Disrupting the Disruptors?

The “Going Public Process” in

Transition

July 14, 2021

Aswath Damodaran
Stern School of Business, NYU

Electronic copy available at: https://ssrn.com/abstract=3892419

 Disrupting the Disruptors? The “Going Public Process” in
Transition

Abstract
For decades, private companies planning to enter public markets have used bankers operating as
intermediaries, helping them decide on issue timing and pricing, and in meeting disclosure
requirements. That banker-led process has always had inefficiencies, but without clear alternatives,
companies had to accept the high costs and the money left on the table on the offering date, as
bankers set offering prices well below market prices, and rewarded preferred clients. The IPO
process is being disrupted by three major changes. First, companies are waiting longer to go public,
and are focusing more on scaling up revenues than on building business models that deliver profits,
while private. Second, the investor base for IPOs is shifting, from primarily institutional, to include
more retail investors, many of whom are young, and get their investing cues more from social
media than from roadshows. Third, there are alternatives emerging to the banker-led process, with
a few turning to direct listings and many more, especially in the last two years, using special
purpose acquisition companies (SPACs). These alternatives clearly are works in progress, and
need improvement, but change is coming. In the final part of the paper, we look at disclosures that
companies are required to make when they go public, and argue that they not only suffer from
bloat, but are not in sync with changes that have occurred in both the companies going public, and
those who trade their shares in the immediate aftermath of going public. We argue for reducing
disclosure bulk and an easing of restrictions on companies making projections about the future,
since these restrictions actually make it easier for companies to sell pie-in-the-sky stories.

Electronic copy available at: https://ssrn.com/abstract=3892419

 For decades, the process that private companies in the United States have used to get listed
on public markets has followed a familiar script. The private company files a prospectus, providing
prospective investors with information about its business model and financials, and hires an
investment banker or bankers to manage the issuance process. The bankers, in addition to doing a
roadshow where they market the company to investors, also “price” the company for the offering,
having tested out what investors are willing to pay, and guarantee that they will deliver that price,
all in return for an underwriting commission. In the last few years, that process has been disrupted
as younger companies, often with little to show in terms of revenues and earnings, but powered by
potential for growth, have entered public markets. That shift has led to a questioning not only of
the IPO process, from companies believing that they were getting good value for their underwriting
commissions in selling and pricing services from banks, to getting too little in services from
bankers for the services provided, but also of existing information disclosure rules, from investors
and traders who feel that the information disclosed in prospectus is insufficient to assess whether
companies are being priced or valued correctly.

Setting the Stage

As a prelude to examining how change is coming to the IPO process, let’s start by looking
at how that process has evolved over time, and the experiences of both issuing companies and
investors along the way. We will begin by looking at the cycles that have characterized the IPO
market over its history, with periods of plenty, followed by periods of paucity. We will then focus
on the banker-led IPO process and how companies that go public through that process perform
on their first day of trading, and how market-set prices deviate from banker-set offering prices.
In the final section, we will follow up by looking at how IPOs perform, relative to the rest of the
market, in the months and years after the offering.
Boom and Bust Cycles
The IPO market has always gone through hot and cold periods, with the number of
companies going public rising and falling over time, as can be seen in figure 1:

Electronic copy available at: https://ssrn.com/abstract=3892419

Source: Jay Ritter
Note the explosion of public offerings during the nineties, as the dot com boom drew technology
companies into the market, and the subsequent drop off, as the market corrected.
Historically, the number of companies going public has not only tracked overall market
performance, rising in bull markets, and falling in bear markets. Note the precipitous drop in IPOs
after the 2008 crisis, as both private companies and investors pulled back from markets. That
makes the surge in IPOs in 2020 noteworthy, given that COVID shut the global economy for a
large portion of the year, and markets were in crisis at least for the first quarter of the year. The
contrast between IPO behavior in 2020 to prior crises can be seen by looking at public offerings
in 2020, by month in figure 2:

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 Figure 2: Number of IPOs: January 2020 to May 2021
160

140

120

100

80

60

40

20

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20
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Source: Dealogic

Not only did the number of offerings hit all-time highs in the last two quarters of 2020, but that
surge continued and accelerated in 2021, which is shaping up to be the biggest year in history for
public offerings.
Offering Date Price Jumps
In the banker-led IPO model that has dominated IPOs for much of the last century, the
bankers set an offering price that they guarantee to deliver, when the stock starts trading. Not
surprisingly, bankers tend to underprice offerings, and stock prices for initial public offerings tend
to jump on the first day of trading, with much of the increase occurring at the open of the trading
day. The extent of the jump has varied over time, and in figure 3, we look at the average returns
on the first day of trading, over time:

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 Figure 3: IPO Returns on First Day of Trading (Value Weighted)
$40.00 70.00%

$35.00 60.00%
$ left on table by issuing companies ($ billions)

$30.00

% Return on first day of trading

50.00%

$25.00
40.00%
$20.00
30.00%
$15.00

20.00%
$10.00

$5.00 10.00%

$0.00 0.00%
80
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20
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20
20
20
20
1st Day Return - VW Amount left on table ($ billions)

Source: Jay Ritter (2021)

