The Softbank-WeWork End Game: Savior Economics or Sunk Cost Problem?

Since my pre-IPO post on WeWork, where I valued the company ahead of its then imminent offering, much has happened. The company’s IPO collapsed under the weight of its own pricing contradictions, and after a near-death experience, Softbank emerged as the savior, investing an additional $ 8 billion in the company, and taking a much larger stake in its equity. As the WeWork story continues to unfold, I am finding myself more interested in Softbank than in WeWork, largely because its actions cut to the heart of so many questions in investing, from how sunk costs can affect investing decisions, to the feedback effects from mark-to-market accounting, and finally on the larger question of whether smart money is really smart or just lucky.

WeWork: The IPO Aftermath

It has been only a few weeks since I valued WeWork for its IPO, but it seems much longer, simply because of how much has changed since then. As a reminder, I valued WeWork at about $10 billion pre-money, and $13.75 billion with the anticipated proceeds of $3.5 billion added on. I also argued that this was a company on a knife’s edge, a growth machine with immense operating and financial leverage, where misstep could very quickly tip them into bankruptcy, with a table illustrating how quickly the equity slips into negative territory, if the operating assumptions change:

Download spreadsheet

Soon after my post, the ground shifted under WeWork, as a combination of arrogance (on the part of VCs, bankers and founders) and business model risks caught up with the company, and the IPO was delayed, albeit reluctantly by the company. That action, though, left the company in a cash crunch, since it had been counting on the IPO to bring in $3 billion in capital to cover its near-term needs. In conjunction with a loss of trust in the top management of the company, created a vicious cycle with the very real possibility that the company would implode. As WeWork sought rescue packages, Softbank offered a lifeline, with three components to it:

1. Equity Buyout: A tender offer of $3 billion in equity to buy out of existing stockholders in the firm to increase its share of the equity ownership to 80%. In an odd twist, Softbank contended that, after the financing, “it will not hold a majority of the voting rights… and does not control the company… WeWork will not be a subsidiary of Softbank. WeWork will be an associate of Softbank”. I am not sure whether this is a true confession of lack of control or a ploy to keep from consolidating WeWork (and its debt load) into Softbank's financials.
2. Added Capital: Softbank would provide fresh debt financing of $5 billion ($1.1 billion in secured notes, $2.2 billion in unsecured notes and $1.75 billion as a line of credit) and an acceleration of a $1.5 billion equity investment it had been planning to make into WeWork in 2020, giving WeWork respite, at least in the short term, from its cash constraints.
3. Neutering Adam Neumann (at a cost): The offer also includes a severing of Adam Neumann’s leadership of the company, in return for which he will receive $1 billion in cash, $500 million as a loan to repay a JP Morgan credit line and $185 million for a four-year position as a consultant. I assume that the consulting fee is more akin to a restraining order, preventing him from coming within sighting distance of any WeWork office or building.

Since that deal was put together, the storyline has shifted, with Softbank now playing the lead role in this morality play, with multiple questions emerging:

1. What motivated Softbank to invest so much more in a company where it had already lost billions? Some are arguing that Softbank had no choice, given the magnitude of what they had invested in WeWork, and others are countering that they were throwing good money after bad. 
2. With mark-to-market rules in effect at Softbank, how will accountants reflect the WeWork disaster on Softbank’s books? I think that fair-value accounting is neither fair nor is it about value, but the WeWork write down that Softbank had to take is a good time to discuss how fair-value accounting can have a feedback effect on corporate decision making.
3. Is Masa Son a visionary genius or an egomaniac in need of checks and balances? A year ago, there were many who viewed Masa Son, with his 300-year plans and access to hundreds of billions of dollars in capital, was a man ahead of his time, epitomizing smart money. Today, the consensus view seems to be that he is an impulsive and emotional investor, not to be trusted in his investment judgments. The truth, as is often the case, lies somewhere in the middle.
4. Since Softbank is a holding company, deriving a chunk of its value from its perceived ability to find start-ups and young companies and convert them into big wins, how will its value change as a result of its WeWork missteps? To answer this question, I will look at how Softbank’s market capitalization has changed over time, especially around the WeWork fiasco, and examine the consequences for its Vision fund plans.

Sunk Cost or Corporate Rescue!

In the years that WeWork was a private company, Softbank was, by far, the largest investor in the company. In August 2019, when the IPO was first announced, Softbank had not only been its largest capital provider, investing $7.5 billion in the company, but had also supplied the most recent round of capital, at a pricing of $47 billion. That lead-in, though, raises questions about the motives behind its decision to invest an extra $ 8 billion to keep WeWork afloat. 

• It’s a corporate rescue: There are some who would argue that Softbank had no choice, since without an infusion of capital, WeWork was on a pathway to being worth nothing and that by investing its capital, Softbank would avoid that worst-case scenario. In fact, if you believe Softbank, with the infusion, WeWork has a pre-money value of $8 billion, with the infusion, and while that is a steep write down from the $47 billion pricing, it is still better than nothing. 
• Good money chasing bad: The sunk cost principle, put simply, states that when you make an investment decision, your choice should be driven by its incremental effects and not by how much you have already expended leading up to that decision. In practice, though, investors seem to abandon this principle, trying to make up for past mistakes by making new ones. In the context of Softbank’s new WeWork investment, this would imply that Softbank is investing $ 8 billion in WeWork, not because it believes that it can generate more than that amount in incremental value from future cash flows, but because it had invested $7.5 billion in the past.

