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Valuable Lessons from WeWork and Other Unicorns

Recent scandals among tech’s unicorns have turned investor attention to hypergiant funding and blitzscaling: Outcome Health faced an investor lawsuit regarding misleading claims; John Carreyou’s NYTimes bestseller “Bad Blood: Secrets and Lies in a Silicon Valley startup” centers around fraud charges faced by Theranos; and, most recently, WeWork has faced negative publicity for its IPO plans. But what is “hypergiant” funding and “blitzscaling,” and how can companies avoid becoming cautionary tales?

The dangers of conflating “hypergiant” funding with “blitzscaling”

Due to unprecedented amounts of global dry powder, “hypergiant” funding rounds have become more prevalent among venture capital (VC) and growth equity investors. Global funds held as dry powder, or kept in reserve, have increased from $400 million in 2003 to $2 trillion in 2018. Many top global VC funds, such as Sequoia Capital, Andreessen Horowitz, and NEA, have raised later-stage venture funds of $1 billion or more since 2018. As a result, “hypergiant” rounds of $250 million or more steadily increased from 38 over the course of 2014 to 35 per quarter in 2018.

Increases in hypergiant rounds have coincided with the rising popularity of a strategy known as “blitzscaling.” Reid Hoffman began teaching a class called “Technology-Enabled Blitzscaling” at Stanford University in 2015; according to Hoffman, the term can be described as “what you do when you need to grow really, really quickly.” He elaborated, “It’s the science of rapidly building out a company to serve a large and usually growing market, with the goal of becoming a first mover at scale… Google revolutionized how we find information – it has over 60,000 employees and has created many more jobs at its AdWords and AdSense partners.”

Learning from the mistakes of WeWorks and others

WeWork’s failed IPO demonstrates the dangers of conflating large funding with rapid scaling. Not all companies with large funding possess the same fundamentals to be successful at rapidly scaling.

The classic venture capital playbook is to jointly fund startups through a series of gate-staged rounds (i.e., Series A, Series B). Each round’s purpose and size are intended to reflect a startup’s needs at that specific stage. This strategy reduces risk for venture capital firms, as nearly 2/3 of startups stall and fail to exit or raise follow-on funding.

Masoyohi Son, CEO of Softbank and its Vision Fund, was said to have launched the Vision Fund to transform VC’s typical playbook of gate-staged investments. Softbank typically decides on its own if a venture is worthy of funding that is significantly greater than its ask. In 2018, while the median size of late-stage VC investments was $35 million, Softbank led or sourced 18 funding rounds of $350 million or more.

These days, if a startup needs to raise capital, it is easier than ever to tap into private markets. Therefore, it comes as no surprise that the median gestation period from seed to IPO has lengthened from 3.2 years in 2000 to almost a decade in 2019.

However, with WeWork’s recent failed IPO, it makes sense to examine sound hypergiant funding principles. Specifically, some entrepreneurs mistakenly believe that massive capital investments alone can be used to achieve a sustainable competitive advantage. While blitzscaling encourages rapid expansion in order to take advantage of network effects, it does not urge companies to ignore lean methodologies or standard investing concepts.

Valuable lessons from WeWork’s recent IPO failure

Hypergiant funding is not the inherent reason for WeWork’s failure, or Outcome Health’s recent lawsuits for that matter; rather, company executives ignored many basic principles. Notably, after WeWork’s failure, the NYSE tweeted the following:

“Before you take your company public ask yourself these four questions:

Is there a compelling business case for going public?
Is there a clear, strategic roadmap for the long term?
Is your company’s financial house in order?
Is the right executive team in place?”