Across the entire time period, the percentage return on the first day of trading was about 18-
20%, and much higher during hot markets (1990s, 2018-2021). Figure 3 also lists the money left
on the table by issuing companies, from the underpricing, and not surprisingly, it tracks the
percentage jump on the first trading day.
The underpricing of IPOs and the resulting first-day returns is clearly money left on the
table by issuing companies, with the beneficiaries being those who are able to buy shares at the
offering price, and that has led to some questioning of why these issuing companies do not push
back harder. One reason is that only a small slice of the shares outstanding is actually offered in
most IPOs, and that it often serves the company to have an opening day pop, drawing positive
press and perhaps price momentum that will carry into subsequent time periods. In figure 4, we
track the dollar value of shares offered on the first trading day, as a percent of the market
capitalization of companies, over time:

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 Figure 4: IPO Proceeds $ Value and % of Market Capitalization
$45,000.00 30.00%

IPO Proceeds as % of Mkt Cap at Open of First Trading Day

$40,000.00
25.00%
$35,000.00
IPO Proceeds (millions of $)

$30,000.00 20.00%

$25,000.00
15.00%
$20,000.00

$15,000.00 10.00%

$10,000.00
5.00%
$5,000.00

$- 0.00%
80
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Proceeds Proceeds as % of Mkt Cap

Source: Jay Ritter

Note that while there have been periods in time where the IPO proceeds have been as large as
25%-30% of overall market capitalization, IPOs in recent years have seen proceeds dip well below
10% of overall market capitalization. Read in conjunction with figure 3, where returns on the first
trading day have surged in recent years, there is reason to believe that the banker-set offering
price has little to do with value, and operates more like a loss leader in a retail store, a deliberate
attempt to leave money on the table, so as to draw more investors into the stock.
Aftermarket Returns
A company, once listed on public markets, continues to trade, until it gets delisted or
acquired, and in figure 5, we look at the returns in the three years, post listing, broken down by
IPOs each year from 1980 to 2019:

Electronic copy available at: https://ssrn.com/abstract=3892419

 Figure 5: Long Term (3 years post-offering) Returns on IPOs: 1980 to 2019
60.00%

40.00%

20.00%

0.00%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

-20.00%

-40.00%

-60.00%

-80.00%

Mkt adjusted Style adjusted

Source: Jay Ritter (2021); Returns are measured from the offer price, with excess returns computed relative to market
as well as adjusted for price to book & market cap)
The returns on IPOs in the three years, post-listing, were woeful in the 1980s and 1990s, but have
perked up significantly in the last decade.
A NASDAQ study of IPOs from 2010 to 2019 provides a more in-depth analysis of how
IPOs perform in the post-listing period, and we reproduce those results in Figure 6:

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 Figure 6: Aftermarket Returns on IPOs, tracked over time

Source: NASDAQ Economic Research

Put simply, at least between 2010 and 2019, the longer an investor holds on to a newly listed
publicly traded company, the worse the returns become. Three years after the IPO, almost two
thirds of the listed firms underperformed the Russell 2000.

Disruptions in the IPO game

As the number of public offerings has surged in the last few years, there have also been
disruptions at three levels. The first is in the types of companies going public, with many firms
entering the public markets with large losses and unformed business models. The second is a
change in the investor base, as IPOs draw in more retail investors to their offerings. The third is
the emergence of alternatives to the banker-managed status quo, first in the form of direct
listings and later in blank check companies or SPACS.
Types of companies going public
For much of the twentieth century, the prototype for a private company that was going
public was that of a small, growing company, with a working business model, and a need for
capital that exceeded what venture capitalists could offer. Most companies that went public had
either turned the corner, reporting small profits, or quickly shrinking losses. That has changed

Electronic copy available at: https://ssrn.com/abstract=3892419

over the last two decades, as the private capital market has expanded, and public market
investors have been drawn to invest in private businesses.1
To trace the changes in companies going public, we use Jay Ritter’s expansive data on
companies going public over time. We have tracked the revenues and profitability of companies
that went public between 1980 and 2020, in figure 7:
Figure 7: IPO Characteristics over time: Revenues and Profitability
250 100%

90%

200 80%

70%

150 60%

50%

100 40%

30%

50 20%

10%

0 0%
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020

Revenues (in constant $) % Profitable

Source: Jay Ritter (2021)

As you can see, the median going-public company has become larger (in terms of revenues, in
constant dollar terms) and less profitable; only 20% of firms that went public between 2016 and
2020 were making money, in contrast to the 80% of firms that went public between 1980 and
1990. It is true that profitability measured using GAAP can bias earnings down for companies
with significant R&D expenses and customer acquisition costs, but even accounting for that, the
trend line is clear. In addition, the age of the median company going public has almost doubled
over the period, increasing from 6 years in the 1980s to the almost 12 years by 2020.2

1
To illustrate, Uber, as a private, was able to raise billions of dollars not only from public equity titans like Fidelity
and T. Rowe Price, but also from the Saudi Sovereign Fund, allowing it to raise $20 billion in capital, an amount that
would have been unreachable a few decades ago, for a private company.
2
An additional factor complicating comparisons to history is the increased presence of private equity investors,
who take mature public companies private, make operating and/or financial changes, and bring them back to
public markets. Levi Strauss, which was founded in 1853, went public in 1971 and then was taken private in 1985,
had an IPO in 2019.

