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IPO Disclosures Are Ripe for Reform

MAG SUM22 Cohen 1290x860 1 | IPO Disclosures Are Ripe for Reform | Coletividad
Carlo Giambarresi/theispot.com

Current financial disclosure rules let would-be public companies shape a rosy narrative about their prospects and obscure information that investors should know.

Rules meant to protect investors have turned out to be no match for bankers pitching today’s businesses to the public markets.

In theory, disclosures required of would-be public companies should provide investors with the critical information needed to determine whether they want to buy in, and at what price. Less obviously but equally important, disclosures should bolster good management practices by establishing sound performance metrics. However, existing disclosure regulations fail on both counts. They are outdated, and it is time for them to change.

Current rules were designed for a different era, when the companies going public were more established and had proven business models. Today’s companies, in contrast, often have untested business models. What companies disclose about their customers is completely voluntary, so executives can — and do — select data that paints their companies in the best possible light. Their disclosures are bloated, uninformative, and often misleading, and investors lack the data they need to make informed decisions or to hold managers and board members accountable.

As an alternative to one-size-fits-all disclosure rules, we propose triggered disclosures tailored to the value drivers of the company going public. Under these disclosures, claims about customer value and potential market size must be supported by consistent, objective collection of baseline data related to those claims. These slimmer, more focused disclosures would provide investors with a better basis for valuing and pricing today’s companies. They also could force founders and managers to tell more realistic stories about their businesses, not fairy tales, while holding them accountable for delivering on their promises. 

Disruptions in the IPO Game

As the number of initial public offerings has surged over the last few years, we’ve seen significant changes in both the types of companies seeking to go public and the investor base. Many companies enter the market with large losses and no tangible pathway to profitability. While 80% of the companies that went public between 1980 and 1990 were profitable, only 20% of those going public between 2016 and 2020 were. Companies are also waiting longer to go public — the age of the median company was 12 years in 2020, compared with six years in the 1980s — and spending more time scaling up revenues instead of building profitable business models. A growing fraction of these businesses emphasizes the number of users or subscribers they have instead of traditional financial measures such as earnings.

In the meantime, the investor base has grown to include many small retail investors aided by the introduction of low- or no-cost trading platforms like Robinhood. These less sophisticated investors almost surely have less time to devote to the careful study of disclosure statements than the institutional clients and wealthy individuals to whom investment banks have historically marketed IPOs. And even though these newer investors have more access to investment advice and data on businesses that plan to go public, they also are more likely to take a company’s published metrics at face value and be duped by misleadingly grandiose claims. 

The Disclosure Dilemma

The U.S. Securities and Exchange Commission’s rules on disclosure have not kept up with these disruptions. The Securities Act of 1933 first laid out the information companies have to provide in an IPO prospectus (known as the Form S-1), which requires that a company issuing stock provides information on its business model and the risks in that model, and a description of the planned share offering and what it plans to do with the proceeds. 

Investors have always struggled with pre-IPO companies’ lower profiles, lack of a standardized financial history, limited historical pricing data, and opaque share counts. But these issues have become more of a concern as more money-losing companies have gone public — often with dual-class shares that have different voting rights — and the expanded use of stock-based compensation. 

Disclosure Bloat

Through their disclosure rules, regulators have tried to accomplish two sometimes contradictory objectives: to protect investors and to make it easier for companies to go public. Although the core requirements haven’t changed much, the filings themselves have become longer and more detailed, which in some sense runs contrary to both objectives. Apple’s and Microsoft’s prospectuses, at 73 and 69 pages, respectively, were considered long at the time. In contrast, Uber’s 2019 prospectus was 285 pages long, with a separate 94-page section for its financial statements and other disclosures. Airbnb needed a whopping 350 pages for its Form S-1, and another 84 pages for the appendices.

Despite their burgeoning length and level of detail, disclosures have not necessarily become more useful. The additional material often provides little insight into the company’s outlook and is frequently misleading. Some of the most important data remains undisclosed in the following ways: 

The risk profile section is uninformative. Although well intentioned, this section of the prospectus has lost its focus. Originally designed to provide transparency about the risks that investors face with low-profile companies, they have become a catchall where lawyers state any risks, no matter how unlikely, that the company could be sued over if excluded. Relevant and material risks can end up getting missed when placed alongside a mountain of irrelevant ones. 

