Author, The Fairshare Model
"If you invested in WeWork at a $47 billion valuation, you’re getting fleeced!"
So exclaimed congresswoman Alexandria Ocasio-Cortez (Dem.-NY) during an informative hearing of the .S. House of Representatives Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets on September 11, 2019. Her comment was part of one of several interesting exchanges between lawmakers and a panel of experts, comprised of three academics, one securities regulator, and an attorney in private practice. [Viewable here.]
Wall Street on Parade reports that “The thrust of the hearing was the negative impact that the ballooning private equity market is having on the dramatically shrinking pool of publicly traded stocks and the good of society in general.” Renee Jones of Boston College testified that there are half as many public companies in the U.S. today as there was a decade ago, and the number of public offerings was less than in the past. And that last year, there was twice as much equity capital raised in the private offerings as in the public ones.
Explanations for this trend are largely speculative because there is little data available on private equity transactions. That said, the panelists believed regulatory changes caused the private equity market to swell in recent years.
For example, the number of shareholders a company may have before it is subject to the disclosure requirements for a public company is now 2,000—it used to be 500. Another reason is that revisions to Rule 144 made it easier for stock in a private company to be resold—this provides a degree of liquidity to a company’s employees and private investors, easing the pressure they exert to go public.
Reasons for fewer IPOs were also discussed. An abundance of private money is a key factor. Another is that companies feel that the emphasis in public markets on quarterly results, and the cost to comply with reporting requirements, do not benefit their business. For small companies, the cost of a Rule CF (crowdfunding) offering—which is limited to about $1 million—represents a significant proportion of the sought-after proceeds, and it must be paid before a company knows if it can sell its offering.
Valuation came up several times. The topic is of particular interest to me, as it’s the focus of my new book, The Fairshare Model: A Performance-Based Capital Structure for Venture-Stage Initial Public Offerings.
Here, I’ll touch on an exchange in the hearing that highlights unfairness in the IPO market—private investors routinely secure "price protection" when they invest, but IPO investors never get it. Price protection describes deal terms that can retroactively reduce an investor's buy-in valuation to deliver a higher rate of return.
Since public investors buy-in at a far higher valuation than their private counterparts, they get a double dose of valuation risk—they buy in at a higher valuation, and they don't get a safety net.
Representative Ocasio-Cortez brought up the parent company of WeWork which reportedly was valued at $47 billion in January 2019, when a private round of financing took place. At the time of the hearing, its potential IPO valuation was in freefall, due to concerns about its business model, the potential for the founder/CEO Adam Neumann and his spouse to control the company, and evidence that he had engaged in self-dealing transactions.
Ocasio-Cortez waved a news article about WeWork and said it “had raised money on a previous valuation of $47 billion. And now they just decided overnight—'just kidding, we’re worth $20 billion.’ They’ve cut it by over half. Correct?”
Subsequent events soon indicated that the congresswoman was even more right than she imagined!
Days after the hearing, WeWork reportedly eyed an even lower IPO valuation—$10 billion, a fifth of what it had been just months earlier! Shortly thereafter, the company announced that it would postpone it altogether. The following week, it announced that Neumann would no longer be its CEO.
Those evaluating its business model sensed higher-than-expected failure risk—reason to doubt the company would achieve the performance that it promised. Then too, investors were being asked to buy in at a very high valuation, so WeWork presented high valuation risk.
Other companies have gone public using the type of super-voting shares for founders that WeWork had, but other aspects of its governance provided another reason for investors to pass. As cracks in its “valuation dam” appeared, they grew and the apparent value poured out.
WeWork’s governance concerns will be addressed but it will be harder to re-engineer the business model before it refiles for an IPO. And it almost certainly will try again because:
WeWork is a venture-stage company—it requires fresh infusions of capital to survive.The January financing was its eighth private round—it will be tough to attract many more.The public market offers the best prospect for an attractive exit for private shareholders.
However, the big story here shouldn’t be WeWorks per se for it merely illustrates a bigger problem with capital markets—market forces are not strong enough to benefit average investors.
For instance, unlike many areas of commerce, companies don’t compete for investors by offering lower valuations and/or better deal terms. I explain that in a 2017 article called The Case for a Valuation Disclosure Requirement. In this article, my message is that public investors routinely get a lousy deal when they invest in a public startup.
To wit, all venture-stage investors—private and public—assume two basic risks; failure risk, and valuation risk. (Fraud is not a unique form of risk, it is simply failure risk and valuation risk, garnished with false and/or misleading disclosure.)
Failure risk is that a company will not achieve the operational goals that investors anticipate. Due diligence can help investors assess it and the valuation, but failure risk is omnipresent. Private investors in the failed unicorn, Theranos, conducted notably poor due diligence. They did not discover that the company’s technology was grossly unable to perform as the founder/CEO claimed, thus they also badly misjudged its valuation.
Valuation risk is the risk of overpaying for a position, and one can overpay for a company that has no failure risk. The fundamental problem is that it is difficult to perform due diligence on the valuation of a venture-stage company. In part, it’s because it is hard to get valuation data on comparable private companies. But the most significant reason is that no one—no one—knows how to reliably value a venture-stage company. That's because such an endeavor relies on projections that are often wrong.
For that reason, sophisticated private investors rely more on getting the right deal terms, than on getting the right valuation. Such deal terms provide price protection, often is ways that are unclear to entrepreneurs who are happy about the apparent valuation they got.
CNBC reports that investors in WeWork’s January financing will benefit from a deal term known as a price ratchet, which “could give them $400 million worth of additional shares (for free) in the event of a weak IPO performance. This is expected to be the biggest of that type of protection in history if and when the start-up goes public.”
Put another way, WeWorks’ January investors were satisfied with its business model, untroubled by corporate governance issues, and willing to accept a unicorn valuation of $47 billion because they believed that public investors would soon accept an even higher valuation so long as they received price protection.
Price protection is a great idea. It can ensure that investors make money even when they fail to accurately assess failure risk.
Sophisticated private investors routinely get price protection and it ought to be provided to IPO investors too. The Fairshare Model shows how it could happen. It adapts the VC investment model—which limits valuation risk—to the IPO market.
The Fairshare Model has two classes of stock—both vote but only one is tradable.
IPO and pre-IPO investors get the tradable stock. Employees get the tradable stock too, for actual performance as of the IPO.For future performance, employees get the non-tradable stock; it converts to the tradable stock based on milestones. The milestones can be whatever the two classes agree to, even measures of social good.
The Fairshare Model encourages investors to invest in startups, a category of enterprise that has proven to be an engine of economic growth and job creation. It also provides a path to ameliorate income inequality that does not depend on taxes because the beneficiaries of any rise in the issuer's market value includes average people—non-accredited investors and employees.
Wall Street on Parade closed its reporting by saying “U.S. markets once commanded the respect and trust of the world. Today, U.S. markets are simply a well-orchestrated wealth transfer mechanism for the one percent.”
Arguably, that will continue to be the case until venture-stage IPOs come with price protection.