So, how do you resolve this question? As I see it, the Softbank rescue of WeWork may have helped it avoid a near term liquidity meltdown, but it has not addressed any of the underlying issues that I noted with the company’s business model. In fact, it has taken a highly levered company whose only pathway to survival was exponential growth and made it an even more levered company with constrained growth. In fact, Softbank has been remarkably vague about the economic rationale for the added investment and their story does not hold up to scrutiny. I do realize that Masa Son claims that “(t)he logic is simple. Time will resolve . . . and we will see a sharp V-shaped recovery,” in WeWork, but I don’t see the logic, time alone cannot resolve a $30 billion debt problem and there are enough costs in non-core businesses to cut to yield a quick recovery. At least from my perspective, Softbank’s investment in WeWork is good money chasing bad, a classic example of how sunk costs can skew decisions. To those who would counter that Softbank has a lot of money to lose and smart people working for it, note that the more money you have to lose and the smarter people think they are, the more difficult it becomes to admit to past mistakes, exacerbating the sunk cost problem. In fact, now that Softbank will have more than $15 billion invested in WeWork, they have made the sunk cost problem worse, going forward.

Accounting Fair Value

I understand the allure of fair value accounting to accountants. It provides them with a way to update the balance sheet, to reflect real world changes and developments, and make it more useful to investors. The fact that it also creates employment for accountants all over the world is a bonus, at least from their perspective. I think that the accounting response to Softbank’s WeWork mistake illustrates why fair value accounting is an oxymoron, more likely to do damage than good:

1. It is price accounting, not value accounting: In Softbank’s latest earnings report, we saw the first installment of accounting pain from the WeWork mistake, with Softbank writing down its WeWork investment by $4.6 billion and reporting a hefty loss for the quarter. The reason for the write-down, though, was not a reassessment of WeWork’s value, but a reaction to the drop in the pricing of the company’s equity from the $47 billion before the IPO to $8 billion after the IPO implosion. 
2. With Softbank supplying the pricing: If you are dubious about the use of pricing in accounting revaluations, you should even more skeptical in this case, since Softbank was setting the pricing, at both the $47 billion pre-IPO, and the $8 billion, post-collapse. As I noted in the last section, there is nothing tangible that I can see in any of Softbank’s numerous press releases to back these numbers. In fact, if WeWork had not been exposed in its public offering, my guess is that Softbank would have probably invested more capital in the company, marked up the pricing to some number higher than $47 billion and that we would not be having this conversation.
3. Too little, too late: As is always the case with accounting write-downs and impairments, there was very little news in the announcement. In fact, given that the write down was based upon pricing, not value, the market knew that a write off was coming and approximately how much the write off would be, which explains why even multi-billion write offs and impairments usually have no price effect, when announced. Incidentally, the accountants will offer you intrinsic valuations (DCF) to back up their assessments, but I would not attach to much weight to them, since they are what I call “kabuki valuations”, where the analysts decide, based on the pricing, what they would like to get as value, and then reverse engineer the inputs to deliver that number.
4. With dangerous feedback effects: If all fair value accounting did was create these write downs and impairments that don’t faze investors, I could live with the consequences and treat the costs incurred in the process as a jobs plan for accountants. Unfortunately, companies still seem to think that these accounting charges are news that moves markets and take actions to minimize them. In fact, a cynic might argue that one motivation for Softbank’s rescue of WeWork was to minimize the write down from its mistake. 

I am not a fan of fair value accounting, partly because it is a delayed reaction to a pricing change and is not a value reassessment, and partly because companies are often tempted to take costly actions to make their accounting numbers look better. 

Smart Money, Stupid Money!

I hope that this entire episode will put to rest the notion of smart money, i.e., that there are investors who have access to more information than we do, have better analytical tools than the rest of us and use those advantages to make more money than the rest of us. In fact, it is this proposition that leads us to assume that anyone who makes a lot of money must be smart, and by that measure, Masa Son would have been classified as a smart investor, and wealthy investors funneled billions of dollars into Softbank Vision funds, on that basis. I am not going to argue that the WeWork misadventure makes Masa Son a stupid investor, but it does expose the fact that he is human, capable of letting his ego get ahead of good sense and that at least some of his success over time has to be attributed being in the right place at the right time. 

So, if investors cannot be classified into smart and stupid, what is a better break down? One would be to group them into lucky and unlucky investors, but that implies a complete surrender to the forces of randomness that I am not yet willing to make. I think that investors are better grouped into humble and arrogant, with humble investors recognizing that success, when it comes, is as much a function of luck as it is of skill, and failure, when it too arrives, is part of investing and an occasion for learning. Arrogant investors claim every investing win as a sign of their skill and view every loss as an affront, doubling down on their mistakes. If I had to pick someone to manage my money, the quality that I would value the most in making that choice is humility, since humble investors are less likely to overpromise and overcommit. I think of the very act of demanding obscene fees for investment services is an act of arrogance, one reason that I find it difficult to understand why hedge funds are allowed to get away with taking 2% of your wealth and 20% of your upside.

Leading into the WeWork IPO, the question of where Masa Son fell on the humility continuum was easy to answer. Anyone who makes three hundred year plans and things that bigger is always better has a God complex, and success feeds that arrogance. I would like to believe that the WeWork setback has chastened Mr. Son, and in his remarks to shareholders this week, he said the right things, stating that he had “made a bad investment decision, and was deeply remorseful”, speaking of WeWork. However, he then undercut his message by not only claiming that the pathway to profit for WeWork would be simple (it is not) but also asserting that his Vision fund was still better than other venture capitalists in seeking out and finding promising companies. in my view,  Masa Son needs a few more reminders about humility from the market, since neither his words nor his actions indicate that he has learned any lessons. 

Softbank: The WeWork Effect

WeWork may have been Masa Son’s mistake, but the vehicle that he used to make the investment was Softbank, through the company and its Vision fund. As WeWork has unraveled, it is not surprising that Softbank has taken a significant hit in the market. 

Note that Softbank has lost more than $15 billion in value since August 14, when the WeWork IPO was announced, and much of that loss can be attributed to the unraveling of the IPO, and how investor perceptions of Masa Son’s investing skills have changed since.