While these questions may seem basic, they summarize many enduring considerations as companies scale and tap private or public markets for additional funding. Below are some guiding principles to keep in mind:

A great vision and business plan are fundamental. As the proverb goes, “Vision without action is a daydream. Action without vision is a nightmare.” A company’s vision should be clear, concise, and inspiring. An example is Microsoft’s vision at its founding, “A computer on every desk and in every home.” In order to execute a vision, companies should have a comprehensive business plan that lays out objectives, actions to obtain them, and the timeframe to accomplish these actions.
Business models are paramount. Capital-intensive, low-margin businesses cannot sustain a competitive advantage with new technology and massive funding alone. Total addressable market (TAM), barriers to entry, customer satisfaction, and sustainable free cash flow (or a feasible, well-conceived path towards one) are enduring investment concepts. Alibaba raised only $50 million venture capital before becoming cash-flow positive in its third year of operation, and Facebook was generating over $1.5 billion in operating cash flow prior to going public.
The core business is foundational. Investors often heavily discount new, additional products and growth avenues. Yet, some companies begin rapid expansion into new areas without fixing the fundamental issues in their core business first. An example is WeWork’s launch of its elementary school product area known as WeGrow.
Scale at the right time, rather than as a result of access to capital. It makes more sense to scale when there is data available on the competitive landscape and the degree to which a product satisfies a strong market demand, such as a sizeable serviceable addressable market (SAM), strong user growth, and/or requisite proof-of-concept data (i.e., clinical studies). Scale too quickly and the company might stall; mistakes can become compounded. On the other hand, scaling too slowly might not be aggressive enough.
Internal controls should not be sacrificed for profit. WeWork was forced to react to investor concerns regarding related-party transactions, such as Mr. Neimann’s personal ownership positions in buildings leased by WeWork and We Co’s $6 million purchase of the trademark of the word “We” from a company controlled by Mr. Neimann. Internal controls such as audits and expenditure review triggers for items over $1,000 can pay dividends later on.
Accounting principles exist for a reason. Overly complex spreadsheets can generate accounting mistakes if they become too cumbersome to operate and update. A lack of financial standardization can result in inappropriate revenue recognition and theft. Finally, separation of bookkeeping and auditing becomes crucial as companies scale. Investors value independent audits, and strategic investors are known to request Quality of Earnings (QoE) reports for larger scale acquisitions.
Governance matters. Companies should implement written codes of conduct and implement structures that avoid bias and conflicts in decision making. Elizabeth Holmes of Theranos prevented subsequent board efforts to replace her by multiplying the voting rights of her shares to give her 99% of total voting rights. At WeWork, Neumann’s voting shares and the stipulation that significant power passes to his wife, the company’s Chief Brand and Impact Officer, in the event of his death raised significant concerns. A newer investment strategy – Environmental Social & Governance (ESG) – has emerged in recent years, and it emphasizes some of these concepts. ESG and sustainable investing focus on relations with employees, customers, and stakeholders, as well as proper corporate governance – leadership, pay, voting rights, and history with the SEC and regulatory bodies.
Accountability fosters growth. As companies scale, specialization becomes more important. Key performance indicators (KPIs) and accompanying analytics are critical to the deployment of a significant amount of capital. Additionally, intermediate milestones allow companies to course-correct early in the journey at significantly less expense.
Cultures that cultivate fear can be dangerous. At Theranos, for example, would-be whistleblowers were threatened with lawsuits, and some employees were fired and marginalized over criticism of company practices. As a company quickly grows, executives should manage and measure their cultures to ensure they are addressing employee concerns and encouraging trust.
Reliability prevails in relationships with customers and investors. There are serious repercussions for presenting false information to healthcare providers, patients, and investors. Following Wall Street Journal allegations that Outcome Health misled advertisers by overcharging clients and manipulating campaign results, key investors decided to sue Outcome Health for committing fraud, and the company is being forced to reinvest $159 million in the company while the co-founders step aside from daily management. In the case of Theranos, the SEC charged CEO Elizabeth Holmes with “massive fraud.” As part of the settlement, Holmes must return millions of shares to the privately held company, pay a $500,000 fine, and she cannot serve as an officer or director of a public company for 10 years.

Conclusion

Modern scandals among notable unicorns in healthcare and technology have caused entrepreneurs and investors to reflect on recent events. While global dry powder remains high and the number of unicorns has multiplied, hype does prevail over math in a world that relies on ratios such as Return on Invested Capital (ROIC). Sooner or later, sophisticated investors penalize dysfunctional business models. That said, with the appropriate framework and culture, companies can easily avoid becoming yet another cautionary tale.

