um that's great Today we're going to complete our discussion of private company valuation and the process. We'll talk about IPOs, what makes them different. It's kind of a lead-in.
And it's something we talked about in the last session. Let's re-emphasize. You have two companies.
They look exactly the same. They're in the same business, same financial practices, same metrics. One is privately owned and the other is a publicly traded company. Which one should have the higher cost of equity and why? Same company.
One is fully privately owned, one is publicly traded. Right. And the reason is?
Liquidity. No, but at this stage, for the cost of equity, there is no liquidity component, right? So you can bring it in if you want, but it's a fact that the owner of a private business can never be as fully diversified as an investor in a publicly traded company. It's one of the great ironies. You have an owner who's worth $10 billion, but all of the $10 billion is in one business.
I have an advantage over that owner, even if I only have $1 million, because I can spread my money across 15 companies, which means that owners worry a lot more about idiosyncratic risk. And we'll start with that today when we talk about that total beta, how we try to bring it in. So if you're advising the owner of a private business, we'll ask about what can you tell an owner of a private business to do that can reduce that idiosyncratic risk component.
Now let's talk about illiquidity. Obviously, there is this illiquidity issue. But one of the things I'm going to challenge today is the way illiquidity is dealt with in private company valuation is people value a company, and then they knock off 20%, 25%. Big chunks.
As the money, they say it's an illiquidity discount. I'll tell you the source of that discount, because as an owner, you're really pissed off, right? Because you've taken a million dollars off my value.
you claim, I'll show you where those discounts come from. And I'll also argue that it can't be the same discount for every private business. Let's see what, let's suppose I come to you with four different privately owned businesses and illiquidated in all of them.
But here's where the different, two are profitable, two are unprofitable. Already, I want you to think about where will the discount be greater, profitable or unprofitable. And the other is whether you're about to buy, you could be a long-term buyer or a... cash constrained buyer first if you look at those four businesses profitable versus unprofitable which one would you have a bigger discount on and tell me in in two terms why you want a bigger discount with the unprofitable company well if you have you know if it's unprofitable it's generating negative you which and the opposite is it's profitable i i don't have i get liquidity through the cash flows right think of a private business where i buy three times cash flows even though it's not liquid i can collect the cash flow each year in three years i get my cash back so i would expect the discount to be greater for unprofitable businesses now it doesn't matter who the buyer is do we all care about liquidity the same way you Not necessarily. If you're a long-term buyer who has no cash needs, you might view illiquidity as a lesser issue.
I think one of the biggest things you can arbitrage in markets to me, I'm going to take the word out. I know arbitrage is a very dangerous word, that you can exploit in markets as an investor is if you care about liquidity less than other people do. It's to me, one of the biggest competitive advantages you can bring to markets. Let's go back to November of 2008. the market was in shambles.
Financial service companies were decimated. And Warren Buffett stepped in and took two big positions, one in Bank of America and one in Goldman Sachs. The reason public investors were terrified is they said, if we buy these companies and things keep going and we want to get out, we can't get out.
They cared about illiquidity. What did Warren Buffett have that they did not? He was investing insurance company capital.
insurance company capital, actuarial tables don't panic on you. You don't need the money for nine years. You don't need the money for nine years without a crisis, with a crisis.
He could afford to take those bets because he didn't care about liquidity as much. So already I'm laying the foundations for when you attach an illiquidity discount, it can't be one number fits all. It's got to be a function of the company and the buyer. And you should be, if you're an appraiser, you should be glad about this, right?
Because if it's 25% of the value and your value is computed mechanically, chat GPT can compute the value. But if you have to actually figure this out, there's something you're bringing to the table. So I think of it as a good thing. And.
talking about illiquidity across time. Take any given buyer, there's an illiquidity at this kind of point in time. Will that change over time?