The knocking down of Softbank’s value by the market may strike some of you as excessive, but there is reason that Softbank’s WeWork investment has ripple effects. Softbank may be built around a telecom company, but like Berkshire Hathaway, the company that Masa Son is rumored to admire and aspire to be, it is a holding company for investments in other companies. In fact, its most valuable holding remains an early investment in Alibaba, now worth tens of billions dollars. While Alibaba is publicly traded and its pricing is observable, many of Softbank’s most recent investments have been in young, private companies like WeWork. With these investments, the pricing attached to them by Softbank, in its financials, comes from recent VC funding rounds and their valuations reflect trust in Softbank’s capacity to pick winners and the WeWork meltdown hurts on both counts. First, investors are more wary about trusting VC pricing, especially if Softbank has been a lead investor in funding rounds, since that is how you arrived at the $47 billion pricing for WeWork in the first place. Second, the notion of Masa Son as an investing savant, skilled at picking the winners of the disruption game, has been damaged, at least for the moment and perhaps irreparably. The easiest way to measure how investor perceptions have changed is to compare the market capitalization of Softbank to its book value, a significant proportion of which reflects its holdings, marked to market:

Investors have been wary of Softbank’s investing skills, even before the WeWork IPO, but the write offs on Uber and WeWork has made them even more skeptical, as the price to book ratio continues its march towards parity, with the market capitalization at 123% of the book value of equity in November 2019. In fact, if you focus just on Softbank’s non-consolidated holdings, public and private, note that the market capitalization of Softbank now stands at 73% of the value of just these holdings, most of which are marked to market. Put simply, when you buy Softbank, you are getting Uber and Alibaba at a discount on their traded market prices, but before you put your money down on what looks like a great deal, there are two considerations that may affect your decision. The first is that the company has a vast amount of debt on its balance sheet that has to be serviced, potentially putting your equity at risk, and the second is that you are getting Softbank (and Masa Son) as the custodian of the investments. If you have lost faith in Masa Son’s investing judgments (in people and in companies), you may view the 27% discount that the market is attaching to Softbank’s holdings as entirely justifiable and steer away from the stock. In contrast, if you feel that WeWork was an aberration in an otherwise stellar investment picking record, you should load up on Softbank stock. As for me, I don’t plan to own Softbank! I don't like grandiosity and Masa Son seems to have been soaked in it.

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Blog Posts

1. Runaway Story to Meltdown in Motion: The Unraveling of the WeWork IPO
2. Sunk Costs and Investing

Disrupting the IPO Process: Challenging the Banker-run Going-Public Model!

In the age of disruption, where young companies are challenging the status quo and upending conventional businesses, it was only a matter of time before they turned their attention to the process by which they are taken public. For decades, the standard operating procedure for a company going public has been to use a banker or a banking syndicate to market itself to public investors at a “guaranteed” price, in return for a sizeable fee. That process has developed warts along the way but it has remained surprisingly stable even as the investing world has changed. In the aftermath of some heavily publicized let downs in the IPO market this year, with the WeWork fiasco topping off the bad news, there is now an active and healthy discussion about how companies should make the transition to being public. Change may finally be coming to the going-public game and it is long overdue.

Going Public? The Choices

When a private company chooses to go public, there are two possible routes that it can take in making this transition. The more common one is built around a banker or bankers who manage the private to public transition:

There is an alternative, though it seems to be seldom used, which is to do a direct listing. In this process, a private company lets the markets set the price on the offering date, skipping the typical IPO dance of setting an offer price, which in retrospect is set too low or too high. 

The company still has to file a prospectus, but the biggest difference is that it cannot raise fresh capital on the offering date, though existing owners can cash out by selling their shares. That is not as much of a problem as it sounds, since the company can choose to raise cash in a pre-listing round from interested investors, or to make a secondary offering, in the months after it has gone public. In fact, one advantage that direct listing have is that there is no lock-up period, as there is with conventional IPOs, where private investors cannot sell their shares for six months after the listing. If you are interested in the details of a direct listing, this write-up by Andreesen Horowitz sums it up well. Let’s be clear. If this were a contest, the status quo is winning, hands down. While there have been a couple of high-profile direct listings in Spotify and Slack, the overwhelming majority of companies have chosen the status quo. Furthermore, the status quo seems to be global, indicating either that the benefits that issuing companies see in the banker-based model apply across markets or that the US-model has been adopted without questions in other markets.

The IPO Status Quo: The Pros and Cons

To understand how the status quo got to be the standard, it makes sense to look at what issuing companies perceive to be the benefits of having banking guidance, and weigh them off against the costs. In the process, we will also lay the foundations for examining how the world has changed, and why the status quo may be under threat.

The Banker's case

Looking at the status quo picture that I showed in the last section, I listed the services that bankers offer to issuing companies, starting with the timing and details of the offering, all the way through the after-market support. At the risk of sounding like a salesperson for bankers, let’s see what bankers bring, or claim to bring, to the table on each of the services:

1. Timing: Bankers would argue that their experience in financial markets and their relationship with institutional investors give them the insights to determine the optimal timing window for a public offering, where the investment stars are aligned to deliver the highest possible price and the smoothest post-market experience.
2. Filing/Offering Details: A prospectus is as much legal document as it is information disclosure, and past experience with other initial public offerings may allow bankers to guide companies in what information to include in the prospectus and the language to use to in providing that information, as well as provide help in navigating the regulatory rules and requirements for public offerings.
3. Pricing: It is on this front where bankers can claim to offer the most value added for three reasons. First, their knowledge of public market pricing can help them bridge the gap with the private market pricing preceding the offering, and in some cases, reduce unrealistic expectations on the part of VCs and founders. Second, they can help frame the offer pricing by finding the best metric to scale the pricing to and identifying the peer group that investors will use in public markets. Third, by reaching out to investors, bankers can not only gauge demand and fine tune the pricing but also isolate concerns that investors may have about the company. 
4. Selling/Marketing: To the extent that multiple banks form the selling syndicate, and each can reach out to their investor clientele, bankers can expand the investor base for an issuing company. In addition, the marketing that accompanies the road shows can market the company to the larger market, attracting buzz and excitement ahead of the offer date. 
5. Underwriting Guarantee: At first sight, the underwriting guarantee that bankers offer seems like one of the bigger benefits of using the banking-run IPO model, but I am afraid that there is less there than meets the eye, since the guarantee is set first and the price is not set until just before the offering, and it can be set below what you believe investors would pay for the stock. In fact, if you believe the graph on offer day price performance that I will present in the next section, the typical IPO is priced about 10-15% below fair price, making the guarantee much less valuable.
6. After-market Support: Bankers make the case that they can provide price support for IPOs in the after-market, using their trading arms, sometimes with proprietary capital. In addition, researchers have documented that the equity research arms of banks that are parts of IPO teams are far more likely to issue positive recommendations and downplay the negatives.