To learn more about Gilmartin and how we strategically partner with our clients, contact our team today.

Caroline Paul, Principal

IPO Lock-Ups and Early Releases

When a company is about to go public, early investors anticipate the stock rising after the IPO, but they must also endure a mandatory waiting period called the lock-up period. This period keeps pre-IPO investors from immediately selling their stock. Why does this exist, how does it impact the stock and what are some of the recent dynamics around this period?

What Is an IPO Lock-up Period?

The IPO lock-up period is a pre-set period of time – conventionally 180 days – after a company goes public, during which some early investors and employees of the company are not allowed to sell their shares. These restrictions are not mandated by the Securities and Exchange Commission (SEC), but rather are self-imposed contractually by companies or are required by the investment banks underwriting the IPO. Typically, company insiders own a lot more shares than the public market. Therefore, if large shareholders were allowed to off-load holdings immediately after a company goes public, these selling activities could drastically depress the stock’s price. As such, the purpose of a lock-up period is to ensure that shares owned by company insiders do not all flow out together into the public market too soon after the offering, increasing the supply (float) of the stock with a massive inflow of sellers and thereby negatively impacting the stock price. The “cooling-off” period mandated by the lock-up can also help reduce the volatility of the new stock and allow for the market to settle into a share price based on natural supply and demand and initial company performance. The traditional 180 days also give the company time to announce up to two consecutive earnings reports, which can serve to provide additional details and track record regarding the business operations and outlook.

Lock-up periods can also be a way for companies to keep up appearances. When those closest to the company hold their shares, it can signal to investors that they have confidence in the strength of the company. If company insiders start to sell their stock, investors may get suspicious and be tempted to sell their shares as well. Even if the insiders were trying to cash in their stocks for no other reason than simply wanting the money, public perceptions may change based on the selling activity of insiders. The lock-up period can prevent this from happening—at least while the newly public company gets off its feet.

While lock-ups do exist to protect the stock and the shareholders from an over-supply of shares and the potential downward pressure on the stock that can come with that, they can also create an “overhang” or pressure on the stock due to the expectation of an increased supply and concurrent price pressure. This overhang is why a company’s stock price usually drops leading up to and on the day that the lock-up expires.

Early Lock-up Release

Increasingly, some companies and banks are instituting earlier releases from lock-ups in order to lift the “overhang” and downward pressure on the stock and to relieve the pressure of a straight cliff after the 180-day lock-up. The main goal is to keep shares attractive to new investors by delaying the price pressure that can come with insider sales. At the same time, an early release can reward early investors for taking bets on the company by allowing them to benefit from IPO success and by giving them a “safe window” within which to sell their shares. This decision must also be weighed objectively by all constituents, balancing the fiduciary obligations of the board and the executives with their obligations to their institutions. Additionally, the decision should balance the underwriters’ expertise and market knowledge with the fact that they will receive a fee for the underwriting of a secondary offering, at the likely expense of the company’s share price. Keeping in mind all of these considerations, early lock-up releases can be done in several different ways.

Strategies for Lock-up Releases

Companies may decide to have multiple lock-up periods that end on different dates and allow different groups of people to sell their shares at different times. For example, when one lock-up period ends, company executives might be allowed to sell their shares, while a subsequent lock-up ending means regular employees can sell their shares. While this approach can help in the orderly dissemination of shares, it also is generally done confidentially, and the surprise announcement can have a negative effect on both investors and insiders who are not included in the early release. If the stock price goes down as a result of the first early release, those investors who were excluded and who are still locked up then will be faced with a deflated share price when they are finally released from their remaining lock-up period.

Another option is for companies to specify a particular price target as a condition for early lock-up release. Many believe that performance-related lock-up expiration rules are beneficial for shareholders, as this approach is more transparent and formulaic than the informal and private discussions that can often take place between banks and the company about whether to allow early sales. While the confidential discussions and ultimate “surprise” decisions can upset some investors and insiders who are not included in the early-release, public disclosure of lock-up release parameters do not involve this element of surprise or perceived selling hierarchy.