Share counts are confusing. The requirements for disclosing the number of outstanding shares have not changed substantially since the 1980s. But since that time, the types of shares that companies issue have become more complex, adding to confusion about the number of shares actually outstanding. 

In the final prospectus before its IPO, Airbnb reported that there would be about 47 million class A and nearly 491 million class B shares after its IPO. However, the count excluded nearly 31 million options on class A shares and almost 14 million options on class B shares issued at undisclosed strike prices. Plus it left out more than 37 million units of restricted stock that were subject to undisclosed service and vesting requirements. 

In general, the rules on reporting share counts in a prospectus are lax, and the reporting of some types of share ownership is voluntary. This is especially true with restricted shares, where vesting and other contingencies enable companies to undercount the potential number of shares outstanding. This leaves IPO investors with an ownership stake that is possibly less valuable than expected.  

Stories are grand — but misleading. The SEC has strict rules in place limiting companies’ ability to make projections about future revenues or earnings (although companies that go public via a special-purpose acquisition company, or SPAC, have more leeway). But it does not prohibit companies from disclosing metrics — and the definitions of those metrics — that make their valuations appear as big and appealing as possible. As expected, companies are taking full advantage of this.

One often misleading metric is total addressable market (TAM), which purports to show a young company’s growth potential by estimating the total possible demand for its product or service. While the TAM is widely viewed as central to valuing a young company, the lack of consensus on how to estimate its value has allowed companies to inflate numbers, sometimes to the point of absurdity. A significant number of companies that have gone public over the past decade have described unrealistically large TAMs to justify a higher valuation. 

Uber, for instance, claimed that the TAM across its three business lines — ride-sharing, trucking, and food service — was $12 trillion, or roughly 15% of the world’s gross domestic product. Airbnb estimated the short-term stay business to be $1.2 trillion, double the $600 billion in revenues that hotels globally generated in 2019. While both companies can plausibly claim that they will draw in new users and increase the overall size of their markets, the real question is by how much and over what time frame.

For some companies, the path to a higher IPO price comes from cherry-picking details that emphasize the quality or quantity of their users or subscribers. How these factors link to revenues and profits is often only loosely defined, with critical details left out. For example, Uber disclosed how many riders were active over time but did not provide information about its customer acquisition cost (CAC) or how long customers were retained after they were acquired. Airbnb disclosed how long customers were retained after they joined but did not reveal the CAC for those listing or renting properties.

Another potentially misleading metric is adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). Many money-losing companies adjust their disclosed earnings to try to make themselves look better by adding back what they categorize as noncash expenses or extraordinary items. These adjusted EBITDA numbers are labeled as unofficial measures, but companies disclose them in the hope that investors and analysts will base their pricing on them.

While some adjustments are legitimate, others are highly misleading. In particular, some companies add back stock-based compensation and treat it as a noncash expense. This disregards the reality that employee options and restricted stock represent real costs and as such are genuinely relevant expenses, especially for young companies. Some are even more aggressive in their adjustments, adding back important cash expenses such as marketing costs. 

The SEC’s rules about such disclosures are designed to protect investors from overly optimistic forecasts. Yet they still allow many companies to selectively disclose uninformative, misleading metrics without the essential details that would enable investors to make sense of the measures and hold companies accountable for meeting them. This not only leaves investors in the dark but also hurts management accountability. Through selective disclosure, executives are effectively able to move their own performance goalposts. This lack of management discipline sets a bad precedent for the next cohort of executives building companies that they hope to take public.  

Guidelines to Fix Disclosures

The problem, as we see it, isn’t that the SEC mishandles individual disclosure issues. Rather, it and other regulators misunderstand the nature of companies now going public and the information investors need. Today’s IPO companies are no longer mostly young, small, and turning the corner on profitability, and IPO investors are not primarily larger institutions. As a result, the SEC’s disclosure requirements that were written for another era are no longer up to the job. It may make more sense to start fresh, with the following four guiding principles:

Keep the rule book lean. It’s the nature of regulation that new disclosure requirements continue to be added over time. We suggest a variant of a “disclosure in, disclosure out” rule so that when a new rule is added, it must be at the expense of an old, outdated requirement.

Require more information about valuation. While companies going public have no market price history, they have had to raise funds from venture capitalists and investors who set an implicit valuation of the company. Companies and their bankers often selectively use these venture capital rounds to justify the price of their IPOs, but there is no requirement that these valuations be disclosed. We argue that when private companies go public, they should all be required to disclose venture capital raised over their history and the estimated valuation in each round. This would make clear how much cash the company has burned through its lifetime and also would provide transparency on venture capitalists’ behavior and the company’s valuation since its inception. 