Absolutely. Here, I've given the example of 2008 versus 2013. You can pick a crisis time versus a non-crisis time. The reality is in the middle of a crisis, you care about liquidity, getting your cash back much more so than when times are good. So liquidity should not only vary across companies and buyers, it'll vary across time. And the way it's done right now, it does neither.
It's 25% off in the middle of a crisis, 25% no crisis, 25% for a long-term buyer, 25% for somebody who wants cash right now, 25% for a money-losing company, 25% for a money-making company. So we've got to think of ways in which we can come up with different liquidity discounts. Which brings me to my third question. Let's say you own a private business. You're tired of running the business.
You want to sell the business. We've talked about the cost of equity. We've talked about the liquidity.
If you're looking for a potential buyer, and I'm just thinking of groups, which of the following is your best potential buyer if you're the owner of a private business? It could be another private owner. It could be a private equity fund or a publicly traded company. Maybe it's unclear.
Holding all its conscience, who's going to be the one who pays you the highest price given your financials and why? If you're a private buyer, what are the two things that weigh you down? You've got a higher cost of equity because you're not diversified and you have liquidity concerns, right? If you're a public company, whose money are you investing? Shareholder's money, right?
You don't have to be diversified. Your shareholders can take care of it. So you don't have that diversification issue, the cost of equity.
And what happens to your liquidity? You buy this company, it becomes part of a publicly traded company, right? So if your shareholders need liquidity, what do they do?
They sell their shares. Neither liquidity nor diversification matters anymore. And this is, I think, if you think about long-term effects, what this will mean is private businesses over time will increase.
increasingly become either public businesses themselves or become part of public companies because this is almost inexorable. So you look at businesses like, and I give the example of pharmacies. 60 years ago, if you walked into a pharmacy in the US, the owner of the pharmacy was usually behind the counter.
They're all privately owned pharmacies. Today, I challenge you to find a privately owned pharmacy in New York City. You're going to see a CVS, a Duane Reade.
They're all publicly traded companies. And business after business, you're going to see this take over. You know what the last bastion for private ownership was?
Real estate. And even that's crumbling, right? What made real estate a private owner business was your knowledge was localized. You need to know how New York zoning laws work to buy real estate in New York. And the people who knew that were the developers.
And of course, they had the right connections. But increasingly, even that space is being invaded by public companies and private equity investors, diversified investors driving out undiversified investors. Any questions? Because today we're going to put some numbers on both of those. So let's go back to where I left you in the packet where we were talking about.
total beta. And I'll start with that page because we rushed it towards the end. And I want to make sure everybody's clear on what I'm trying to do. I'm trying to estimate what a completely undiversified buyer would see as the risk in a company.
The only problem is all my data comes from public companies. So you take a regression of returns on a stock against returns on a market index. The beta measures the portion of the risk that's market risk. But the regression also gives you an R-square. and by extension an R or a correlation, which tells you how much of the risk in the company comes to the market.
So if you have 50 software companies, you can get the beta for each one and the percentage of risk in each one, the R for each one. I average the beta's out in a cleanup for debt. I get the unlevered beta for the company.
And publicly traded companies, that's all I use. But with private businesses, I'm also going to average the R-squareds or the correlations and tell you typically in a software company, 40% of the risk comes from the market. You're getting the law of large numbers working in your favor.
And the example I gave, let's say your unlevered beta is 0.8 and your correlation with the market is 0.4, you as a private buyer, if you think in terms of algebra, are exposed not just to the 40% of the risk that gave you a beta 0.8, you're exposed to the remaining 60% as well. So all I'm doing with the total beta is scaling the market beta up to bring in the rest of the risk. For a completely undiversified investor, let me emphasize that. So as you get more diversified, you're going to start to see this effect kind of decrease. So in this case, for instance, if you remember the restaurant, I decided to go with high-end retailers for my unlevered beta, 1.18.
