KAAND 16: The Valuation Kaand TACTIC: Get one friendly investor to invest at a high price — that price then becomes the 'valuation' used to raise the next round
THE TACTIC IN ONE PARAGRAPH A startup or unlisted company needs to raise capital but lacks a market-determined valuation. A founder identifies a "friendly" investor—often a shell entity, a high-net-worth individual with aligned interests, or a fund with overlapping incentives—and negotiates a small investment at an artificially inflated price per share. This single transaction, though economically insignificant, sets a "benchmark" valuation. The company then uses this price to justify higher valuations in subsequent rounds, pitching to new investors that the earlier round "proved" the company’s worth. The tactic relies on the assumption that later investors will not scrutinize the original transaction’s terms, the investor’s credibility, or the actual demand for the shares. The friendly investor may exit early, leaving others holding overpriced paper.
HOW IT WORKS IN INDIA SPECIFICALLY This tactic thrives in India due to three structural weaknesses: the opacity of unlisted markets, regulatory arbitrage between jurisdictions, and the absence of enforceable price-discovery mechanisms. First, the Companies Act, 2013, and SEBI’s Issue of Capital and Disclosure Requirements (ICDR) Regulations impose no obligation on unlisted companies to disclose the identity or background of investors in private rounds. Unlike listed entities, which must file shareholding patterns with exchanges, unlisted firms can issue shares to shell companies or proxies without public scrutiny. Second, the gap between RBI’s oversight of non-banking financial companies (NBFCs) and SEBI’s jurisdiction over listed entities creates a blind spot. A fund registered as an NBFC can invest in unlisted shares without the same disclosure requirements as a SEBI-registered alternative investment fund (AIF). Third, the lack of a liquid secondary market for unlisted shares means valuations are not stress-tested by actual trades. The "last transaction price" becomes the de facto valuation, even if the transaction was engineered. Finally, the prevalence of promoter-controlled entities in India means that friendly investors are often part of the same business ecosystem, reducing the risk of pushback.
THE HISTORICAL RECORD The tactic has been documented in at least three high-profile cases. First, in the 2018 collapse of Infrastructure Leasing & Financial Services (IL&FS), the Serious Fraud Investigation Office (SFIO) found that the company had issued preference shares to group entities at inflated valuations to window-dress its balance sheet. The shares, issued at ₹1,000 each, were later written down to ₹1, but not before they were used to secure loans and attract new investors. The SFIO report noted that the valuations were "not based on any scientific method" and were instead "tailored to meet the requirements of the company." Second, in the 2019 case of Dewan Housing Finance Corporation Limited (DHFL), the Enforcement Directorate (ED) alleged that the company had raised funds from mutual funds and banks by pledging loans against assets that were overvalued. The ED’s chargesheet documented that DHFL had used a single transaction with a related party to set a benchmark valuation, which was then used to justify higher debt issuances. Third, in the 2021 collapse of Anil Ambani’s Reliance Capital, the Reserve Bank of India’s (RBI) audit found that the company had issued non-convertible debentures (NCDs) to group entities at above-market rates, using these transactions to inflate its net worth. The NCDs were later defaulted on, but not before they had been used to raise additional debt from public investors.
THE INSTITUTIONS THAT ENABLED IT No tactic of this scale operates in a vacuum. The IL&FS case revealed that statutory auditors—Deloitte, KPMG, and BSR & Co—had signed off on valuations that were later found to be inflated. The National Company Law Tribunal (NCLT) later barred Deloitte from auditing for five years, citing "gross negligence." In the DHFL case, credit rating agencies like CRISIL and ICRA maintained investment-grade ratings even as the company’s liquidity dried up, relying on the same benchmark valuations that were later discredited. Banks, including Yes Bank and State Bank of India, lent against these inflated assets without independent verification. The RBI’s 2020 Financial Stability Report noted that "weak due diligence by lenders" was a recurring theme in such cases. Finally, the boards of these companies—often packed with nominee directors or individuals with conflicts of interest—approved the transactions without questioning the valuations. The SFIO’s report on IL&FS found that the board had "rubber-stamped" decisions without independent scrutiny.
THE CURRENT STATE The tactic remains in use, though regulators have introduced partial safeguards. SEBI’s 2022 amendments to the AIF Regulations now require funds to disclose the methodology used for valuing unlisted investments, but this applies only to SEBI-registered funds, not to NBFCs or individual investors. The RBI’s 2021 Master Directions on NBFCs mandate that loans against shares must be valued at the lower of the last traded price or the book value, but this does not cover private equity or venture capital investments. The Companies Act’s provisions on related-party transactions have been tightened, but enforcement remains weak. In practice, the tactic continues because the incentives have not changed: founders need high valuations to attract talent and investors, and early backers need exit liquidity. Until India develops a liquid secondary market for unlisted shares or mandates independent valuations for all private rounds, the mechanism will persist.
WHAT TO WATCH FOR First, check if the lead investor in a funding round is a shell entity, a newly incorporated fund, or an individual with no prior investment track record. Second, look for a single small transaction setting the valuation for a much larger round—if a ₹10 crore investment sets a ₹1,000 crore valuation, the math is likely engineered. Third, examine whether the company’s subsequent rounds are oversubscribed by the same set of investors, suggesting a lack of independent demand. If the same names appear in every round, the valuation may be a mirage.
This newsletter describes documented business tactics and systemic patterns based on public records, regulatory orders, and published financial journalism. It does not make allegations against any individual or entity. Readers are encouraged to consult primary sources and form their own conclusions.