Anatomy of an IPO Valuation | WSJ - YouTube

- [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)