And I also got the average R squared across these retailers, or 25%, which in terms of correlation is a 0.5 correlation. 1.15 divided by 0.5 gives me a total beta of 2.36. Already you can see the implications of this, right?
Risk-free rate, equity risk cream stay the same. I double my beta. My cost of equity is going to be much greater. Why is it greater? because the buyer is not diversified.
Now, once you get the unlevered beta, though, I need to lever it up. And here I run into a second problem. It's less a problem, but a problem nevertheless. I need a debt to equity ratio, but it has to be a market debt to equity. With a public company, that's easy to get, right?
Market cap, total debt. But with a private company, there is no market equity. So I'll give you the choices you have. One is you can assume that your debt to equity ratio as a retailer or as a restaurant is going to be very similar to the debt to equity ratio of other restaurants.
You see the rationale, right? Restaurant business and the business model requires you lease the space. So basically what you do then is you take the industry average for public companies you applied and say, please, God, let this not be. I'll give you the easy problem is you have a private company that never borrows money. then your problem is solved.
You use a debt to equity ratio of zero. But if you have kind of this opacity, all you have book values, it's better to use an industry average debt to equity ratio, which is a market value ratio, than go with the book value ratio. There's another solution, and it does require some creative thinking. When you do a discounted cash flow valuation, you start with a cost of capital, you come up with a value for the enterprise, you subtract out the debt, you get a value for the equity, right? What if I take your estimated value of equity from your model for my debt to equity ratio.
You see a problem there, though? To get that estimated value of equity, I need the cost of capital. To get the cost of capital, I need it.
You're saying, this is a chicken and the egg problem, right? With Excel, there is a solution to the chicken and the egg problem. You check the iteration box, and you make the equity in your debt to equity ratio.
the equity you have in the denominator, but make sure you check that box because if you don't, Excel will go crazy on you, right? They'll start to draw lines and say, oh my God, everything's blowing up. But if you check that box, it'll actually estimate a debt to equity ratio that is consistent with your estimated value of equity. So you can either use industrial averages or that iterated value of equity, either sense you're getting a cost of equity.
So in this case, I went with the first solution. I used the debt to equity ratio for restaurants, 14.33%. And I came up with a levered beta for my restaurant of 2.56.
My cost of equity is risk-free rate plus beta times risk premium. So the risk-free rate and equity risk premium is exactly the same way I do it for a public company. But my cost of equity is 14.5%. I'll show you what it looks like for a public restaurant, but this number is much higher than the number you're going to see for a public restaurant.
So it's a little more work. to get there, but the same principles are driving me. The only difference is now I bring in total risk into my cost of equity rather than it's the market risk. Now for a cost of debt, I went looking for a rating, but let's face it, S&P is not rating some small restaurant somewhere.
So I had to do the alternative, which we use for public companies as well without a rating, which is to use the interest coverage ratio. Interest coverage ratio I came up with for the restaurant was 3.33. Based on that, you come up with a rating of BB+, which gives me a default spread of 3.25% in an after-tax cost of debt. So again, the fact that you don't have a rating doesn't stop you.
In fact, the way I construct, the way I think about cost of capital for a public company allows me to do this for a private company because I'm not constrained to find things that are only available for public companies. That's pretty much it. My cost of capital is a weighted average of my cost of equity and my after-tax cost of debt. I use the tax rate, an individual tax rate, rather than a corporate tax rate because the restaurant was not incorporated.
which means in New York State, your income flows through into your individual tax returns, which means your tax rate is much higher and your cost of capital 13.25%. Any questions on calculating beta, total beta, cost of equity, or cost of capital for a private company? So the one ingredient that you would see in a private company valuation that you would not in a public company is I have to give you that correlation.
Without that, you're kind of stuck, right? You can get the public company beta, but from there, you can't go to a total beta. If you go to my website, I do have the betas by sector, which you've been using, which are built into your FCFF Ginzo spreadsheets.