For example, Snap, the parent company of social media app Snapchat, went public with an IPO on March 2, 2017 and closed at $24.48 after pricing at $17. The company used a system of multiple lock-ups with different expiration dates. The first lock-up expired in July of 2017 and allowed early investors and insiders to sell up to 400 million shares of the company; volume more than quadrupled from the average, and the stock closed at $15.47 on the day of the first expiration after trending down leading up to that date. A second lock-up expired in August of 2017, again with significant volume and the price closing under $12, allowing regular employees to sell their pre-IPO shares in the company. When this lock-up ended, employees were allowed to sell more than 780 million shares of Snap on the open market.

However, the timing of a lock-up release off of the original terms must really be considered, particularly with respect to quiet periods and material matters in information as they relate to the company. After its December 2011 IPO, Zynga altered its lock-up agreement in early 2012 in order to stagger the shares over five separate stages. In the first stage, some executive insiders were released to sell shares before current and former employees. The price of Zygna shares collapsed just after this initial sale, leading to a flood of activity that unveiled an allegation that the insiders knew about prior to public disclosure. Zynga’s financial operating results were deteriorating, and they still were released from lock-up and sold a portion of their shares, which is what gave rise to claims of insider trading and breach of fiduciary duty.

When Facebook went public, the company established multiple lock-up dates. Facebook’s stock declined so much during these lock-ups that when the largest lock-up released, the stock price actually rose significantly, as shorts covered and investors who had been waiting on the sidelines took advantage of the deflated price. As the stock rose, this could also have given holders of the stock encouragement not to sell, which in turn could put more pressure on shorts.

It is becoming increasingly common to release shareholders early from lock-up provisions, but it is important to understand the entire picture and the number of unknowns when making these decisions. Predicting and understanding what a stock price will do leading up to and following a lock-up is a complex exercise. In addition to the laws of supply and demand combined with the recent and expected financial results of the company, one needs to anticipate the buying and selling activities of investors as well as short sale activities, general market sentiment and movement.

Our team is well-versed in IPO lock-up periods and the strategies surrounding them. Contact us today to schedule an appointment.

Debbie Kaster, Managing Director

IPO Pricing and Shares Offered Dynamics

Going public can be a daunting process, with multiple steps to take, decisions to make, and involvement from many constituents – management teams, boards of directors, investors, lawyers, bankers, and more. All these constituents have different opinions, objectives, and areas of expertise. The culmination of all of this is the pricing of the IPO which is far from an exact science and is impacted by many different inputs and factors (for more, see this previous blog). We often hear of an “upsized” IPO and/or “pricing above the range,” but how are these parameters determined, who determines them, and why? In this blog post, we will shed light on how the magic of a final IPO price is determined.

Building the Book

The level of interest in an IPO indicated by potential investors is arguably the most fundamental factor in determining the IPO price. ‘‘Building the book’’ is the common terminology used to describe the underwriters’ process of obtaining indications of interest, which may include a specific price and quantity matrix of desired share allotment, from potential investors. During the roadshow, as management presents its story to gain interest in the company’s IPO, the underwriters’ capital market groups follow up with the potential investors to gauge interest in the IPO by recording the number of shares each investor would be willing to purchase and how much the investor would be willing to pay. This allows the underwriters to gauge investor demand for the offering once the roadshow concludes, as well as the number of shares that can be sold (including the over-allotment option) and what the optimal price will be. The underwriters look at all indications and the matrix of shares desired at different potential price points to determine the optimal offering price and how many shares to offer.

IPO Price

The book is only one of several factors that determine the final IPO price and shares offered. Other factors include the following:

Quantitative factors including the company’s current sales, expenses, earnings, and cash flow. Projected earnings are also factored in.
Valuation multiples comparable to the company’s industry peers
The size of the current and near-future market for the product or service that the company produces
The marketability of the company’s stock in the current economic environment
The underwriters’ view of current market, industry, and economic conditions and developments. If stock market or industry conditions deteriorate, even a book that had been strong may be impacted.