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 So, what does this all mean? One reading is that companies are waiting longer to go
public, and that they are spending more of this time scaling up revenues, and less of it building
business models that deliver profits. In fact, the other shift that has occurred in a subset of these
firms, where the growth metric that is emphasized is not in a financial measure like revenues or
earnings but in a revenue driver like user or subscriber count.
The IPO Process
The process that a private company follows to go public, for the last few decades, has
been built around bankers as intermediaries. In figure 8, we summarize the traditional IPO
process, with a list of reasons of why many venture capitalists and issuing companies have soured
on the process:

Put simply, the traditional IPO process takes too long, costs too much, and leaves both issuing
companies and investors dissatisfied, the former because the process takes too long and is too
inefficient, and the latter because they feel that only a select few can partake at the offer price.
While banker-led IPOs will not disappear, you can see why the search is on for
alternatives. One alternative is direct listings, where the company dispenses with the banking
services (setting an offering price and roadshows) and lets the market set the price on the
offering date. In figure 9, we describe the direct listing process, with its limitations.

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This process, by reducing the need for banking intermediaries, is less costly but it still takes time
and comes with constraints, especially in the context of raising capital from the offering to cover
future business needs. Focusing just on banking fees, and ignoring the money left on the table
on the offering day, a banker-led IPO can cost between 3.5%-7% of proceeds, whereas a direct
listing costs a third of that amount. It may also be difficult for low-profile private companies to
list directly, when investors are reluctant to invest based upon a prospectus, without someone
else doing the due diligence (asking questions of management, checking the financials). An
additional component of direct listings is that they do not include a lock-up period, restricting
trading by pre-IPO shareholders in the company, and that exposes investors to the concern that
share prices in the aftermath of the listing can be more volatile, as existing shareholders exit.
A special purpose acquisition company (SPAC) offers a different approach to going public,
with an initial listing of an entity that raises public, with the intent of merging with a private
business that wants to be in the public markets. Figure 10 summarizes the structure of a typical
SPAC:

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The sponsors are the key players in this game, since investors in the SPAC are dependent upon
the sponsors finding a target and negotiating a good deal. Unlike the blank check companies on
the 1980s, though, investors get a host of protections, including the rights to vote on approving
both target choice and deal details and to redeem their investment, if they lose faith in the
sponsors, and get back their capital invested. As you can see in figure 11, in 2020 and 2021, SPACs
dominated the IPO process, accounting for more than half of all deals done, both in terms of
deals done as well as funds raised:

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 Figure 11: The Rise of SPACs - 2003-2021
$600 500

450
$500
400

350
$400
$ Value (in billions)

300

Number of deals
$300 250

200
$200
150

100
$100
50

$- 0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
# IPOs 126 256 224 177 233 30 69 159 128 138 210 246 153 98 155 179 154 202 133
# SPACs 1 12 28 37 66 17 1 7 16 9 10 12 20 13 34 46 59 248 330
SPAC Proceeds $0 $0 $2 $3 $12 $4 $0 $1 $1 $0 $1 $2 $4 $3 $10 $11 $14 $83 $105
IPO Proceeds $50 $72 $60 $52 $75 $26 $22 $505 $41 $50 $69 $91 $35 $22 $40 $53 $59 $96 $68

# SPACs # IPOs SPAC Proceeds IPO Proceeds

Looking at SPACs in the context of banker-run IPOs and direct listings, you can see some of the
reasons for their surge in popularity. First, since SPACs go public and raise capital first, and then
go on a search for targets, they may be more time efficient, where they can do deals to take
advantage of short windows of market opportunity. Second, on the disclosure front, while the
information disclosure requirements for SPACs largely resemble those for conventional IPOs,
SPACs have more freedom to make projections and spin stories, albeit with bias and within
reason. Finally, the SPAC sponsors take on the search and deal-making roles, using their industry
knowledge to do due diligence and negotiate the best prices, in effect replacing investor due
diligence with their own. In figure 12, we summarize the trade-offs from SPACS:

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The benefits of the SPAC route to going public have to be weighed against its many costs. The
first is that the SPAC sponsor's subsidized share of the SPAC (which can amount to more than 15-
20% of the capital raised) and the deal-making costs (underwriting fees are 5% or more of the
merger value) may be large enough to wipe out any potential timing and pricing benefits in the
deal. The former effectively dilutes a SPAC investor's holding, right at the start, and the latter
drains value from the deal. The second is that the SPAC sponsors, notwithstanding the
protections built in for investors, are in control not only when it comes to the deal making, but
also of the side aspects on the deal that can benefit them disproportionately. For instance, the
capital provided by a PIPE in a SPAC can be at a discounted price, relative to the deal price. Finally,
to the extent that SPACs are being marketed as being good for private companies planning to go
public, because they allow these companies to time their offerings better and receive higher
market prices, it is worth noting that these benefits come at the expense of investors in these
SPACS. In other words, SPACs claiming that they deliver value to both issuing companies and to
their own investors are trying to eat their cake and have it too.
Is the SPAC model a better one than the banker-led one? The answer to that depends on
whose interests are being considered, and looking at the evidence that has accumulated so far
on public offerings, here is how the different players in the model are gaining or losing from the
game:
1. SPAC Sponsors: The sponsors of SPACs, at least given their current structure, are the clear
winners from this trend. When you receive shares of ownership that are three, four or
even five times your invested capital stake, you have effectively tilted the game in your
favor. At worst, if the deal does not go through, you return the cash to your investors, and
walk away almost unscathed (at least, as an investor). If a deal does get done, you get a
multiple of your original investment, presumably as compensation for finding a target,
and negotiating the price. In a comprehensive paper on SPACs, Klaussner, Ohlroge and

