How to Read a Startup's DRHP: Key Red Flags to Watch
Master the art of reading startup DRHPs (Draft Red Herring Prospectus). Learn to identify red flags in IPO filings for Zomato, Paytm, Nykaa, and future startup IPOs.
How to Read a Startup's DRHP: Key Red Flags to Watch
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Every startup IPO begins with a DRHP—Draft Red Herring Prospectus—a 400-500 page legal document that contains everything you need to know about the company. Yet most retail investors never read it, relying instead on broker recommendations and media hype. This is a costly mistake. Buried in the DRHP's dense legalese are critical disclosures about risks, related party transactions, founder conflicts, and financial irregularities that can predict whether an IPO will be a wealth creator or wealth destroyer. Paytm's DRHP, for instance, contained warnings about uncertain path to profitability, high customer acquisition costs, and regulatory risks—all of which materialized post-listing. In this comprehensive guide, we'll teach you exactly how to read a startup's DRHP, what sections matter most, and the specific red flags that separate good IPOs from disasters. Armed with this knowledge, you'll be better equipped to evaluate Ola Electric, Swiggy, and every future startup IPO.
What is a DRHP and Why Does It Matter?
A DRHP (Draft Red Herring Prospectus) is a preliminary registration document filed with SEBI before a company's IPO. It's called 'red herring' because it contains a disclaimer in red ink stating that the price and size haven't been finalized.
Key Components of a DRHP:
Section | What It Contains | Why It Matters | Page Range (Typical) |
|---|---|---|---|
| Risk Factors | All known risks to the business | Company's own assessment of what could go wrong | 20-80 |
| Business Overview | Description of operations, strategy | Understanding the business model | 80-150 |
| Financial Statements | 3-5 years of audited financials | Historical performance and trends | 150-250 |
| Management Discussion | Management's view on performance | Context for financial numbers | 100-150 |
| Related Party Transactions | Deals with connected persons | Potential conflicts of interest | 30-50 |
| Objects of the Issue | How IPO money will be used | Capital allocation priorities | 10-20 |
| Outstanding Litigation | Pending legal cases | Legal/regulatory risks | 20-40 |
| Promoter Details | Founder backgrounds, holdings | Who's running the company | 30-50 |
Legal Requirement:** Companies must disclose ALL material information in the DRHP. If something goes wrong that wasn't disclosed, the company and bankers can be held liable. This makes the DRHP a goldmine of honest (if buried) information.
Where to Find DRHPs
DRHPs are publicly available from multiple sources:
Section 1: Risk Factors - The Most Important Pages
The Risk Factors section is legally required to list everything that could negatively impact the business. Companies often bury real concerns among generic risks—your job is to separate the two.
Types of Risk Factors:
Risk Type | Generic Example | Serious Example | Action |
|---|---|---|---|
| Business Risk | "Competition may increase" | "We have never been profitable and may never achieve profitability" | Investigate profitability path |
| Regulatory Risk | "Laws may change" | "Our business model may be found illegal under current regulations" | Check regulatory status |
| Financial Risk | "We need capital for growth" | "We may need to raise additional funds at dilutive prices" | Analyze cash runway |
| Key Person Risk | "We depend on management" | "Our founder faces criminal proceedings" | Check promoter background |
| Related Party Risk | "We transact with affiliates" | "Significant transactions with promoter entities at non-arm's length" | Review RPT section |
Red Flag Examples from Real DRHPs:
Paytm (2021):** "We have incurred net losses in each period since inception and we may not achieve or maintain profitability in the future."
Nykaa (2021):** "We have limited experience operating our business at its current scale."
Delhivery (2022):** "We have a history of losses and negative cash flows from operations."
How to Read Risk Factors Like a Pro
Step 1:** Count the total risk factors. More than 50 is concerning—means many things could go wrong.
Step 2:** Identify internal vs external risks. Internal risks (operational, governance) are more concerning than external (market, economy).
Step 3:** Look for quantified risks. "We have incurred losses of ₹5,000 Cr" is more serious than "we have incurred losses."
Step 4:** Check for regulatory/legal risks at the top. Companies must list material risks first—if regulatory issues appear early, they're significant.
Step 5:** Note any unusual disclosures. Risks specific to this company (vs generic industry risks) deserve extra attention.