At least on paper, bankers offer services to issuing companies, though the value of these services can vary across companies and across time.

The Bankers’ Costs

The banking services that are listed above come at a cost, and that cost takes two forms. The first and more obvious one is the banker’s fees for the issuance and these costs are usually scaled to the issuance proceeds. They can range from 3% to more than 8% of the proceeds, with the percentage costs increasing for smaller issuers:

While issuance costs do decrease for larger issuers, it is surprising that the drop off is not more drastic, suggesting either that costs are more variable than fixed or that there is not much negotiating room on these costs. To provide an example of the magnitude of these costs, the banking fees for Uber’s IPO amounted to $105 million, with Morgan Stanley, the lead banker, claiming about 70% of the fees.

There is a second cost and it arises because of the way the typical IPO is structured. Since investment banks guarantee an offering price, they are more inclined to underprice an offering than over price it, and not surprisingly, the typical IPO sees a jump in the price from offer to opening trade on the first day of trading:

Source: Jay Ritter, University of Florida

Thus, the median IPO sees its stock price jump about 15% on the offering date, though there are some companies where the stock price jump is much greater. To provide specific examples, Beyond Meat saw a jump of 84% on the offering date, from its offer price, and Zoom’s stock price at the end of its first trading day was 72% higher than the offering price. Note that this underpricing is money left on the table by issuing company’s owners for the investors who were able to get shares at the offering price, many preferred clients for the banks in the syndicate. In defense of banks, it is worth noting that many issuing company shareholders seem to not just view this “lost value” as part of the IPO game, but also as a basis for subsequent price momentum. That argument, though, is becoming increasingly tenuous since if it were true, IPOs, on average, should deliver above-average returns in the weeks and months after the offering date, and they do not. If momentum is the rationale, it should also follow that newly listed stocks that do well on the offering date should deliver higher returns than newly listed stocks that do badly and there is no evidence of that either. 

Revisiting the IPO Process

Given the costs of using banks to manage the going-public process, it is surprising that there have not been more rumblings from private market investors and companies planning to go public about the process. After the WeWork and Endeavor IPO debacles, the gloves seem to have come off and the battle has been joined.

The Bill Gurley Case for Direct Listings

Bill Gurley has often been an atypical venture capitalist, willing to challenge the status quo on many aspects of the VC business. For many years now, he has sounded the alarm on how private market investors have paid too much for scaling models and not paid enough attention to building sound businesses. In the last few months, he has been aggressively pushing young companies to consider the direct listing option more seriously. His primary argument has been focused on the underpricing on the offering date, which as he rightly points out, transfers money from private market investors to investment bankers' favored clientele. In fact, he has pointed to absurdity of paying for an underwriting pricing guarantee, where the guarantors get to set the price much later, and are open about the fact that they plan to under price the offering. I don’t disagree with Bill, but I think that he is framing the question too narrowly. In fact, the danger with focusing on the offer day pricing jump runs two risks.

• The first is that many issuing companies not only don’t seem to mind leaving money on the table, but some actively seem to view this under pricing as good for their stock, in the long term. After all, Zoom's CFO, Kelly Steckelberg seemed not only seems untroubled by the fact that Zoom stock jumped more than 70% on the offering date (costing its owners closer to $250-$300 million on the offered shares), but argued that that Zoom “got the most added attention in the financial community,” and even picked up business from several of its IPO banks who she said are “trialing or have standardized on Zoom now.” 
• The second is that Gurley's critique seems to suggest that if bankers did a better job in terms of pricing, where the stock price on the offer date is close to the offer price, that the banker-run IPO model would be okay. I think that a far stronger and persuasive argument would be to show that the problem with the banking IPO model is that changes in the world have diluted and perhaps even eliminated that value of the services that bankers offer in IPOs, requiring that we rethink this process.

The Dilution of Banking Services

In the last section, in the process of defending the banker presence in the IPO process, I listed a series of services that bankers offer. Given how much the investing world, both private and public, has changed in the last few decades, I will revisit those services and look at how they have changed as well:

1. No timing skills: To be honest, no one can really time the market, though some bankers have been able to smooth talk issuing companies into believing that they can. For the most part, bankers have been able to get away with the timing claims, but when momentum shifts, as it seems to have abruptly in the last few months in the IPO market, it is quite clear that none of the bankers saw this coming earlier in the year.
2. Boilerplate prospectuses: When I wrote my post on the IPO lessons from WeWork, Uber and Peloton, I noted that these three very different companies seem to have the same prospectus writers, with much of the same language being used in the risk sections and business sections. While the reasons for following a standardized prospectus model might be legal, the need for banking help goes away if the process is mechanical.
3. Mangled Pricing: This should be the strong point for bankers, since their capacity to gauge demand (by talking to investors) and influence supply (by guiding companies on offering size) should give them a leg up on the market, when pricing companies. Unfortunately, this is where banking skills seem to be have deteriorated the most. The most devastating aspect of the WeWork IPO was how out of touch the bankers for the company were in their pricing:

   