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 Ruan (2020), they find that the returns to SPAC sponsors reflect these advantages they
bring to the game (see figure 13)3:
Figure 13: SPAC Sponsor Returns

Source: Klaussner, Ohlrogge and Ruan (2020)

2. Investors in SPACs: There are clearly some deals, where SPAC investors emerge as
winners, as the merged company's stock price soars in the aftermath. An investor in the
SPAC that took DraftKings public in 2019, for instance, would be showing returns of more
than 500% in the period since, and an investor in the Virgin Galactic IPO would have more
than quadrupled their money. That anecdotal evidence, though, obscures a more mixed
story, and to understand it better, you have to examine SPAC investor returns in two
periods, one from the time a SPAC is taken public to when it announces a merger deal,
and one from the weeks and months after the merger deal. In a study by Gahng, Ritter
and Zhang (2021) looked at 110 SPACs from 2010 -2018, and conclude that SPAC investors
do reasonably well, earning an annual return of 9.3%.4 More impressively, the downside
protection on these deals put a floor on their losses, with even the worst deal generating
a positive return (0.51%). In contrast, Klaussner et al. look at returns to SPAC investors in
the weeks and months after a SPAC merger (see table 1) the results are not appealing:

3
Klaussner, M., M. Ohloroge and E. Ruan, 2020, A Sober Look at SPACs. SSRN Working Paper,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3720919.
4
Gahng, M., J.R. Ritter and D. Zhang, 2021, SPACs, SSRN Working Paper,
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3775847.

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 Table 1: Returns to Investors in SPACS

Source: Klaussner, Ohlrogge and Ruan (2020)

Put simply, no matter which measure of returns you look at, and over almost every time
period, investors in SPAC-merged companies lose money. It is true that high-quality
sponsors (with more money at play and better track records from past SPACs) do better
than first-time or low-quality SPAC sponsors, at least in the near term (three months), but
the magic fades quickly thereafter. Finally, the median returns are much worse than the
average, because of a few outsized winners, and that may explain part of the allure, is
that these winner stories get told and retold to attach new investors. If there is a
cautionary note in these findings, it is for investors who invest in SPAC-merged
companies, after the deal is consummated, since it looks like for many of these
companies, prices peak on the day of the deal, and wear down in the months after, partly
because the hype fades and partly because SPAC warrant conversions continue, upping
share count and the dilution drag on value per share.
3. Owners of issuing companies: There are three levels at which you can assess whether
companies that plan to go public benefit from the SPAC phenomenon. The first is in
whether some of the companies that used SPACs to go public would have been unable or
unwilling to do so, in their absence. The second is whether the companies that did go
public, using SPACs, generate higher proceeds than they would have received, if they have
followed the traditional IPO route. While it is almost impossible to test either proposition,
I would assume that given the number of companies that have gone public using SPACs,
some of them would have chosen to stay private, if their only option had been to use the
banker-run process. I would also assume that at least some of the companies that were

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 able to take advantage of the speedier SPAC process to generate higher prices, by timing
their issuances better. The third is how the company's stock price does in the period after
going public, and it is here that I think SPACs have not served private companies well. By
creating layers of dilution, first to sponsors, next when raising capital from PIPEs and
finally from the warrants granted along the way, they impose burdens on the stock that
are difficult for it to overcome. I don't think that too many private companies would be
happy with the post-merger performance that SPAC-merged companies posted in the
table above, since it poisons the well for both future stock issuances, as well as for owners
(VCs, founders) planning to cash out later in the game.
In sum, while we can all agree that the banker-run IPO model has become inefficient and
expensive, there is no consensus (yet) on an alternative. For some large, high profile private
companies, the direct listing approach offers promise, since it significantly cuts back on
intermediation and waste. SPACs have surged in usage, but in their current form, the
intermediation costs (paid to sponsors and for deal fees) are often higher than with the banker-
led model. That said, private companies planning to go public today have more choices than
companies in prior years, and that competition will play a role in bringing down costs and
improving the efficiency in the process. Each of the existing processes will see changes over time,
with banker-led IPOs lowering fees, direct listings adding more freedom to hold capital raised at
the offering and incorporating holding periods and SPAC sponsors scaling back their slice of the
capital.
Investor base
In the banker-led model for IPOs, the investors who received access to the IPO shares at the
offering price tended to be primarily institutional, with a few preferred investment banking
clients thrown into the mix. Since these shares tended to be underpriced, these investors
received a windfall profit, when the shares started trading on the offering date, and there is
evidence that many of them cashed out in the year after the offering. That process was arguably
both inefficient, since funds meant for the issuing company were redirected to public market
investors, and unfair, since only a select few were given access to these shares.
In the last few years, there has been a move towards opening up the process to individual
and retail investors, and this opening is coming from two developments in markets. The first is
the introduction of trading platforms like Robinhood, focused on allowing individual and small
retail investors to trade stocks at low or no cost, and the second is the opening up of access to
online data on companies that plan to go public.
The Bottom Line
As larger and more money-losing companies go public, sometimes using processes which
bypass bankers and other intermediaries, and retail investors, many young and inexperienced,
are drawn into investing in IPOs, it is worth asking the question of whether the disclosure and
market regulatory rules that were written to protect investors need revisiting, in the context of
these changes.