Framework:
Indicator | Green Flag | Yellow Flag | Red Flag |
|---|---|---|---|
| Number of risk factors | <40 | 40-60 | >60 |
| Profitability mentioned | "Path to profitability clear" | "May take time to be profitable" | "May never be profitable" |
| Regulatory language | Generic compliance mentions | "Regulations are evolving" | "Business model may be illegal" |
| Litigation | None material | Standard business disputes | Criminal cases against promoters |
Section 2: Related Party Transactions - Follow the Money
Related Party Transactions (RPTs) are deals between the company and its promoters, directors, or their associates. While some RPTs are legitimate, they're also the most common vehicle for siphoning money.
What to Look For:
Transaction Type | Legitimate Use | Red Flag Indicator |
|---|---|---|
| Property Rental | Renting office from promoter at market rate | Paying 3x market rent to promoter |
| Service Contracts | Using promoter's logistics company at competitive rates | Exclusive contracts without bidding |
| Loans to/from Related Parties | Normal inter-company financing | Large loans to promoter entities without interest |
| Purchases from Affiliates | Buying supplies at market prices | Above-market purchases from family companies |
| Brand/IP Licensing | Paying reasonable royalty for brand use | Excessive royalties to promoter entity |
Example - BYJU'S (Never IPO'd, but illustrative):** BYJU'S had extensive transactions with promoter-controlled entities, including marketing spending through related companies. These transactions raised questions about whether shareholder money was being efficiently deployed or enriching insiders.
RPT Analysis Framework
Step 1:** Calculate total RPTs as percentage of revenue. Above 10% deserves scrutiny.
Step 2:** Check if transactions are at arm's length (market prices). DRHP should disclose this.
Step 3:** Look for trends—are RPTs growing faster than revenue?
Step 4:** Identify circular transactions (company pays promoter entity, which invests back).
Step 5:** Review post-IPO RPT policy. Good governance requires board approval for large RPTs.
Checklist:
Question | Green | Red |
|---|---|---|
| RPT value vs revenue | <5% | >15% |
| Independent verification | "At arm's length per auditor" | No verification mentioned |
| Trend | Stable or declining | Growing rapidly |
| Post-IPO policy | Board approval required for all RPTs | No clear policy |
| Nature | Operating transactions | Financing/investment transactions |
Section 3: Financial Statements - Beyond the Headlines
DRHPs contain 3-5 years of audited financials. Most investors look at revenue and profit—but the real insights are elsewhere.
Key Metrics to Calculate:
Metric | Formula | What It Reveals | Good Threshold |
|---|---|---|---|
| Revenue Quality | Cash from Operations / Revenue | Are revenues converting to cash? | >70% |
| Working Capital Trend | Receivables + Inventory - Payables | Is cash being tied up? | Stable or declining |
| Burn Rate | Annual Cash Consumption | How fast is cash depleting? | Declining YoY |
| Contribution Margin | (Revenue - Variable Costs) / Revenue | Does core business make money? | Positive and growing |
| Customer Concentration | Top 10 customers as % of revenue | Revenue stability risk | <30% |
Red Flags in Financial Statements:
1. Revenue growing, cash flow declining: Company may be booking revenue that doesn't convert to cash
2. Receivables growing faster than revenue: Customers aren't paying on time—potential bad debts
3. Inventory buildup: For product companies, rising inventory suggests demand problems
4. Changing accounting policies: Any change in revenue recognition, depreciation, etc. deserves scrutiny
5. Audit qualifications: Even minor qualifications in auditor's report are serious
Cash Flow Statement: The Truth Detector
The cash flow statement is harder to manipulate than the P&L. Focus on:
Cash from Operations (CFO):** - Should be positive for mature companies - For startups, should be improving (less negative) - Compare to reported profit—large divergence is a red flag
Cash from Investing (CFI):** - Check acquisition spending - Large capex relative to revenue may indicate scaling issues
Cash from Financing (CFF):** - How is the company funding operations? - Continuous equity raises suggest inability to generate internal cash
Example Analysis:
Company | Reported Profit | Cash from Operations | Divergence | Assessment |
|---|---|---|---|---|
| Zomato (FY23) | -₹971 Cr | -₹450 Cr | Cash better | ✅ Normal startup |
| Paytm (FY23) | -₹1,776 Cr | -₹2,100 Cr | Cash worse | ⚠️ Investigate |
| Nykaa (FY23) | +₹63 Cr | +₹280 Cr | Cash better | ✅ Healthy |
Section 4: Objects of the Issue - How Will They Use Your Money?
This section details exactly how IPO proceeds will be deployed. Vague or concerning use of funds is a major red flag.
