Most everyone has had their say about the collapse of WeWork’s failed initial public offering (“IPO”).[1] Clearly, this failure was overdetermined, as many competing causes can explain it, including: (1) the extraordinary level of self-dealing that its CEO, Adam Neumann, regularly engaged in; (2) the corporate governance structure that locked up all voting power and control in him; (3) a system of non-GAAP metrics that more than raised eyebrows; (4) an extraordinarily high valuation for a company that, despite its claims of being a high-tech start-up, was closer to a simple real estate firm; and (5) the unstable personality of its founder (who, on a continuum from Elon Musk (brilliant but reckless) to Martin Shkreli (a felon with pretensions), seems closer to the latter end). But you knew all that.

What you probably did not know, however, is that there is one additional reason why WeWork skidded from a $47 billion valuation (based on a final round of private equity financing in January 2019) to near bankruptcy in October, only weeks after it released its prospectus. This reason involves a relatively new practice called the “IPO ratchet.”

Although some are content to view WeWork’s fiasco as simply evidence of a bubble,[2] these broad brush-stroke accounts miss something important that only emerges if we analyze WeWork’s proposed offering at a considerably more granular level. Once this is done, a pattern becomes evident that has been missed and sadly suggests that the SEC has been asleep at the switch.

This pattern goes back well before WeWork to at least 2013. Over recent years, finance scholars have noted that mutual funds have begun to invest heavily in later rounds of private equity financings for high-tech start-ups, probably to gain an advantage over their rival mutual fund families that instead wait for the IPO.[3] But mutual funds invest quite differently than do venture capital firms. While the VC firms focus on monitoring the start-up and seeking seats on its board, the major mutual funds seem to disdain monitoring and instead focus on contractual provisions that protect their expected rate of return. In particular, mutual funds seek two types of provisions; (1) redemption rights that allow them to escape (possibly if the IPO is delayed), and (2) a pricing “ratchet” that entitles them to additional shares in the event that the IPO prices below the valuation reflected in the final private-equity round. Such an outcome (a “down round” in the vocabulary) entitles the holders of this ratchet provision, depending upon the particular contractual provision, to additional shares that place them in the same (or nearly the same) economic position as if the IPO had priced at a level equal to the last private-equity round valuation.[4]

Although these ratchet provisions are often described as “anti-dilutive,” the accuracy of this description depends on your perspective – because the issuance of the additional shares can be highly dilutive both to the public investors in the IPO (who may already be disappointed that the IPO fell below the anticipated pricing level) and to those who bought (without a ratchet provision) in earlier private equity rounds. In the case of WeWork’s failed IPO, the principal holder of the ratchet provision was SoftBank, the Japanese investment bank whose billionaire founder, Masayoshi Son, had long been WeWork’s principal backer. According to a computation by Renaissance Capital, LLC, which specializes in analyzing IPOs, the ratchet clause held by SoftBank would have entitled it to more than $400 million in additional shares if WeWork’s IPO were to come in with less than a $14.5 billion valuation.[5] If the IPO came in as low as $10.5 billion, the shares to which SoftBank (and certain other holders of similar ratchet clauses) would have been entitled jumped to slightly over $500 million.[6] Today, WeWork is probably worth well less than $10 billion.

But nothing about this potential dilution was disclosed to the public. Instead, WeWork’s prospectus said (way back in its financial statements at page F-115) only that:

“The conversion ratio for the Senior Preferred Stock is adjusted on a broad weighted-average basis in the event of an issuance (or deemed issuance) below the applicable Senior Preferred stock price, as adjusted.”

This cryptic disclosure tells the IPO investor very little. If the investor is sophisticated, the investor may realize that these words imply a partial ratchet. Generally, the shares so issued in a partial ratchet would be modest. But, because SoftBank had made a large investment ($5 billion) in WeWork’s final private equity round, the reverse was true here. Equally strange (as Renaissance Capital pointed out), the prospectus further disclosed that once SoftBank invested the final $1.5 billion it owed WeWork, WeWork would issue SoftBank a warrant exercisable for the company’s stock. Again, however, the terms of this warrant and the number of shares that might be issued under it were not disclosed. Investors were simply left in the dark.

The SEC’s failure to require fuller disclosure would be less concerning if this were just a one-shot freak occurrence. But it is part of a larger pattern. Anti-dilutive ratchet clauses have become fairly common – apparently being now used in around 15 percent of recent IPOs.[7] Although they only have impact when the IPO is completed at a price below that specified in the ratchet clause, such “down round” issuances have regularly happened. For example, late stage investors in Square, Inc. held a full ratchet when Square went public in 2015, which resulted in the issuance of $93 million in additional shares.[8] Chegg, Inc.’s IPO in 2013 had a similar clause that resulted in $146 million in additional shares, and Box, Inc.’s IPO in 2015 saw an additional issuance of $67 million pursuant to its ratchet clause.[9] All that was different about WeWork was that SoftBank’s very large final round investment of $5 billion would have entitled it to a share issuance at a record level (possibly as much as $400 million to $500 million) if the IPO had been completed at a valuation below that of the final private-equity  round.