Understanding the IPO game

Before embarking on an analysis of whether existing disclosure rules and IPO regulations
need to be changed, we need to understand the IPO game, since it differs in fundamental ways

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from investing in seasoned publicly traded companies. In this section, I will focus on three aspects
of the IPO process that set it apart from investing in the rest of the public market.
Price versus Value
While we often use the words value and price interchangeably in finance, they are the
results, in our view, of two very different processes. The value process has its roots in the
fundamentals of a business, its cashflows, growth and risk, with the end game being estimating
the intrinsic value. The pricing process is the result of demand and supply, and while the
fundamentals play a role, they are often drowned out by mood, momentum and behavioral
factors. To price an asset, you generally look at what investors are willing to pay for “similar”
assets, and in the context of equities, you do so by using a standardized price (a multiple) and a
peer group of companies. Figure 14 summarizes the value and pricing processes:
Figure 14: Value versus Price

In an efficient market, the value and the pricing process converge, and while gaps between the
two may exist, they are random and cannot be exploited for gain. All active investing strategies
are built on the premise that there are times when price and value can diverge systematically,
either across time or for subsets of stocks, and that the resulting gap between value and price
can be exploited for profit.
While this tension between value and price plays out in all markets, initial public offerings
are more of a pricing play than other parts of the market for two reasons. The first is the absence
of reliable historical data, either because the company going public is young or because the
accounting is unreliable, for earlier time periods. The second is that companies that are going
public tend to have business models that are still evolving, making it more difficult to do
valuations based upon fundamentals. The contrasts between value and pricing allow us to draw
a distinction between traders and investors. Traders play the pricing game, trying to gauge mood
and momentum, using charts and incremental news stories, and then timing their trades
accordingly. Investors try to value companies based upon fundamentals and put their faith in
prices adjusting to value. Table 2 below draws the distinction more fully.

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 Table 2: Traders versus Investors

It should come as no surprise that there are most of the participants in the IPO process are
traders, not investors, and are thus less interested in fundamentals and more interested in
indicators of mood shifts and momentum changes.
Stories versus Numbers
As access to data improves and tools become more powerful, valuation has increasingly
become number-driven, with models and excel spreadsheets as representations. In the process,
though, analysts have lost sight of one of the core truths in valuation, which is that a good
valuation is a bridge between stories and numbers. Figure 15 illustrates the links:
Figure 15: Stories and Numbers

Put simply, every number (growth, margins, discount rates) in your valuation has to have its roots
in a story, and every story you tell about a company (great management, superior brand name)
has to have a number that captures it. The connections between story and numbers arelaid out
more explicitly in figure 16, starting with a story and ending with a valuation.

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 Figure 16: Story to Numbers in Steps

While this link between stories and numbers is always true, young companies, the balance of
which one dominates varies across a company’s life cycle, as can be seen in figure 17:

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 Figure 17: Stories and Numbers across the Corporate Life Cycle

Note that while numbers play a dominant role in valuing and pricing mature companies, it is
narratives or stories that drive how we price younger companies. With initial public offerings,
this makes stories the key determinants of value and price, and the shift in emphasis to revenue
growth at the expense of business models and profitability that we have seen in companies going
public has made story telling even more dominant.

Disclosure Dilemma
To understand what private companies should be disclosing at the time that they go
public, we will begin by looking at the challenges that public market investors face, when they
consider investing in an initial public offering. We will follow up by examining what regulators,
especially in the United States, have come up with as disclosure requirements to overcome these
challenges, and then examine why those disclosure requirements may need change to reflect the
disruptions that have occurred in the IPO market.
Private to Public Market Transitions: Value and Pricing Challenges
When a private company transitions to being publicly traded, investors interested in trading
or investing in that company face at least five challenges. Since private companies range the
spectrum, it should come as no surprise that some of them are more difficult to value and price
than others.
1. Low Profile: In general, private companies tend to be less known and have less news
coverage than public companies. There are obviously exceptions to this rule, as was the