   Source: Financial Times

   I would explain this pricing disconnect with three reasons. The first is that bankers are mispricing these companies, using the wrong metrics and a peer group that does not quite fit, not surprising given how unique each of these companies claims to be. The second is that the bankers are testing out prices with a very biased subset of investors, who may confirm the mistaken pricing. The third and perhaps most likely explanation is that the desire to keep issuing companies happy and deals flowing is leading bankers to set prices first and then seek out investors at those prices, a dangerous abdication of pricing responsibility.
4. Ineffective Selling/Marketing: When issuing companies were unknown to the market and bankers were viewed as market experts, the fact that a Goldman Sachs or a JP Morgan Chase was backing a public offering was viewed as a sign that the company had been vetted and had passed the test, the equivalent of a Good Housekeeping seal of approval for the company, from investors' perspective. In today’s markets, there have been two big changes. The first is that issuing companies, through their product or service offerings, often have a higher profile than many of the investment banks taking them public. I am sure that more people had heard about and used Uber, at the time of its public offering, than were aware of what Morgan Stanley, its lead banke, does.  The second is that the 2008 banking crisis has damaged the reputation of bankers as arbiters of investment truths, and investors have become more skeptical about their stock pitches. All in all, it is likely that fewer and fewer investors are basing their investment decision on banking road shows and marketing.
5. Empty guarantee: Going back to Bill Gurley’s point about IPOs being under priced, my concern with the banking IPO model is that the under pricing essentially dilutes the underwriting guarantee. Using an analogy, how much would you be willing to pay a realtor to sell a house at a guaranteed price, if that price is set 20% below what other houses in the neighborhood have been selling for?  
6. What after-market support? In the earlier section, I noted that banks can provide after-issuance support for the stocks of companies going public, both explicitly and implicitly. On both counts, bankers are on weaker ground with the companies going public today, as opposed to two decades ago. First, buying shares in the after-market to keep the stock price from falling may be a plausible, perhaps even probable, if the issuing company is priced at $500 million, but becomes more difficult to do for a $20 billion company, because banks don’t have the  capital to be able to pull it off. Second, the same loss of faith that has corroded the trust in bank selling has also undercut the effectiveness of investment banks in hyping IPOs with glowing equity research reports. 

Summing up, even if you believed that bankers provided services that justified the payment of sizable issuance costs in the past, I think that you would also agree that these services have become less valuable over time, and the prices paid for these services have to shrink and be renegotiated, and in some cases, entirely dispensed with.

Why change has been slow
Many of the changes that I highlighted in the last section have been years in the making, and the question then becomes why so few companies have chosen to go the direct listing route. There are, I believe, three reasons why the status quo has held on and that direct listings have no become more common.

1. Inertia: The strongest force in explaining much of what we see companies do in terms of investment, dividend and financing is inertia, where firms stick with what's been done in the past, partly because of laziness and partly because it is the safest path to take.
2. Fear: Unfounded or not, there is the fear that shunning bankers may lead to consequences, ranging from negative recommendations from equity research analysts to bankers actively talking investors out of buying the stock, that can affect stock prices in the offering and in the periods after.
3. The Blame Game: One of the reasons that companies are so quick to use bankers and consultants to answer questions or take actions that they should be ready to do on their own is that it allows managers and decisions makers to pass the buck, if something goes wrong. Thus, when an IPO does not go well, and Uber and Peloton are examples, managers can always blame the banks for the problems, rather than take responsibility.

I do think that at least for the moment, there is an opening for change, but that opening can close very quickly if a direct listing goes bad and a CFO gets fired for mismanaging it.

The End Game

As the process of going public changes, everyone involved in this process from issuing companies to public market investors to bankers will have to rethink how they behave, since the old ways will no longer work.

Issuing companies (going public) 

1. Choose the IPO path that is right for you: Given your characteristics as a company, you have to choose the pathway, i.e., banker-led or direct listing that is right for you. Specifically, if you are a company with a higher pricing (in the billions rather than the millions), with a public profile (investors already know what you do) and no instantaneous need for cash, you should do a direct listing. If you are a smaller company and feel that you can still benefit from even the diminished services that bankers offer, you should stay with the conventional IPO listing route.
2. If you choose a banker, remember that your interests will not align with those of the bankers, be real about what bankers can do for you and negotiate for the best possible fee, and try to tie that feee to the quality of pricing. If I were Zoom's CFO, I would have demanded that the banks that underpriced my company by 80% return their fees to me, not celebrated their role in the IPO process.
3. If you choose the direct listing path, recognize that the public market may not agree with you on what you think your company is worth, and not only should you accept that difference and move on, you should recognize that this disagreement will be part of your public market existence for your listing life. 
4. In either case, you should work on a narrative for your company that meets the 3P test, i.e., is it possible? plausible? probable? You are selling a story, but you will also have to deliver on that story, and overreaching on your initial public offering story will only make it more difficult for you to match expectations in the future.

Investors

1. Choose your game: In my last post, I noted that there are two games that you can play, the value game, where you value companies and trade on the difference, waiting for the price to converge on value and the pricing game, where you buy at a low price and hope to sell at a higher one. There is nothing inherently more noble about either game, but you should decide what game you came to play and be consistent with that choice. In short, if you are a trader, stop pondering the fundamentals and using discounted cash flow models, since they will be of little help in winning, and if you are an investor, don't let momentum become a key ingredient of your value estimate.
2. Keep the feedback loop open: Both investors and traders often get locked into positions on IPOs and are loath to revisit their original theses, mostly because they do not want to admit mistakes. With IPOs, where change is the only constant, you have to be willing to listen to people who disagree with you and change your views, if the facts merit that change.
3. Spread your bets: The old value investing advice of finding a few good investments and concentrating your portfolio in them can be catastrophic with IPOs. No matter how carefully you do your homework, some of the investments that you make in young companies will blow up, and if your portfolio succeeds, it will be because a few big winners carried it. 
4. Stop whining about bankers, VCs and founders: Many public market investors seem to believe that there is a conspiracy afoot to defraud them, and that bankers, founders and VCs are all part of that conspiracy. If you lose money on an IPO, the truth is that it may not be your or their faults, but the consequence of circumstances out of anyone's control. In the same vein, when you make money on an IPO, recognize that it has much to do with luck as with your stock picking skills.