But if you go to my website, I also have a data set of total betas. And I'm terrified of how people use it because they don't look at the word total and understand. It's designed to estimate a cost of equity and capital.
If you have completely undiversified investors, you would never use it for a public company. If you have a private business where the buyer is completely undiversified, that'll give you a sense of what you'd be using. And those betas will be the average total beta across all companies is like 3.3. It's not one because you're scaling up the beta.
So that's step one. I've got a discount rate. It took me a while to get there.
Step two, I'm going to clean up the financials. There are two things that cleaning up involves. One is. converting leases to debt.
That principle did not change just because I do a private company. And in 2013, people were not doing this for any company. So I capitalized the leases, which replaces the lease expense with interest expenses and a depreciation amount.
I did bring in the fact that if I buy the restaurant and I can't cook, I have a problem. The food has to come from somewhere. So I have to hire a chef. And it's tricky. You can't go hire a chef, the cook at a McDonald's and say, it's a French restaurant.
So presumably the salary I'm paying is a reasonable one. So you better check around and what French chefs make, $150,000. That becomes part of my expenses.
It lowers my income. So that was the bulk of the cleaning up. So with private companies, don't take the numbers that you see on the page as a given.
You might have to do some cleaning up. That cleaned up number gives me operating income of $370 million. And that's going to become my base operating income. It's cleaned up for leases, bringing in the salary that I have to pay the chef.
And now I have to stop asking questions. I hired a French chef, but the chef who's running the restaurant has a name and connections. And it's the point that Isaac raised last week, last session, which is, hey, if I buy this restaurant and that person leaves, will the restaurant still be filled to the gill? Because I told you, it was at capacity. And this is tricky, right?
How do you assess what will happen if a named chef leaves? Any ideas on how you'd assess how much? You could run an experiment, right?
You could do surveys. But ultimately, you're going to have to make a judgment call. Here, I assume that 20% of...
the restaurant's revenues come from the keepers. Could that be 50? Could it be 80?
There's some business the key person leaves. They're done for, right? There is no value left because everything is personal. The more personal a business is, the more you worry about the keepers. That knocks out the 370,000 you saw on the previous page.
I've knocked it down by 20% saying, hey. I'm not going to make as much income, even though I've had a really good chef, because this person doesn't have the same rate. You're selling this restaurant, right?
And I'm doing this. What does it do to your value? When I knock off 20%, it knocks off the value.
And that upsets you. You want to sell it. Is there a way in which you might be able to reduce the key person discount? But the operating effect will still kick and you got to have a personal show up, right?
It's not that they want you want to be part. Now I'll give you an example. I used to have my four kids, all four were braces and we had an orthodontist who did just kids.
Name is Howie. And this is a sticky business, right? I thought you get, I've never had braces. I thought you get braces and you're done. It turns out that every month you have to go and they fiddle with the braces and they lighten.
So this is, and each time you go and they collect your money. So I got to know Howie really well. And so I take my kids and he said, can I ask you a question? I said, it's about teeth, don't ask me. He said, no, no, no, it's about finance.
So I said, okay, what's your question? He said, I'm planning on retiring. This is new. You're like 40 years old.
He said, I've made a lot of money. I said, I know. I can see it in my credit cards. And he said, I'm thinking about selling my dental practice.
And the numbers I'm getting from potential buyers, I mean, I'm making a lot of money. How come they're not paying it? And I said, Howie, you're a dentist. If next month I showed up and there's a new dentist here, it's not like I continue with the dental practice. I'm saying, where's Howie?
He's gone. I'm leaving too. And then he asked me the question, what can I do? And I gave him the suggestion that most of you can come up with.
What can, how we do to reduce that discount? One is, I said, you can sell the business and stay on for a year or two. What will you do?
Sit in a big armchair, make it a massage chair if you want. And every time a patient comes in, you lead them over to the dentist, you act like a best friend, say, you know, kind of. Now, often with personal practice, you get that overlap here with the. people selling the business will actually stay on for a while over that.