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 case when Facebook, Airbnb and Google went public, but investors know less about most
private companies that are going public.
2. Lack of standardized financial history: In conjunction with the lack of news coverage,
private companies often do not have financial statements that go back in time. Even if
they do have historical financials, they are not governed by accounting standards that
publicly traded companies follow, making them difficult to use in comparisons and
analysis.
3. No/Limited pricing history: When investing in or trading on publicly traded companies,
investors often draw on past stock price history to make judgments on whether a stock is
under or overpriced. When valuing IPOs, investors do not have this crutch, having to draw
on, at best, data on the most recent VC rounds and pricing.
4. Corporate governance: Investors in publicly traded companies have to value or price their
corporate governance concerns, reflecting their expectations that managers may not
always make decisions that are in the shareholders’ best interests. With seasoned
companies, they can draw on the history of corporate governance in the company to
make these judgments, but with private companies, they are often in the dark on
potential corporate governance issues. These problems are exacerbated in IPOs by the
presence of founder or founders as top managers, and venture capitalists as lead
investors.
5. Share count: Since public market investors buy and sell shares in the company, the
aggregate value of equity in the company has to be converted into a per share value. That
conversion requires an assessment of share count, and that exercise can be difficult in
IPOs for three reasons. The first is that on their pathway to going public, private
companies raise capital in multiple rounds from venture capitalists, creating equity claims
in the form of convertible preferred shares and warrants. The second is that many private
companies compensate employees with options and restricted share units, as they grow,
some vested and others unvested. The third is that in most public offerings, the issuing
company will add to its share count in the initial public offering, if it plans to raise cash for
the company.
While these concerns have always been part of the IPO process, the first three have become
more of a concern as more money losing companies go public and the last two have been
exacerbated as companies adopt dual-class shares, with different voting rights, and expand their
use of stock-based compensation.
Disclosure rules and evolution
The SEC’s rules on disclosure for public companies were written decades ago, and have
been changed over time, trying to accomplish two, sometimes contradictory, objectives. The first
is to protect those who may buy shares in these companies, by filling in the information gaps.
The second is to ease the process of going public, especially for smaller companies, by
streamlining disclosure requirements. The roots of the current disclosure requirement go back
to the Securities Act of 1933, where the information that companies have to provide in a S1
(prospectus) were first laid out. In an S1, an issuing company has to provide information on its
business model, a description of the planned share offering and what it plans to do with the
proceeds. It also has to contain information on the offering price, once it is set, and the share
count after the offering.

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 As part of its description of its business model, the issuing company also provides financial
statements, using the same accounting standards that publicly listed companies follow, for the
previous three years; an exception is carved out for companies with less than $1 billion in
revenues that qualify as emerging growth companies (EGC), where you need only two prior years.
In addition, companies that plan to go public are also required to list out risk factors that may put
them in peril.
Finally, the SEC puts tight restrictions on projections that the issuing company can make
for future years in the prospectus. In fact, companies typically do not make financial projections
for the future in the prospectus, though they are given more leeway if they go with the SPAC
route. Even with SPACs, though, the forecasts have to be tightly framed, to avoid legal jeopardy.
While the core requirements of the prospectus have not changed much over time, the filings
themselves have become more detailed and longer over time. To provide a measure of the
disclosure bloat, we looked at the prospectus filings of a few high-profile companies from the last
four decades:
Table 3: The Bulking Up of Prospectus – 1980 - 2020
Year of
IPO Number of pages in prospectus Appendices
Apple 1980 73 0
Microsoft 1986 52 17
Yahoo! 1996 54 20
Amazon 1997 47 35
Netflix 2002 79 24
Google 2004 124 59
Facebook 2012 150 36
Twitter 2013 164 55
Uber 1019 285 94
Airbnb 2020 350 84

Consider two high profile offerings from the 1980s, Apple and Microsoft, and contrast them with
the filings from IPOs in more recent years. Apple’s prospectus from 1980 was considered long,
running 73 pages, and Microsoft’s prospectus in 1986 was 69 pages long, with the appendices
containing the financials. In contrast, Uber’s prospectus in 2019 was 285 pages long, with a
separate section of 94 pages for the financial statements and other disclosures, itself an increase
on the Facebook prospectus from 2012, which was 150 pages, with 36 pages added on for
financial statements and other add-ons.
Disclosure Holes
While disclosures have become longer and more detailed, it is not clear that they have
become more informative. In fact, you could argue that the limitations of disclosure are in the
details:
1. Legalistic risk profile: At the risk of sounding hyperbolic, there is no section in a prospectus
that has become less useful to investors than the risk profile section. While well
intentioned and intended to provide transparency on the risks that investors faced in low

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 profile companies, they have increasingly lost that focus and instead become a catch all
to preempt any risks that the company may be sued. Thus, in Uber’s risk profile, it states
“we expect our operating expenses to increase significantly in the foreseeable future, and
we may not achieve profitability”, a statement that is true for almost any young, money-
losing company and mostly useless as a guide to investors.
2. Share count confusion: While the disclosure requirements for share count have not
changed substantially since the 1980s, share structures have become more complex at
companies, creating more confusion about shares outstanding. Airbnb, in its final
prospectus, before its initial public offering asserted that there would be 47.36 million
class A and 490.89 million class B shares, after its offering, but then added that this share
count excluded not only 30.87 million options on class A shares and 13.79 million options
on class B shares, but also 37.51 million restricted stock units, subject to service and
vesting requirements.
3. Big story pieces, without details: While companies adhere to SEC restrictions on
projections in the prospectus, they have no qualms about making claims that make their
valuation stories bigger. In general, companies have become adept about using broad
brush components to advance their story lines, without providing explicit details.
a. Total Addressable Market (TAM): A significant number of companies that have
gone public in the last decade have used their estimates of total addressable
market (TAM) to get investors to attach a higher value/price. While the notion
that knowing the TAM is central to valuing a young company, the lack of consensus
on how to estimate it has allowed companies to inflate numbers, sometimes to
the point of absurdity. In figure 18, I draw on three companies, Uber and Peloton
from their 2019 offerings, and Airbnb from its 2020 listing, to illustrate how TAMs
have spun out of control:

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 Figure 18: Total Addressable Markets (TAM), in prospectus