Bankers

1. Get real about what you bring to the IPO table: As I noted before, public and private market changes have put a dent on the edge that bankers had in the IPO game. It behooves bankers then to understand which of the many services that they used to charge for in the old days still provide added value today and to set fees that reflect that value added. This will require revisiting practices that are taken as given, including the 6-7% underwriting fee and the notion that the offer price should be set about 15% below what you think the fair prices should be.
2. Speak your mind: If one of the reasons that the IPOs this year have struggled has been a widening gap between the private and public markets, bankers can play a useful role in private companies by not only pointing to and explaining the gap, but also in pushing back against private company proposals that they believe will make the divergence worse. 
3. Get out of the echo chamber: An increasing number of banks have conceded the IPO market to their West Coast teams, often based in Silicon Valley or San Francisco. These teams are staffed with members who are bankers in name, but entirely Silicon Valley in spirit. It is natural that if you rub shoulders with venture capitalists and founders all day that you relate more to them than to public market investors. I am not suggesting that banks close their West Coast offices, but they need to start putting some distance between their employees and the tech world, partly to regain some of their objectivity. 

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IPO Lessons for Public Market Investors

This year, I have found myself returning repeatedly to the IPO well, as high profile companies have chosen to go public, and like a moth to a flame, I have been drawn to value them. There was much enthusiasm at the start of 2019 that this would be a blockbuster year for IPOs, not just for the companies going public, but also for public market investors who would now get a chance to own pieces of companies which had made venture capitalists and private market investors rich, at least on paper. While many of these companies, with the exception of WeWork, have gone public and raised large amounts of capital, many of the new listings have disappointed in the after market. The WeWork fiasco, while creating vast collateral damage, has also created healthy discussions about how venture capitalists price private companies and whether public market investors should base their pricing of the latest VC rounds, whether the IPO process itself is in need of a change, what the share count that we should be using in computing market capitalization at these young companies and whether investors should even enter this space, where uncertainty abounds and cash burn is more the rule than the exception.

An 2019 IPO Pricing Retrospective

It is estimated that nearly 200 companies will go public this year, an increase of about 5% over last year's 190 IPOs, but still well below the 547 companies that went public in 1999. The first half of the year was a good one for investors in these IPOs, but investors have soured on these companies in the last few months. One way to measure the performance of these young companies in the after market is to look at how the Renaissance IPO ETF, a fund that tracks larger initial public offerings and weights them based upon free float, has done over the course of the year:

Since the fund tracks IPOs for 500 trading days after the listing date, it is not quite a clean measure of this year's IPOs, but it is a good proxy. Notwithstanding all of the negative press you may have read about IPOs in the last few weeks, and third quarter damage, the Renaissance ETF IPO has outperformed the market over the course of this year.

To take a closer look at a subset of these IPOs, I focused on seven of the offerings this year - Uber, Lyft, Pinterest, Slack, Levi Strauss, Peloton and Beyond Meat - and looked the performance of each of these stocks since the opening trade on the offering date:

To compare the performance of these offerings, I standardized performance by looking at how much $100 invested in each stock at the open price on the first trading day would have done, in periods ranging from a day to the year to date:

I have tracked the returns that investors would have earned if they had invested at the offer price and at the open price on the first trading day. Note first that five of the seven stocks registered a jump in excess of 20%, comparing the open price to the offer price, when they started trading. Looking at the returns in the year to date, the outlier is Beyond Meat, on an almost unbelievable run from its offer price, but of the remaining six stocks, only Pinterest has gone up, relative to it first trade price. Uber, Lyft and Slack have been awful investments, though if you had received Slack shares at the offer price, the pain would be more bearable. Even Levi Strauss, not a young or a tech company, has seen rough going in the months since its initial public offering. Peloton has been listed only ten trading days, but it has to hope that the worst is behind it.  What does this all mean? First, in spite of recent setbacks, investors in IPOs collectively have done reasonably well over the course of the year, but only if they spread their bets. Second, in the midst of this good news, some of the most hyped IPOs have had difficulty gaining traction, and since these companies attract the most attention from investors and the financial press, they are contributing to the perception that investing in IPOs has been a loser's game this year.
   IPO Lessons for Public Market Investors

In my post on the Peloton IPO, I opined on how venture capitalists price companies and how the pressures that they have put on companies to scale up quickly, often without paying heed to building good business models, is playing out. In this one, I would like to look at the public market side of the IPO process, again looking for common threads.

1. It stays a pricing game

At the risk of repeating myself, the price of an asset and its value are determined by different forces and estimated using different tools. and while they may be good estimates of each other in an efficient market, they can diverge, creating both opportunities and dangers for investors:

It is not just venture capitalists that play the pricing game. Most public market investors do as well, and this is particularly true when companies first go public for three reasons:

1. The IPO process: The IPO process is one of gauging demand and supply and setting a price based on that assessment, not estimating the value of businesses. It is the job of the bankers managing the process is to make this judgment, usually based upon the responses they get from their investor clientele. Thus, it should be not surprising that the bulk of the backing for an offering price comes from finding a pricing metric (revenue multiple, user value etc.) and relevant comparable firms (a subjectively judgment). 
2. Self Selection: The players who get drawn into the IPO game tend to be those with shorter time horizons who feel that their strength is in riding momentum, when it exists, and detecting shifts, before the rest of the market does. In short, the IPO market is built for traders, not investors.
3. Type of companies: Most initial public offerings tend to be of firms that are younger and often  less formed than their more seasoned public counterparts. Consequently, more of their value lies in the future and there is more uncertainty in assessing numbers, leading investors to abandon these stocks, claiming that there is too much uncertainty, giving pricing almost all of the stage.

So what if the IPO market is a pricing game? First, trying to use value tools (like DCF) or fundamentals to explain IPO pricing, and what causes these prices to move on a day-to-day basis in the after market is a recipe for frustration. The nature of the pricing game is that mood and momentum can not only cause these companies to be priced at numbers very different from value, but also cause price movements on trivial, perhaps even irrelevant, news stories. Second, playing the momentum game is akin to riding on the back of a tiger, with the danger being that you will be consumed, if the game shifts. Take a look at Beyond Meat's price movements over the course of this year, since its IPO, and you can see how quickly momentum can shift in a stock, and the decisive effects it has on pricing.