It's tough to do because you want to retire and move to Florida, but wherever you're going to move, I'm saying you can't do that yet. But with personal business, and of course, you want to make sure that the person selling the business signs a non-compete clause because your nightmare is the French chef sells the restaurant, you pay this price, then he opens the restaurant right next door. So you try to protect yourself as best as you can.
But whatever you do, there will be an impact on value. And just because you're having a private company doesn't mean fundamentals don't matter. Remember the point about to grow, you need to reinvest. And how much you reinvest will depend on what kind of return on capital you make. In this case, I estimated a 2% growth rate, the inflation rate.
You know why I had to stop at 2%? What did I tell you up front that's going to cap my growth? They were already capacity. Every table was taken.
And unless I can think of a creative way of increasing the number of seatings I get per night or open for lunch every day, which creates huge costs or maybe open a bigger, make the restaurant bigger. I mean, is it possible I could grow faster if I want to grow faster? I've got to bring in the capex needed for that. In this case, I'm going to leave it at the inflation rate of two percent.
This is because you're having it because the restaurant is open for sitting. That's a good question. Will I charge lower prices because the chef's gone?
Maybe that 20% drop will give me the capacity to then grow for the next five years. In which case you can put in the growth till you get to capacity. Or I'm going to cut prices.
I can't charge the prices I charge with the big name restaurant. So that's the other. So I'm not sure which way I will go yet. So for the moment, I'm going to leave it at the inflation rate. But even growing the inflation rate requires reinvestment, right?
Why? Because I would replace the oven in my kitchen every five years. That's going to cost me more because of inflation than it did five years ago.
To compute my reinvestment rate, I divide the growth rate by the return on capital, which is a number I can still get out even if it's a private company. I need a 10% reinvestment rate. I've got my cost of capital.
I've got my operating income. I've got my reinvestment rate. I'm ready to do the valuation. It's a stable growth, not perpetual growth model. And here, there might be a pause in the perpetual, right?
Private business, it might not last forever. So one thing you might say is, rather than make this restaurant go on forever, how many years are left in the lease? 25, I'm going to have it for 25 years, come up with the value, and then at the end, you're done. So bring in that flexibility with the private company.
Here, I'm going to stay with the perpetual growth model. That perpetual growth model. Using the adjusted EBIT and the cost of capital gives me a value of $1.449 million for the restaurant. But I have $928,000 in present value of lease commitments. I have to subtract it out.
And the value that I get for the equity after adjusting for the key person and the diversification, the lack of diversification of the buyer, is $521,000. So to the extent that the lease carries over to the new buyer, you're basically paying $521,000 to buy the equity of the share buyer. Now, what I haven't considered so far is the fact that if I buy this restaurant, remember, I'm an investment banker. I quit my job. I buy the restaurant because I've seen shows about restaurants and they all look glamorous.
And then I realized that running an actual restaurant is not that glamorous. There are things I have to do that I don't like doing. I want to go back to entering numbers in spreadsheets because the kitchen keeps breaking down.
The chef doesn't show up. Is it a liquidity issue, right? And I've got to factor. to that end.
The question is, how do you bring it in? So I'll start with what we did today, which is it can't be one number across the board. It has to vary across companies.
We'll talk about some of the things, healthy versus unhealthy, small versus large. It has to vary across time. You're in a crisis, the discount should be higher than if times are good. And it should vary across buyers. So you have to be adaptable.
So let's talk a little bit about illiquidity discount. Let me go back. to the way people do it, which is knock off this 20 or 25%.
Now, much of what you see in private company appraisal comes from a gentleman whose name is Shannon Private. He wrote the original book on valuing private business in the 1980s, and then he created a business around it, and appraisal is kind of built on it. So much of what you see as practice comes from what he suggested people should do.