Use of Proceeds | Good Sign | Concerning Sign |
|---|---|---|
| Growth Investment | "₹500 Cr for warehouse expansion with projected 30% capacity increase" | "₹500 Cr for general corporate purposes" |
| Debt Repayment | Paying high-cost debt to improve margins | Paying debt when company needs growth capital |
| Acquisition | Identified targets with clear synergies | "Unidentified acquisitions" |
| Working Capital | Supporting revenue growth | Funding operating losses |
| OFS (Offer for Sale) | Small portion (<20%) by long-term investors | Large OFS by recent investors (exit) |
OFS Analysis:** Offer for Sale means existing investors selling shares—the company doesn't receive this money. High OFS ratios suggest investors want to exit rather than fund growth.
IPO | Fresh Issue | OFS | OFS % | Assessment |
|---|---|---|---|---|
| Zomato (2021) | ₹9,000 Cr | ₹375 Cr | 4% | ✅ Mostly growth funding |
| Paytm (2021) | ₹8,300 Cr | ₹10,000 Cr | 55% | ⚠️ High investor exit |
| Nykaa (2021) | ₹630 Cr | ₹4,700 Cr | 88% | ⚠️ Investor exit |
| Delhivery (2022) | ₹4,000 Cr | ₹1,235 Cr | 24% | ✅ Reasonable mix |
General Corporate Purposes: The Black Hole
"General Corporate Purposes" is a catch-all category that gives management discretion. It should be: - Less than 25% of proceeds (SEBI guideline) - Not the largest use of funds - Accompanied by some specificity about potential uses
- Doesn't have clear growth plans - Wants flexibility to do acquisitions/investments without disclosure - Is raising money it doesn't really need (valuation capture)
Section 5: Promoter and Management Section
This section reveals who's actually running the company and their track record.
Key Questions:
Question | Where to Find | Green Flag | Red Flag |
|---|---|---|---|
| Promoter background | Promoter Details section | Relevant experience, clean record | No relevant experience, litigation history |
| Promoter holding post-IPO | Capital Structure | >50% promoter holding | Promoters selling aggressively |
| Lock-in period | Terms of the Issue | Extended voluntary lock-in | Minimum mandated only |
| Management compensation | Related Party Transactions | Reasonable relative to revenue | Excessive salaries, bonuses |
| Prior ventures | Promoter Background | Successful exits | Failed ventures, legal issues |
Lock-in Analysis:** SEBI mandates minimum lock-ins, but promoters can voluntarily extend: - Minimum promoter lock-in: 18 months for 20% of holding - Extended lock-in: Shows confidence in long-term value
Compensation Red Flags:** - Founders paying themselves more than company's total profit - Large bonuses despite losses - Perks (cars, housing, travel) excessive relative to company size
Due Diligence on Promoters
Beyond the DRHP, independently verify:
Putting It All Together: The DRHP Scorecard
Use this framework to systematically evaluate any startup DRHP:
Category | Questions | Weight | Score (1-5) |
|---|---|---|---|
| Risk Factors | Are risks manageable? Any deal-breakers? | 20% | - |
| Related Party Transactions | Are RPTs reasonable and at arm's length? | 15% | - |
| Financial Quality | Cash flow matching revenue? Improving margins? | 25% | - |
| Use of Proceeds | Clear, growth-oriented use of funds? | 15% | - |
| Promoter Quality | Strong background, aligned incentives? | 15% | - |
| Valuation | Reasonable relative to peers and growth? | 10% | - |
| <strong>Total</strong> | - | <strong>100%</strong> | <strong>-</strong> |
Scoring Guide:** - 4.0+: Strong IPO, consider applying - 3.0-4.0: Average, apply only if valuation is compelling - 2.0-3.0: Weak, avoid unless very cheap - Below 2.0: Red flags, do not invest
Final Checklist Before Applying
Before clicking 'Apply' on any startup IPO:
☐ Risk Factors (all of them) ☐ Related Party Transactions ☐ Cash Flow Statement (3 years) ☐ Objects of the Issue ☐ Promoter Background
☐ Post-money valuation vs revenue (EV/Revenue) ☐ OFS percentage of total issue ☐ Cash runway at current burn rate ☐ RPTs as % of revenue
☐ Promoter background (external sources) ☐ Customer/employee reviews (Glassdoor, social media) ☐ Auditor reputation ☐ Peer valuations
If yes, the DRHP analysis supports your decision. If no, the IPO hype is driving you—not fundamentals.
Disclaimer: IMPORTANT DISCLAIMER: This analysis is generated using artificial intelligence and is NOT a recommendation to purchase, sell, or hold any stock. This analysis is for informational and educational purposes only. Past performance does not guarantee future results. Please consult with a qualified financial advisor before making any investment decisions. The author and platform are not responsible for any investment losses.
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