Each company’s TAM is immensely larger than the existing market. For instance,
Airbnb estimates the short-term stay business to be $1.2 trillion, double the $600
billion in revenues that hotels globally generated in 2019. Peloton is anticipating
a target market of subscribers which is three times larger than the number of gym-
members in the market in 2019. It is true that each of these companies can

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 plausibly claim to draw new users in and increase market size, but the question is
by how much and with what basis.
b. User/Subscriber count: For some companies, the pathway to a higher pricing or
value comes from emphasizing growth in user or subscriber numbers, with the link
to revenues and profitability only loosely defined, and critical details left out on
the cost of acquiring users/subscribers and churn/renewal rates. Using Uber,
Peloton and Airbnb again to illustrate this process, we look at the user numbers
provided by each company in its prospectus, in table 4:
Table 4: Business Unit Statistics for Uber, Airbnb and Peloton
Year -2 Year -1 Most Recent
Uber riders/consumers (millions) 45.00 68.00 91.00
Uber trips (millions) 1818.00 3736.00 5220.00
Peloton Subscribers ('000s) 108.00 246.00 511.00
Airbnb Nights booked (millions) 185.80 250.30 326.90
Of these three companies, Airbnb is the only one that provided a cohort table,
showing the percent of guests who returned, based upon when they first used the
system. None of the companies provided detail on the costs of acquiring a new
user or subscriber, a critical input in determining the value of growth. In addition,
tactics can be used to accelerate user acquisitions, through partnerships and
bonuses, just before public offerings to inflate user numbers.
c. Gross and Net Revenue: For companies that operate as intermediaries (like ride
sharing or online merchandizing), using the gross revenues generated, rather than
the company’s slice of those revenues, can make a company’s financials look more
substantial. With Uber and Airbnb, the gross billings (booking value) are much
higher than the revenues that represent the company’s shares, as can be seen in
figure 19:

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 Figure 19: Gross Bookings versus Revenues - Uber and Airbnb
$70.00

$60.00

$50.00

$40.00

$30.00

$20.00

$10.00

$-
2018 2019 2017 2018
Airbnb Uber
Gross Bookings $29.40 $38.00 $34.40 $49.80
Revenues $3.70 $4.80 $7.90 $11.30

Revenues Gross Bookings

While both Uber and Airbnb showed high growth in both gross bookings and
revenues in the year leading into their IPOs, the revenues are between 12-13% of
gross bookings at Airbnb and about 23% at Uber.
d. Adjusted earnings numbers (adjusted EBITDA) & ratios (gross margins): Many
money-losing companies that are planning to go public have found a simple tactic
to make it look like they are making money or at least not losing as much, by
adding back what they categorize as non-cash expenses or extraordinary items to
their accounting bottom lines. In table 5, we look at net income and adjusted
EBITDA numbers from Uber, Peloton and Airbnb prospectus:
Table 5: Net Income and Adjusted EBITDA: Uber, Peloton and Airbnb
Uber (2017) Peloton (2019) Airbnb (2019)
Net Income -$4,033 -$196 -$674
+ Stock Based Compensation $137 $90 $54
+ Other Adjustments $1,254 $35 $791
Adjusted EBITDA -$2,642 -$71 $171

These adjusted EBITDA and earnings numbers are labeled as unofficial measures,
but the intent is to get investors and analysts to base their pricing of these
numbers. While some of the adjustments are legitimate, others clearly cross the
line. In particular, adding back stock-based compensation, on the mistaken
rationale that it is a non-cash expense and thus similar to depreciation, is wrong,
a clear misreading of the reality that for young companies, employee options and
restricted stock are compensation expenses and need to be treated as such.

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It is ironic that the SEC’s rules that restrict companies from making detailed and specific
projections for the future, designed to protect investors from overreach, are working against that
end game. In fact, we would argue that many issuing companies are effectively getting the best
of both worlds, using large total addressable markets and diffuse user statistics to make their
valuation/pricing stories bigger, without having to provide the details that can be used by
investors to evaluate them and hold them accountable.
Disclosure fixes
While it is easy to take issue with the SEC on individual disclosure issues, the problem, as we
see it, is that the SEC and other regulators are misunderstanding the nature of the companies
that are going public and the informational needs of investors who choose to trade shares in
these companies. Operating on the beliefs that companies going public are young and mostly
small companies that have turned the corner on their business models, and that those who seek
out shares in these companies are investors that are interested in valuing these companies, they
have crafted disclosure requirements that mirror those of more mature, seasoned public
companies. In truth, neither of these beliefs is true. Companies that are going public in today’s
markets are older and have more revenues that companies that went public a few decades ago,
but they also have less-formed business models. The market players buying shares in these
companies are traders, not investors, caring less about fundamentals and more about
momentum and incremental information. If you add in changes in the IPO process, with bankers
being displaced entirely (as in direct listings) or replaced by SPAC sponsors, it is clear that rather
than tinker with existing disclosure rules, it may make more sense to start afresh, with the
following guiding principles.
1. Less is more: There is no arguing that prospectuses have become too long and loaded
with distracting disclosures. We would recommend cutting back on disclosure, starting
with the risk section. To the extent that some of these disclosures are purely for legal
protection, we would recommend a legal section that can be written by lawyers for
lawyers. Since the nature of regulation is that new disclosures continue to be added over
time, we would suggest a variant of a “disclosure in, disclosure out” rule, where when a
new disclosure is added, it has to be at the expense of an old and outdated requirement.
This notion that more disclosure is better than less is dangerous, and it has made annual
reports and prospectuses into data dumps.
2. More Pricing information: While companies going public have no market price data, they
have had to raise capital from venture capitalists along the way, and in each of these
venture capital rounds, there has been an implicit pricing of the company. While
companies and their bankers often selectively use these VC rounds to justify their IPO
pricing, there is no organized disclosure requirement on VC capital rounds and pricing.
We would argue that all private companies be required to disclose VC capital raised over
their history and the company pricing in each round, both to make clear how much cash
the company has burned through over its lifetime, but also to provide transparency on
VC behavior. Put simply, the pricing from small VC capital rounds should be weighted less
than those from larger VC capital investment, and pricing based upon a sequence of
capital rounds from the same VC should be trusted less than pricing based upon diverse
VC rounds. Consider, for instance, the (incomplete) information on VC rounds and capital