And he suggested some good things, but he also suggested some really bad practices that have stayed in bed. And one of the practices was to knock off this 25%. And it almost like they made up the 25% and then they were looking for ways to back it up.
And there were two sets of studies that private company appraisers have pointed to repeatedly as to why the 25% is okay. The first is studies of what are called, because observing illiquidity. discounts means you have to have something we can see the price without the illiquidity and the price with the liquid illiquidity right and with there are publicly traded stocks which sometimes make restricted stock issues what are restricted stocks restricted stocks of stocks you buy where you're not allowed to trade the stock for five years so let's suppose i'm a company my stock is trading at ten dollars and i decide to raise ten million dollars with a restricted stock issue so i go to maladdin and say hey what restricted stock issue, you can't trade for the next five years, would you pay $10 per share, even though that's the current price?
Would you pay more or less? You'd pay less because I'm stopping you from trading. You see why restricted stock studies give you a chance to observe illiquidity?
Because when these companies make restricted stock studies, you can see the price at which people buy the restricted stock compared to the market price. And these restricted stock studies find discounts of 20, 25, 35%. There's a second group of studies that are more recent. This last 20 years, appraisers have started using this.
We know how IPOs work, right? There's a company announces an offering, there's an offering date, and on the date, the company goes public. In the months leading up to an IPO, though, you often find transactions where owners of the private business, because remember, before the IPO, it's owned by multiple people, Vc and other owners, where owners sell their stake.
to somebody else in the business. You can observe the price, you observe the IPO price, and then you take the difference and you say that's because they cared about liquidity. They wanted to get the cash out.
Those discounts are immense, 40, 50%. Now, if you're an appraiser, you want big discounts. Tell me why.
What is it about appraisers that make them like big discounts? They can do what? So that they can... undervalue all the assets.
Why do they want to undervalue them? Because usually when you're publicly traded companies or in mergers, the bias pushes you up, right? What is it about private company appraisal that your clients want you to give them a low number?
Most of these numbers are not for transactions. What are they for? Taxes, divorce court.
The client wants you to say your company's worth nothing. You say, great, amazing. That's what I wanted to hear.
So over time, private company appraisers latched on to this, put big discounts. And when the IRS said that number looks too low, you know what they did? We have studies, restricted stock studies that back it up 30% discounts.
But the problem with both these things is there's a selection bias that is monstrous. Let's think about what the selection bias is. We talked about companies issuing restricted stock, right?
What do they say the restricted stock is? A discount of 25-30%. If you're a healthy company, you'd be a lunatic to issue restricted stock because you're giving away equity at a huge discount. So guess what kinds of companies issue restricted stock?
Basket case companies. So after about 20 years of restricted stock studies being used in courts as justification, finally, the IRS decides to spend enough money to hire a statistical expert who came in and looked at these restricted stock studies to see the extent of the sampling bias. And he looked at the studies.
He said the discount is 30%. You're right. But if you control for the fact that these are trouble companies that essentially, you know, and money losing companies, he said about seven or eight percent of this discount is for the illiquidity. The rest is for the fact that they're just bad trouble companies.
I mean, you have to ask, why did it take the IRS that long to come up with it? But, you know, they were bureaucrats. They said, I wouldn't want to pay $100,000 for an expert witness.
Find me one in the street for $500,000. And the courts actually said, you know what, that makes sense. And courts being courts, what do you think they allowed as a discount? 30% the appraiser, 8% the IRS.
They went right down the middle. This is why we get into trouble in court systems. Each side pushes it. But finally, this restricted side, that's why you turn to IPOs. And IPOs have a different selection batch.
Because every company that announces it's going to go public, actually go public. Not necessarily, right? So how do these studies work? They start with companies that actually went public and they work backwards looking for transactions. If you wanted to make the study statistically unbiased, you know what you need to do, right?
Start at the front end. Look at all companies that announced that they're going to do an IPO. Look at transactions in all of these companies, including the companies that don't go public.