Standardize the share count. Rather than letting companies judge for themselves what to count in their shares outstanding, we recommend that restricted share units be counted as part of shares outstanding and that options be separated out, along with exercise prices and maturity. These changes will make it clear just how much ownership an investor will receive when buying shares in the IPO and enable a more accurate estimate of how much share prices should appreciate when a company achieves a certain overall equity valuation.

Require companies to tell the whole story. The solution to companies’ tendency to pad their disclosures with misleading or uninformative details about their business potential isn’t to restrict it. Markets abhor vacuums, and preventing companies from forecasting the future only allows others who are less scrupulous and less informed to fill the space with their own stories. The status quo lets pre-IPO companies off the hook, since they can selectively provide the outline of a narrative that paints them in the most favorable light without filling in key details. 

Company disclosures should be tight, relevant, complete, and standardized. Leadership should not be given free rein over what disclosures to include and how those disclosures should be defined. Instead, they should be required to include additional disclosures that are triggered by the company’s particular business model, its investor base, and the specific claims it makes. Next, we’ll discuss how that might work.

Triggered Disclosure

We propose that any company that wants to build its story around certain metrics in addition to basic financial information, such as the balance sheet and income and cash-flow statements, will trigger the required disclosure of a more systematic collection of details that are necessary to understand the economics of its particular business model. 

Consider the use of the TAM, which companies going public have increasingly used to support high valuations. The number includes all possible buyers, whether or not they would be interested in the company’s products or services at current prices. These figures are often aspirational, with little justification, and companies typically provide no timeline for how long it will take them to capture that market.

With triggered disclosure, companies that specify a TAM would have to provide the following additional information to prevent them from using the figure as simply a marketing ploy. 

What the TAM is based on. Companies disclosing the TAM would also have to specify a more conservative figure known as the serviceable addressable market (SAM), which refers to the number of people who would be interested in a company’s current products or services at current prices. They would also have to show exactly how they measured the TAM and SAM (ideally, through survey work conducted by a reputable third-party market research firm) so that investors would have confidence that the figures have a sound basis. 

For example, Uber’s Form S-1 included in its SAM every trip of less than 30 miles across the 57 countries in which it operated at the time, along with a “near-term SAM” covering 63 countries, without addressing the number of potential customers at current prices. In contrast, Peloton estimated its SAM and related measures using more conventional definitions through extensive survey work. Investors who may be skeptical of a lofty TAM could still look to a well-supported SAM as a more achievable intermediate metric. All prospects are not equal: Some are more inclined toward a company than others. This layered approach acknowledges the reality that the likelihood that prospects will convert to paying customers falls on a continuum.

Estimates of market share. It’s one thing to project a TAM in the billions, but unless a company says what share of that market it expects to capture over a specific period of time, the number is worse than meaningless. We recommend requiring that TAM disclosures be accompanied by a forecast of how quickly the company will penetrate that market. The worry that they will be held accountable if their revenues do not measure up to their promises should act as a check on companies that are tempted to significantly inflate their TAMs.

Ongoing disclosure. Companies usually provide a TAM, SAM, and other variants on a one-shot basis, disclosing such figures in their pre-IPO prospectuses and never again. We believe that investors should be given these measures on an ongoing basis, in quarterly filings, annual reports, or supplementary presentations. These updates will allow investors to see how well the company is tracking relative to its previous forecasts and let them know whether conditions have changed. Also, companies that know they will be held accountable for their IPO disclosures after they go public will have an incentive to make those disclosures realistic and achievable.

As long as investors continue to assign premiums for companies that have bigger markets, companies will be tempted to overestimate their TAMs. These recommendations should at least check those tendencies. 

Better Insights Into Transaction-Based Companies

While TAM disclosures apply to all types of businesses, transaction-based companies — those whose revenues come from selling a product or service — require other key disclosures that make it possible to accurately assess the quantity and quality of their customers.1 We suggest that the following should be shared:

Active customer count. Active customers are those who have placed at least one order during a specific time period, and it’s important to understand how their numbers change over time. Tracking active customer counts over time provides insight into the drivers of revenue growth, whether that’s an increase in the number of buyers, an increase in average revenue from each buyer, or a combination of the two. For businesses with a free usage tier, it also illuminates how those revenues are distributed — for example, does 90% of the revenue come from only 5% of users? 

