined price after a set time. This is one method of purchasing shares in India’s top start-ups.

Buy from Promoters 

Direct investment in the companies can be done through Private placements. To invest a significant stake in a company, approach a trusted wealth manager, investment bank, or broker who can help in connecting with the company’s promoters and introduce to a list of unlisted companies. They also help in arriving at a mutual fair value for the unlisted shares. 

 Buy AIFs or PMS which pick up unlisted shares

Financial institutions offer portfolio management services (PMS) and alternative investment funds (AIF) that buy unlisted shares. 

Many of these funds invest to capture pre-IPO valuations or to profit from a rise in valuations following an IPO. But there is also a risk associated when trying to capture the valuations following an IPO, the prices can immediately fall after they are listed. Examples:- When Uber got listed in the US markets the prices started dropping right after listing in the stock market.

Buy through Equity crowdfunding platforms and Angel Funds

A method through which large groups of investors fund start-ups and small businesses in exchange for stock ownership is called Equity crowdfunding. Individuals who provide funding to promising start-up companies in exchange for a stake in the company, usually in the form of equity or royalties, are known as angel investors. Individuals who are looking forward to making huge investments can invest as angel investors or through equity crowdfunding platforms.

How are Unlisted Companies Valued?

There is no market price for shares of unlisted companies because they are not traded on stock exchanges. Instead, investors and promoters agree on a fair value for the share.

Comparable company analysis is the most commonly used method for estimating the value of a private company. This method entails looking for publicly traded companies that are the most similar to private firms. The analysis includes finding out companies in the same industry, preferably a direct competitor, with similar age, size, and growth rates. 

Equity valuation metrics such as price-to-sales, price-to-earnings, and price-to-book can also be used for valuations. The EBITDA multiple can aid in determining the enterprise value of a target company.

When employees dilute their stock options or promoters through private placements, unlisted shares enter trading circles. The investors further decide on the fair value before concluding the transaction.

Taxation of Unlisted Companies Investment

Long-term capital gains from investing in unlisted companies are taxed at a rate of 20%. However, there is an indexation benefit, where the cost of inflation can be added to ease out the taxation. The minimum holding period is 2 years.

Disadvantages of Investing in Unlisted Shares

Lack of liquidity: Unlisted shares cannot be easily converted into cash. They cannot provide cash flow in an emergency and might take several weeks to liquidate.

Higher Taxes: Long-term capital gains taxes on listed securities is currently 10%, while long-term capital gains taxes on unlisted securities is 20%.

Limited company-specific data: Unlisted company disclosure norms are relaxed, and as a result, they do not frequently provide news and information about their current affairs. It gets difficult for investors to track the growth of the company in which they have invested. If investors continue to invest in a company with poor financial performance, they may lose money.

Listed shares can be used to obtain loans or advances: Loans and advances against stock exchange listed and traded shares are relatively easy to obtain. However, it is difficult to obtain loans against unlisted shares which are illiquid by nature. The fair value of unlisted shares is also difficult to ascertain, due to which getting any loan becomes even more difficult.

Listed Stocks vs Unlisted Stocks

 Listed StocksUnlisted Stocks
Taxation (LTCG) LTCG is taxed at 10%, where the holding period of the investment is more than 1 year.LTCG is taxed at 20% with indexation benefit  (you can add inflation cost). The holding period is a minimum of 2 years.
Companies Listed companies are well-established and in a stable state. IPO due diligence and regulatory filings have been completed. Investor presentations are easily available.Unlisted companies are in the early stages of a revolution. Due diligence is the responsibility of investors and there is no transparency in financials.
Process The investing process is simple, and there is little paperwork involved.The investing process is not simple, more paperwork is involved if stock is not available in Demat form. Counterparty risk is involved.
Liquidity Large cap and mid cap companies with high volumes have good liquidity but small cap companies can have lower liquidity.Poorer Liquidity. Another risk of purchasing unlisted shares in the hope of profiting from an IPO is that the IPO may not occur anytime soon. Furthermore, there is no guarantee that you will be able to exit before the IPO.
Valuation Valuation does not require negotiation because it is determined by the market.Negotiation is a requirement for understanding future earnings growth, the right buying price, etc. When deciding whether to invest in unlisted shares, the promoter’s willingness to protect the interests of minority shareholders is very important.
Risk Associated Lower risk associated Higher risk associated
Due Diligence Process Less Stringent More Stringent 
Source: Tavaga Research

Advice for retail investors:

Unlisted companies come into the headlines generally when the market is in a bull phase. The shares of these unlisted companies are generally brought during a momentum by most of the investors. 

A retail investor should only invest in unlisted stocks if they have room for this category after allocating to domestic and international equity via mutual funds, fixed income instruments, and gold. 

The risk is high. A well-known subsidiary of one of the top private banks was in the news a couple of years back, however, the price has only decreased since then and the company never managed to get listed on the bourses due to reasons best known to the company. 

The commission rate of brokers or intermediaries is very high, so investors should always keep a note of these rates before making any investment. 

It is always better to make an informed decision with the help of investment advisors

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