And guess what? You're going to see that. You're going to see a transaction price and then you're going to see a drop because when they don't go public, the price drops statistically again a problem and when i you know when i've made this argument 20 years ago we said what choice do we have i said no they are there is actually a much larger sample you can use on illiquidity every publicly traded stock has an illiquidity discount right you buy apple and you sell it instantaneously even though the price did not change you're going to leave some money on the table. Not the brokerage cost, but what's the cost I'm talking about?
Try it. In fact, after class, buy a stock, sell it instantaneously. You won't get your money back. It's a bid-ask spread. It's tiny for Apple.
It's 0.1%. But you try this on a Nasdaq stock. Don't do it with real money. Do it with other people's money. You could leave 15% or 20% of the money on there.
You can have a... bid-ask spread of 50 cents on a $2.50 stock. So when you buy, you pay 250. When you sell, you get back $2.
I said, we have an illiquid discount in every publicly traded company. Why not look across these companies at what that discount, what causes that spread to vary across companies? I'll come back and show you what the results are, but I'm going to milk this restricted stock study at least one additional step. So even if you're an appraiser that says, I'm going to go with restricted stock studies. They gave me a discount of 25%.
What struck me as strange was how many of these studies computed a median discount and then threw all of the data away. I don't know whether you're familiar with Bill Silver. Bill used to teach the foundations class.
He was a legend. He taught for 30 years. He used to teach the foundations classes before me.
Bill Silver did a lot of research in his lifetime. But he laughs about the fact that his most quoted studies, a study he did on restricted stocks, kind of a throwaway study during the summer. And here's what he did.
He looked at the discounts on these restricted stocks. So basically, you know, what you have on the left side is one minus the discount. So think of that as the inverse of the discount.
And then he looked at why the discount varied across different restricted stock companies. In other words, he used all the data, kind of amazing concept for people who think about data. And he ran a regression where basically he said, I can tell you what the discount is as a function of how big your revenues are.
It turned out that companies with higher revenues have a smaller discount than companies with smaller revenues. He found that it depended on how much of the block you were issuing. Were you issuing 5% of the shares? The larger the block, the bigger the discount. He also found that if a company made money, put a 0-1 variable, if he made money, put in one.
that the discount was greater if you're a money losing company than a money making company and finally also was checking to make sure that there was no secondary relationship where you're getting money on the side on a different transaction whether you're a customer yeah if you use more stock then the probability of having more liquidity inside like you have so many issues probably 30 of its blocks but it's restricted so you get the 30 block so would you demand a bigger discount or a smaller discount now that you did for the year you can't sell what i've heard about you It used to be two years. So whatever it is, this bigger block, you have more danger over the next three years. If terrible things happen to your company, you can't get out.
You have a bigger slice of the company, the discount. I took that regression out and I said, look, I want to focus on one aspect of this regression. Remember the median discount is 25%, but you have big companies and small companies.
So what I did was I held everything as constant, looked at based on the regression, what would happen to the discount if your revenues went from $5 million to $10 million to $1 billion in revenues. Intuitively, I'd expect the billion-dollar revenue company to have a smaller discount than the $5 million company. I also looked at what would happen to the discount if you're a money-making company, that's a purple column, as opposed to a money-losing company.
So if you're an appraiser, you see how this helps you differentiate across companies. I come in, I'm your first client. He asked me, what do you know? He asked me about, so I have five million revenues, I'm a money losing company.
My discount is going to be almost 35%. In contrast, your next client comes in, making a billion dollars in revenues, the money making company, your discount is going to be closer to 15%. So actually that regression can be milked to actually give you different discounts for companies based on their size and based on whether they're money making or money losing. So even if you're a true believer in restricted stock discounts, it's no excuse to use 25% for every company, at least adjust the discounts for the size of the company and the health of the company. And this is the study on IPO discounts.
