Anatomy of an IPO Valuation | WSJ


– [Narrator] Unicorns
are getting haircuts. Unicorns are high-flying startups valued at over a billion dollars,
but these companies are seeing their valuation
shrink when they go public. Payment processor Square took a three billion dollar
IPO haircut in 2015. Cloud computing company Domo took over 1.7 billion dollars
off the top in 2018. And the latest high-profile haircut came this year from The We Company. WeWork’s parent company
got a virtual buzz cut, lowering its valuation
by 32 billion dollars before the company withdrew its IPO. Private investors have infused
these companies with cash, betting they have the potential
to corner their markets. Private valuations have
become an accepted yardstick for what these companies are
worth on the public market. But many investors
believe these valuations often overstate a firm’s
likely true worth. Here’s how that can happen. Private startups seeking
investments typically undergo a series of funding
rounds, where investors, usually venture capital
and private equity firms, provide cash in exchange
for equity in the company. Each new round of fundraising sets a new valuation for the company. These valuations are usually
based on several factors, including market size,
revenue, and management. Some investors and analysts contend that the entire process tends to carry a bias towards higher prices,
because private markets are filled almost exclusively by investors who want their stakes to appreciate. What makes private markets
different is that they generally aren’t subject to the skepticism that’s common in public markets. Private funding is fueled by optimism. Private investors, unlike
their public counterparts, typically are constrained in their ability to sell their stake in the
company, and they can’t bet against the stock by selling it short. There are a number of factors that often make private
market valuations higher. One popular way of enticing investors is to offer them preference shares, securities that offer
perks above and beyond the ownership stake
conferred by common stock. Preference shares are often sold to private-run investors
and are more valuable than the common shares that
are typically sold in an IPO, which helps explain why
private market valuations often end up higher
than public market ones. One common form of preference stock sold in early funding rounds comes
with a liquidation preference, which ensures investors can get
back whatever they invested, even if the company is
sold at a lower valuation. A second preference stock
feature, known as ratchet, means early investors
can get additional shares if the company does an
IPO at a lower price than the one at which they bought in. But during a valuation,
these higher share classes are valued equally to common stock, even though they aren’t
entitled to the same payoffs, making common stock appear more valuable than it actually is, bloating
a company’s valuation. Square was valued at six billion dollars after its last round of funding before going public. But a study found that special promises to late-round investors had
inflated this valuation. The study calculated Square was actually worth 2.2 billion dollars, close to the 2.6 billion dollar valuation the company received for its IPO. A second reason for high valuations is that private companies aren’t subject to the strict accounting practices that public companies must use. They are far freer to present investors with nonstandard data that
paints a rosier picture of their financial health. The We Company presented investors with a metric called
community-adjusted EBITDA. It excluded many of its major
expenses, including rent, making the companies
losses appear smaller. In entering public
markets, companies agree to report standard numbers
based on rules set by the SEC. This enables investors to more accurately compare
different firms’ finances. Private market valuations
can be a useful data point for investors, but the
rude awakening that firms like The We Company have received at times is making many analysts
and portfolio managers increasingly skeptical
of those big numbers, and forcing unicorns to take
a little or a lot off the top. (soft music)

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