The problem here is not just that IPO investors have been denied full disclosure. There is a deeper problem with the perverse incentives that such a clause creates. Assume an early round investor has bought a large block of the issuer’s stock at a cheap price and is hoping for a high valuation in the IPO. In the final private equity round, it might be prepared to buy at an inflated price (for a smaller block) if this were believed to create “momentum” and encourage IPO investors to buy later at an even higher price. Now, add to this scenario the additional fact that the late stage investor negotiates a full ratchet clause with respect to this final private equity round. As a result, this investor has negotiated a “heads-I-win, tails-I-break-even” deal. Even if the IPO price is below the final round’s valuation, the investor will be held harmless.[10] The issuer might also be motivated to grant this ratchet based on its own desire for an inflated IPO valuation.

Effectively, such provisions create a moral hazard problem, as the investor is guaranteed a minimum return based on the price it paid in the final equity round. This investor faces no downside, and, as a result, this type of transaction should encourage mispricing in IPOs. Put simply, some will rationally overpay in the final private round in the hopes of inflating the IPO price, knowing that the economic risk of a “down round” falls mainly on the IPO investors who are diluted. The harm for the public investor is not just dilution, but the risk that the IPO will be overpriced, only to fall in the aftermarket when securities analysts catch up with it.

What WeWork really shows is that serious conflicts of interest exist among investors in venture capital deals. Public investors in the IPO appear particularly exposed, although one would have thought that SEC-mandated disclosure would have protected them. At a minimum, the WeWork fiasco illustrates that underwriters and their counsel did not perform as gatekeepers in the manner that the Securities Act contemplates because material risks were only hinted at, and not disclosed.

Practices such as the IPO ratchet may increase the prospect of a “bubble.” A logical prediction is that higher IPO valuations will result when IPO ratchets are used (because the late round private equity price is more likely to be inflated). Here, more empirical research is needed on how “ratchets” and similar contractual provisions affect IPO pricing. Still, one recent, provocative study finds that unicorns have been greatly overvalued (on average at 48 percent above “fair value”), and it attributes this overvaluation in part to financial guarantees to late round private equity investors.[11] Overvalued IPO stocks eventually fall in the public market — once the efficient market forces a return to reality. Thus, IPO investors may pay too much, sometimes will be diluted, and finally will often experience a stock price fall. Only because WeWork could not even make it to the roadshow stage were public investors spared this last experience.

All that is certain today, however, is that the SEC needs to wake up and require better disclosure.

ENDNOTES

[1] Technically, in 2019, WeWork reorganized and changed its name to “The We Company,” which is the name on its registration statement. Amendment No. 1 thereto was filed on September 2, 2019. Nonetheless, this column will use the name “WeWork,” as this is how most still refer to it.

[2] For a provocative column on this blog adopting this perspective, see Jesse M. Fried and Jeffrey N. Gordon, “The Valuation and Governance Bubbles of Silicon Valley,” CLS Blue Sky Blog, October 10, 2019.

[3] See Sergey Chernenko, Josh Lerner, and Yao Zeng, “Mutual Funds As Venture Capitalists?: Evidence from Unicorns” (https://ssrn.com/abstract=2897254). Josh Lerner is a professor at the Harvard Business School and his co-authors are former students of his.

[4] Id. at 18-19. See also, Will Gornall and Ilya A. Strebulaev, “Squaring Venture Capital Valuations with Reality” (https://ssrn.com/abstract=2955455) (April 20, 2019) (both papers discuss IPO ratchets and other contractual devices used in VC financings).

[5] See Renaissance Capital, “WeWork’s anti-dilution provisions could grant $400 million to SoftBank and others,” September 12, 2019.

[6] Id.; see also Kate Rooney, “WeWork investors like SoftBank have an obscure protection worth millions in a devalued IPO,” (https://www.cnbc.com/2019/09/24/softbank-has-a-multi-million-dollar-protection-in-weworks-ipo.html).

[7] For this estimate, see Gornall and Strebulaev, supra note 4.

[8] See Rooney, supra note 6, and Chernenko, Lerner, and Zang, supra note 3, at 36 to 37.

[9] Both Rooney, supra note 6, and Chernenko, Lerner, and Zang, supra note 3, provide this same data.

[10] Here, one qualification is needed: If the IPO is called off (as in WeWork), then the party who overpaid in the final private round loses (as happened in WeWork).

[11] See Gornall and Strebulaev, supra note 4. This article is forthcoming in the Journal of Financial Economics.

This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.