2. On a shaky base

In the pricing game, you estimate how much to pay for a company by looking at how similar companies are being priced by the market, usually scaling price to a common metric like earnings, book value or revenues, as well as its own pricing history. With initial public offerings, this process gets more difficult for two reasons:

1. Peer Group Framing: With most public companies, a combination of the company's operating history and market learning leads to a consensus on what its peer group should be, for pricing purposes. Thus, when pricing Coca Cola or Adobe, investors tend to agree more than they disagree about what companies to put into the peer group for comparison. For many IPOs, especially built around new business models and practices, there is much more confusion about what grouping to put the company into. Not surprisingly, the IPOs try to influence this choice by framing themselves as being in businesses that will deliver a higher pricing, explaining why almost every one of them likes to use the word "tech" in its description.
2. Past Pricing History: Unlike publicly traded companies, where there is a market price history, the only price history that you have with IPOs is from prior VC rounds. To understand this may be problematic, let me focus on the seven IPOs I highlighted in the last section and provide information on the private investor funding of each, leading into the IPO:
   

   
   Note three problems with using this information as a basis for public market pricing. First, in most cases, the pricing for the company is extrapolated from a small VC investment. With Lyft, for instance, the estimated pricing of $14.5 billion from the most recent round was extrapolated from an investment of $600 million for the company for a 4.1% share of the company. Second, this problem is worsened by the fact that VC investors can and usually do negotiate for post-investment protections, when they invest. For instance, ratchets allow VCs to adjust their ownership stake in a company upwards, if a subsequent funding round is based upon a lower pricing for the company. In effect, VCs are being provided with options, and as I noted in this post on unicorns, the presence of these additional features makes simplistic extrapolation to pricing from a VC investment almost impossible to do. Third, even if the pricing is correctly extrapolated from the last VC investment, all you need is one over optimistic venture capitalist to push the pricing beyond reasonable bounds. In the case of WeWork, it can be argued that much of the surge in pricing in the company came from Softbank's continued investments in the company and not a reflection of consensus among venture capitalists.

In the traditional IPO model, where investment bankers form a syndicate to sell the shares at a pre-set offer price, it can be argued that the primary service that bankers provide, if they do their job well, is to use their access to public investors to fine tune the pricing. This year's experiences with Peloton and Uber, where the stock price dropped on the offer day, and with WeWork, where the pricing estimates imploded to the point of imperiling the public offering, has led some founders and venture capitalists to question whether it is worth hiring bankers in the first place. 

3. With an unstable share count

We all know the process for estimating market capitalization for a firm, and it involves taking the stock price and multiplying by the number of shares outstanding. For most publicly listed firms, that calculation should yield a value fairly close to the truth, but IPOs are different for two reasons. First, an overwhelming number in recent years have had two classes of shares (sometimes three) with different voting rights and being sloppy and missing an entire share class will cause devastating errors in computation. Second, most of these companies are young and cash-poor, and they have chosen to compensate employees with equity, either in the form of restricted shares and options. The way in which investors and analysts deal with these employee equity claims ranges from the abysmal to the barely acceptable, again with significant consequences. Let's take the Peloton case, where the company in its final prospectus listed itself as having 41.8 million class A shares, with lower voting rights, and 235.9 million class B shares, with higher voting rights, after its IPO, yielding a total share count of 277.7 million shares. That is the share count that has been used by journalists in writing about the offering and by most of the data services since, in estimating the implied pricing of $8.1 billion for the company, at the offer price of $29. That is patently untrue, and the reason is in the same prospectus, where Peloton states that "the number of shares..... does not include:

• 64,602,124 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock  outstanding as of June 30, 2019, with a weighted-average exercise price of $6.71 per share; 
• 883,550 shares of our Class B common stock issuable upon the exercise of options to purchase shares of our Class B common stock  granted between June 30, 2019 and September 10, 2019 with a weighted-average exercise price of $23.40 per share; 
• 240,000 shares of our Class B common stock issuable upon the exercise of a warrant to purchase Class B common stock outstanding as  of June 30, 2019, with an exercise price of $0.19 per share;"

Focus on just the first bullet, where Peloton admits that there 64.6 million options, with an exercise price of $6.71. Given that the offer price was $29/share and the open price was $27, is there any doubt that at some point in time, sooner rather than later, these options will get exercised and become shares? In fact, in what universe can you ignore these options in estimating market capitalization? The reason this practice can lead to dangerous mis-pricing is simple. Let's assume that the Peloton bankers came to the conclusion that $8.1 billion was a reasonable value to attach to its equity, based upon past VC rounds and peer group pricing. To get to an offer price, they cannot divide that number by just the shares outstanding (277.7 million), since that will treat the options as worthless. In my valuation of Peloton, I did what I think should always be done, which is to value the options as options, which allows me to include at-the-money and out-of-the-money options, as well as time value, net that option value from my equity value and then divide by the 277.7 million shares.  If you find option pricing models too opaque, here is a simpler way to get to value per share from the estimated equity value:

Thus, if the Reuters story quoted above is correct in its judgment that the bankers wanted to price Peloton at $8.1 billion, the estimated offer price per share, counting only the 64.6 million additional options would have been:

Alternatively, it is possible that this was a journalistic error in extrapolation and that the bankers took options into account and meant to price it at $29/share, in which case the implied market capitalization for Peloton at the $29 offer price, using the exercise proceeds short cut, would have been:

Implied Market Cap at $29/share = 277.7 * $29 + 64.6* ($29 - 6.71) = $9.5 billion

To see why this matters, any enterprise value or pricing multiple that you compute for Peloton should be based upon the $9.5 billion estimate, not the $8.1 billion, if the stock was trading at $29. I think that we are generally sloppy in market capitalization calculations, but that sloppiness has much bigger consequences with IPOs. So, as investors, we should follow the Russian adage of "trust, but verify", when it comes to share count.