With all of this, the underwriters must also balance the interest of multiple involved parties. The company’s executives and early investors want to price the shares as high as possible in order to provide the highest return and raise as much capital as possible. On the other side, the buyers, led by institutional investors, want the lowest possible price in order to increase the chances of a positive return, not only in the immediate aftermarket, but in the long-term as well.

In a well-received offering, buyers may be willing to pay at the high-end of the filing range or above in order to start building their long-term positions. In a scenario like this, the investment bank will go back to more price sensitive buyers and let them know that other buyers are willing to pay more, and unless they are as well, they may receive a smaller allocation or miss out altogether on the IPO. By then pricing above the mid-point of the filing range, the company will raise more money than originally expected without further diluting the private investors, management team and other company employees who own stock.

Interestingly, for an IPO that is oversubscribed and prices at the mid-point of the filing range or higher, there is an expectation that the stock will trade higher in the immediate after-market. And while this appears to leave the issuing company with less money raised, this so-called IPO discount helps to entice investors to buy into a company that has not yet proven itself as a public entity and provide an attractive entry point for building a position. In addition, as one of the goals of an IPO is to create liquidity, it is a positive to see the stock trade up and have active volume.

Looking further at price increases in the aftermarket, much of the buying demand is a result of long-term investors receiving only a portion of the necessary shares to build a meaningful position in their portfolio. As an example, a fund may only receive 50,000 shares on the IPO, but need an additional 200,000 shares to build a meaningful position. They may then choose to build this position over the first few days of trading when liquidity is highest with an end result of a 250,000 share position with a volume weighted average price (VWAP) that is nearer to the closing price over the first few days than it is to the IPO price. While the lead underwriters will work to price an offering at the highest possible price while balancing the need for aftermarket performance, pricing remains more of an art than science. Unknown factors such as short-term traders, retail demand and even unknown long-term buyers can all cause a stock to rise more than expected after pricing.

Shares Offered

The other input that can be modified for the final IPO terms is the total number of shares offered, with the main drivers of this number being the quality and breadth of the investor demand along with the total desired funds to be raised. Upon filing the S-1 with the SEC, the issuing company indicates the number of shares to be registered and pays a registration fee that is based on that number of shares multiplied by the high-end of the filing range. The Securities Act of 1933 (Securities Act), does provide that an issuer may upsize or downsize an IPO if the changes in volume and price represent no more than a 20 percent change from the maximum aggregate offering price set forth in the fee table in the effective registration statement.

While strong demand can lead to a higher IPO price, it can also lead to more shares being offered. There are scenarios where buyers may be price sensitive even in the face of strong demand, but if the banks feel the book contains breadth and quality of the investors who want to build long-term positions, they may recommend upsizing the deal. By doing so, the largest, high-quality investors can be given meaningful allocations which they can build on in the aftermarket.

Of course, the number of shares offered will impact capitalization and ownership/dilution, so this must be carefully considered. It will be of utmost importance to company insiders, investors and individuals who held shares pre-IPO. So, the shares offered is an important input in the big picture and can impact the capitalization, ownership, and future issuances for the company.

Ultimately, pricing an IPO is an exercise in balancing the interests of multiple parties while optimizing the outcome and predicting market reactions. While there is no exact science to follow, underwriters are well-versed and experienced in the many inputs and dynamics that lead to a successful IPO.

Our team is here to answer any questions you may have about pricing IPOs and advise you in what to expect when it comes time to price your offering. Contact us to learn more.

Debbie Kaster, Managing Director

What is a Shelf Registration?

A shelf registration statement (or form S-3, in SEC terminology), is a flexible registration with the SEC that allows an issuer to essentially “pre-register securities” without a specified issuance date or terms.