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 raised by WeWork in the years before its IPO in 2019, that we were able to cobble
together from news releases in table 6:
Date Investors Capital Raised Imputed Pricing
Apr-09 NA $17.50 $97.00
Nov-10 NA $41.00 $440.00
Jul-11 Aleph $156.40 $4,800.00
Jan-12 NA $6.90 NA
Fidelity, Glade Brook, Capital
Partners, JPM Chase, T. Rowe
Oct-14 Price $355.00 $5,000.00
Mar-15 Glade Brook Capital Partners $433.00 $10,200.00
Jul-15 Legend Holdings, Hony Capital $690.00 $15,800.00
Aug-17 Softbank $4,400.00 $21,100.00
Aug-17 NA (Debt) $702.00 NA
Aug-18 Softbank (Debt) $1,000.00 NA
Nov-18 Softbank $3,000.00 $45,000.00
Jan-19 Masayashi Son, Softbank $2,000.00 $47,000.00
Amazon, Fidelity, Greenoaks, T.
May-19 Rowe Price $575.00
Total Private Capital raised $13,376.80
While we have the benefit of hindsight on the company, there are two red flags in this
table that some investors may have noticed, if they had been provided the information.
The first is that the company has burnt through close to $14 billion in cash already,
indicating that its business model is one that eats through cash. The second is that one
player, Softbank (in multiple forms) has been responsible for supplying more than half of
this capital and been the key driver in pushing WeWork’s pricing up and into the
stratosphere on the most recent rounds.
3. Rather than restrict storytelling, require fuller stories, with more connection to numbers:
The idea that allowing companies to make projections and fill in details about what they
see in their future will lead to misleading and even fraudulent claims does not give
potential buyers of its shares enough credit for being able to make their own judgments.
In fact, markets abhor vacuums, and preventing companies from forecasting the future
only allows others, less scrupulous and informed, to fill in the empty spaces with their
own details. The disclosure status quo is letting young companies off the hook, since they
can provide the outlines of a story (total accessible markets, multitude of users, growth
in subscribers) without filling in the details that matter (market share, subscriber renewal
and pricing).
4. Clean up and standardize share count: We need clarity and uniformity when it comes to
share count. Rather than let companies make off-the-cuff judgments on what to count in
their shares outstanding or use bludgeons (like fully diluted share count), we would
recommend that restricted share units be counted as part of shares outstanding, and
options be separated out, with exercise prices and maturity.

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 5. User/Subscriber/Customer details (conditional disclosure): With users, subscriber or
customer data, it strikes us as counterproductive, especially given the misgivings we have
about disclosures becoming denser and longer, to require all companies to disclose
information on unit economics. Instead, we would argue for triggered disclosure, where
any company that wants to build its story around its user or subscriber numbers (Uber,
Netflix and Airbnb) will have to then provide full information about these users and
subscribers.
Put simply, better disclosure rules for initial public offerings have to be tailored to the types of
companies going public as well as the types of investors/traders who are drawn to buying shares
in these companies.

Conclusion
For decades, the going public process in the United States has followed a familiar script,
with bankers acting as intermediaries. Disruption is now coming to the going-public process, as
the companies that are going public today are larger, have more revenues and less formed
business models than the companies of the past, and the market for these offerings is shifting
away from institutions to individual and retail investors. The banker-led process, already being
critiqued for its offering costs and underpricing, has seen challenges in the form of direct listings
and SPACs, and while both of these alternatives have limitations, it is clear that change is on the
way. As these changes occur, the regulatory and disclosure rules also need rewriting, with the
focus on slimming down prospectuses and allowing companies more freedom to make forecasts
and tell their business stories more fully. While this may seem like a recipe for companies to
overreach and over promise, we argue that the existing restrictions on forecasts and projections
have the perverse effect of allowing companies to cherry pick data (promoting absurdly large
total addressable markets) and modify earnings (with adjustments to earnings and EBITDA), and
undercut both investors and traders who may be interested in investing in companies. In
addition, as more companies market themselves, based on user and subscriber numbers, we
argue that these companies should be then required to provide the rest of the relevant
information on these users and subscribers, including churn/renewal rates, user breakdown by
cohort/age groups and customer acquisition costs.

Electronic copy available at: https://ssrn.com/abstract=3892419