The actual period of activity isn’t what’s most important. Wayfair, Amazon, and Airbnb, for example, define an active customer as one who has placed at least one order over the past 12 months. In contrast, Lyft, Overstock, and many other companies define a customer as active if they placed an order in the past three months. For most companies, either window would be appropriate. What is more important is that this data be disclosed for a sufficiently long time period to reveal the trajectory of growth. 

Total orders. Knowing the total number of orders is necessary to understand whether revenue growth is coming from an increase in the number of purchases or from an increase in the value of each purchase. Along with the count of active customers, it can also reveal whether orders are increasing because the company is attracting more customers or because they are shopping more frequently or buying more with each purchase.

Customer acquisition cost. Investors need to know how expensive it is to acquire new customers, making CAC an essential disclosure. 

Contribution profitability. Once a company has acquired customers, it must generate profits from them while they are active. It is important, then, to know how customers contribute revenue over time and how that revenue translates into incremental profitability. This variable or contribution profitability is calculated by deducting expenses that grow as revenue increases — such as labor and materials, fulfillment, and payment processing — but not expenses that are relatively fixed in nature, such as rent on manufacturing facilities or the salaries of the executive team.

Promotional activity. It can be easy to significantly increase sales through enticing targeted promotions, creating the illusion of rapid growth that may not be sustainable over the long run. But promotional costs are often completely invisible, showing up on income statements as reductions in revenue rather than as expenses. Promotional activity should be explicitly disclosed to understand how it might be influencing revenue growth.

Customer cohorts. Tracking how long different groups of customers have been active is one of the most informative disclosures a customer-based business can provide. Knowing how activity changes the longer that customers stay on a platform and how these patterns are evolving across different customer cohorts can provide investors with unparalleled visibility into the customer acquisition costs or changing retention patterns for each group. 

While most businesses are transaction-based, there are other types as well, including subscriber-based businesses, advertising businesses based on user activity instead of direct purchases, and lending businesses. For these, our guiding principles remain the same, although the specific disclosures will be different. (See “Triggered Disclosure Requirements in Summary.”)

The Managerial Payoff

While disclosure policies requiring more focused and triggered disclosures are designed primarily to help investors, the shift will also benefit founders and managers.

First, requiring managers to report more details about the TAM and the economics of user value (such as customer acquisition costs and contribution margin) will force them to think through their valuation stories more carefully before offering them to the market. This may dampen the initial pricing of these companies, but these more realistic and detailed stories will provide clearer road maps for creating profitable business models over the long haul. 

Second, the metrics required for disclosures can also be used by managers and board members to track how well they are performing relative to their forecasts. If their performance deviates, the metrics can also guide them toward midcourse corrections. Say, for instance, that customer acquisition costs rise much faster than anticipated. If those costs have been disclosed and are available to investors, shareholder pressure can create stronger incentives for management to bring down the costs and enhance the value of yet-to-be-acquired users. Public disclosure creates healthy discipline that, over time, can make companies more robust.

Finally, executives at younger companies, in anticipation of their future IPOs, will be more inclined to manage their businesses in a sustainable way if they know they will be accountable for the wider collection of disclosures that we recommend. The relative youth of their companies provides them with the time they need to make sure that when they are filing their own IPO prospectuses, the customer-related data they have to disclose will be as strong as possible.

It is true that some founders’ endgame is to get the highest possible pricing for their company and cash out before the market catches on. But many others aim to build long-standing and valuable businesses. We believe that our disclosure proposals will help them. What’s more, if regulators support our recommendations, even the founders looking for the highest possible IPO price will be forced to come around as well.

Written by Aswath Damodaran. Kerschner Family Chair in Finance Education and a professor of finance at the Stern School of Business at New York University. Daniel M. McCarthy is an assistant professor of marketing at Goizueta Business School at Emory University. Maxime C. Cohen is the Scale AI Chair in Data Science for Retail, a professor of retail and operations management, and codirector of the Retail Innovation Lab at the Desautels Faculty of Management at McGill University.

References

1. For more information on exactly how these disclosures can come together to inform an assessment of overall valuation, see D.M. McCarthy, P.S. Fader, and B.G.S. Hardie, “Valuing Subscription-Based Businesses Using Publicly Disclosed Customer Data,” Journal of Marketing 81, no. 1 (January 2017): 17-35.

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