The issuer of a shelf registration is not required to specify the exact amount or offering price of each type of security in its registration statement, but includes only an aggregate dollar amount of securities to be offered. An S-3 has a three-year lifespan, during which time the securities are “put on the shelf,” so to speak, allowing securities to be sold at any point within the registration period. An effective shelf registration statement permits issuers to take securities “off the shelf” and offer them to the public on a continuous or delayed basis.

Shelf registrations are generally used when the issuer does not intend to immediately sell its securities. It can be used for both debt and equity offerings, which can be sold in one or more offerings from time to time. If utilized for equity, the shares in a shelf registration must be primary shares. There is no limit on the amount of securities that can be registered, and takedowns are communicated via a prospectus supplement.

S-3 Eligibility

To be S-3 eligible, a company must have been a public company for at least 12 months prior to filing the registration statement, have a timely reporting history for the last 12 months, and cannot not be in default on indebtedness or dividend payments since the end of its last fiscal year.

Shelf-eligible companies are divided into two classes based on the size of the issuer’s public float.

A larger company can use a shelf if (1) within 60 days of filing the S-3, the aggregate market value of its public float is at least $75 million, or (2) only nonconvertible investment-grade securities are being offered.
Smaller companies with a public float of less than $75 million can utilize a shelf registration if the company (1) meets all of the other eligibility requirements, (2) is not a shell company, (3) has a class of common equity securities listed on a national securities exchange, and (4) does not sell in a 12-month period more than the equivalent of one-third of its public float.

Although there is no limit on the number of shares an issuer may sell under a shelf registration statement, in certain circumstances the issuer may be required to obtain the consent of its stockholders.

Pros and Cons of a Shelf Registration:

As with any financing tool, there are pros and cons associated with a shelf registration. Some of the advantages of utilizing a shelf registration are outlined below:

Allows immediate access to the market without the need to wait for SEC clearance, as the SEC will not review offering documents for a takedown under an existing shelf registration.
Allows the issuer to opportunistically take advantage of strong capital market windows or strong company stock performance windows.
Allows companies to incorporate by reference reports that are filed after the effective date of the S-3, thus eliminating the need to file post-effective amendments and prospectus supplements upon new business and financial developments.
Lower cost than an S-1.

However, unfortunately the capital markets do not always appreciate the filing of a shelf registration as a positive event. Complaints arise primarily for some of the following reasons:

Investors seek to avoid dilution, and as a precursor to a potential upcoming issuance of shares, a dilutive event, the filing of a shelf registration statement is viewed negatively. The hope, of course, is that if S-3 filers sell securities, they do so at a higher price to minimize shareholder dilution.
Filing a shelf registration signals to the market that a financing is forthcoming, which creates an overhang on the stock and can depress its performance. Big institutions might opt not to buy shares in the open market when they can instead wait and buy in an upcoming follow-on financing.
Some might view an active shelf registration as easy access to capital for management that can potentially be used haphazardly.

Capital Market Trends: Why Shelf Registrations Have Become More Popular

In recent years, access to capital markets has been very volatile, making it challenging for companies– particularly those in the growth stage – to fund their businesses via the public markets. Raising capital during these times has been difficult for multiple reasons including that available capital has decreased and doing public offerings can be costly, not to mention the negative impact to the price of a stock if an offering is announced but not completed.

As these trends have developed, less traditional approaches to raising public capital have emerged. These less traditional (or alternative) approaches – whether they are registered direct offerings, “at-the-market” offerings, “over-the-wall” offerings, or “overnight” offerings – have the intention of allowing companies to take advantage of an open “market window” on short notice, and to quickly and cost-effectively raise capital.

Regardless of the approach, to raise money as a public company – even via a not traditional method – requires a registration statement. Thus, the popularity of the shelf registration has grown.

Conclusion

Shelf registration statements are very useful tools that allow issuers to quickly and cost-effectively access the capital markets, providing the ability to opportunistically raise capital. Shelf registrations give issuers great flexibility in timing, structure, amount and terms of a financing and are a tool that should be understood and used appropriately by public companies. For more information on shelf registrations and other methods of raising capital, contact us.

Debbie Kaster, Managing Director