4. And a Bar Mitzvah Moment waiting!

At this stage, I don't blame you if you are puzzled by how I approach IPOs. As soon as an IPO is announced, I use the prospectus to value the company, but I just confessed earlier that the IPO market, at listing and in the periods afterwards, is a pricing game, not a value game. So, why bother with a DCF in the first place?

• If your intent is to trade IPOs, you should not care about value, but mine is different. I consider myself an investor, not a trader, not because it is a more noble calling but because I am a terrible trader. 
• As an investor, I have faith that when investing in equity in a business, there will eventually a reckoning, where price converges on value. I use the word "faith" because there is no mechanism that guarantees this convergence.

Young companies that go public are often adept at playing the pricing game, delivering more users, subscribers or revenues, if that is what the pricing gods want, and their stock prices often continue to rise, even though their fundamentals don't merit it. It is my belief that each of these companies will face what I call a "Bar Mitzvah" moment, where the market, hitherto focused on magical metrics, asks the company about its pathway to profitability. As I look back over time, the very best of these companies, and I would include Facebook, Google and Amazon in this grouping, are ready for this moment, since they have been building viable business models, even as they delivered on market metrics. Many of these young companies, though, seem unready for this question, and the market punishes them, as was the case with Twitter in 2014.

Go where it is darkest!

Even if you accept my proposition that price eventually converges to value, if you subscribe to old time value investing, you are probably wondering why I would want to try to put my money at risk, investing in these young companies, when it is so much easier to value mature companies like Philip Morris and Coca Cola. I don't disagree with you on your premise that there is a great deal more uncertainty in valuing Uber than in valuing Coca Cola, but I believe that the payoff to imprecisely valuing Uber is greater than the payoff to precisely valuing Coca Cola. After all, what made Coca Cola easy for you to value also makes it easy for other investors to do as well, and the uncertainty that scares you with Uber is scaring most investors away from even trying. It is for that reason that I value companies at the time of their public offerings, and repeatedly thereafter, hoping that I am able to get in at the right price. Here are my estimates of value for the companies on my list at the time of the IPO, with updates on both value and price as trading has continued:

	Levi Strauss	Lyft	Pinterest	Beyond Meat	Uber	Slack	Peloton
IPO Value	$24.23	$58.78	$25.08	$46.88	$32.91	$20.59	$19.35
IPO Offer Price	$17.00	$72.00	$19.00	$25.00	$45.00	$26.00	$29.00
IPO Open Price	$22.22	$87.33	$23.75	$46.00	$42.00	$38.50	$27.17
% Difference	-8.30%	48.57%	-5.30%	-1.88%	27.62%	86.98%	40.41%
Updated Value	$26.59	$54.38	$26.17	$47.41	$35.42	$23.95	$19.35
Price on 8/10/19	$18.96	$38.66	$25.63	$142.73	$29.28	$25.70	$23.21
% Difference	-28.69%	-28.91%	-2.06%	201.05%	-17.33%	5.59%	19.95%
Spreadsheet	Download	Download	Download	Download	Download	Download	Download

At the time of the offering, relative to the open price, only Levi Strauss looked mildly under valued, Beyond Meat was at close to fair value and the other companies all looked over valued. Since the offering, each of these companies has released earnings reports and I updated the treasury bond rates and equity risk premiums in all of the valuations. With Uber and Lyft, the added perturbation comes from legislation passed by the state of California, requiring that drivers be treated as employees, an assumption that I had already built into my valuation, but one that seemed to catch the market by surprise. Incorporating the price changes at all of the companies, and reflecting my updated valuation stories for the companies, Levi Strauss has become more under valued, Uber and Lyft have moved from being over to under valued, Slack and Peloton have converged on value and Beyond Meat has become significantly overvalued. 

1. Levi Strauss's most recent earnings report was not well received by the market, with the stock dropping 1.1% to $18.96. I see its fundamentals justifying a higher value and I bought shares at $18.96.
2. I have gone back and forth on whether to buy Uber, Lyft or both. Lyft looks more under valued, but Uber offers more upside, given its global ambitions. In addition, I prefer Uber's single class of shares to Lyft's multiple voting right classes, and these factors tilted me to buying the latter at $30/share. 
3. Slack and Pinterest are getting close to fair value as their prices have drifted down and Peloton has become less over valued but still has room to fall. For the moment, I will add these companies to my watch list, and track their pricing.
4. With my story for Beyond Meat, I find the price almost unreachable with any story that I craft, and while this was the same conclusion that I drew a few months ago, this time, I tried shorting the stock at $142, but was unable to get my trade through. I fell back on buying put options at a 120 strike price, expiring on December 20, 2019, paying a mind-bending time premium for a two-month option. While the stock has been resistant to the laws of gravity (or value) for must of its listed life, I believe that there are two things that have changed that make this a good time to make this short term intrinsic value bet. One is the listing of Impossible Foods gives investors not just another way of making a macro bet on veganism, but also an easy comparison on pricing. The other is the decision by Beyond Meat to issue 3.25 million shares a few weeks ago, with 3 million shares coming from insiders, suggests that the firm itself may think its stock is over priced.

Some of my bets will go wrong, and if they do, I am also sure that some of you will point them out to me, and I am okay with that. That said, I hope that you make your own judgments on these companies, and you are welcome to use my spreadsheets (linked both above and below) and change the inputs that you disagree with, if that helps.

YouTube Video


Valuation Spreadsheets

1. Levi Strauss (October 8, 2019)
2. Lyft (October 8, 2019)
3. Pinterest (October 8, 2019)
4. Beyond Meat (October 8, 2019)
5. Uber (October 8, 2019)
6. Slack (October 8, 2019)
7. Peloton (September 28, 2019)

Links

1. Twitter: Why a good trade can be a bad investment?
2. Twitter's Bar Mitzvah: Is social media coming of age?