And as I said, when I looked at the study, I said, no way. I don't believe these numbers. I mean, let me ask you a question.
You're a VC in a company. You're expected to go public in two months at $50. If you believe the study, you're actually selling your shares for $25. What universe would you agree to that?
Which leads me to believe that there's something wrong. Anytime you see a research study that delivers a result that just doesn't pass the smell test, the question you're going to ask is, what is the study missing? There's always a sampling issue you can go back to. And as I said, the sampling issue here is, you're not capturing.
all IPOs, you're capturing the subset of companies that actually carry through on their IPOs, you should be expanding the sample up. I remember saying this, and are you doing the study? I said, I'm not interested in this. You're the guy's interest. Do it right.
I mean, I'm not, you know, if you want to use an IPO study, you have to carry this. So the sampling problem is immense in both these cases, which means I wouldn't trust either of these studies further than I can throw them because they don't tell me much about it in the public discourse. As I said, I went to the public market. I'm going to look at every publicly traded stock. You can't accuse me of being biased.
I'm looking at every publicly traded company. And I regress the spread as a percentage of the price. So think of that as the illiquidity discount for a public company as a function of the level of revenues, whether the company is making money or losing money, how much cash the company has.
My argument is the more cash you have, the smaller the discount should be, and how much trading volume there is. the stock. I wanted to pick variables I could get for a private company. So if I take the company that we're looking at, I plug in its revenues, the fact that it's money-making, how much cash it has, and the fact that it never trades. Think of a private company as a public company that never trades.
I get a predicted bid-ask spread as a percentage of the price of 12.88%. I now have a mechanism where if you tell me the characteristic of a private company, I use this regression to get a predicted spread. That predicted spread is going to be different across companies and effectively give me a discount that varies across companies. So you look at the three different approaches, I get very different discounts.
So I use the bludgeon approach. This is the way it's standard approach. Knock off 25%.
I pay $391,000 for the company. If I use the silver adjustment for the fact that the revenues are relatively small, I actually get a bigger discount, $371,000. But if I use the bid-ask-spread approach, the discount I apply is much lower because I think it gives you a fairer sense. It doesn't start with this flawed number that comes from restricted stock studies in this room.
So if any of you end up in private company appraisal, you will see this liquidity discount pass your desk. Now push back, push back on the number, especially if this big chunk of your value disappearing. If you're selling your business, you definitely should be pushing back because you're leaving money on the table for something that is really made up.
Any questions on illiquidity? Yes. Also, I've seen this in the dead market.
The dead-ass brothers. It depends again, right? The debt market across bonds, you would see variations across bonds. A high yield bond, but there's relatively little trading volume.
The spread can be much wider. If it's a high yield bond with very high trading volume, so it's basically a function of liquidity, the kind of bond you're looking at. So in any asset, the bid-ask spread is really an illiquidity discount. That's the way I think about it. The more illiquid an asset becomes, the larger that spread will be.
In fact, it shows up when you compare bid-ask spreads across countries. The bid-ask spread of an... typical Turkish stock is much greater than the bid-ask spread of a typical US stock as a personal price.
It's an illiquidity issue. So that's the first scenario, private to private. You can see all the hoops you got to jump through, the diversification hoop, the illiquidity hoop, the key person hoop. Let's take the second scenario, private company being sold to a public company. Let's go through the pieces.
When I use a discount rate to value the company now, what should I be using? I should just know. Remember, the public company has investors who are diversified. I should be going with the market beta.
What about the liquidity? Not an issue anymore. It becomes part of a public company.
Investors have liquidity by selling or buying their shares. So here's what I ended up with. There's my private company valuation.
There's my public company valuation. Private company, my cost of capital is 13.25%. For the public company looking at the same company, the cost of capital is 8.76%. coming primarily from the fact that I'm replacing a market beta with the total beta.
Will that have consequences? Absolutely. Sold to a public company, the value that I get, because I don't have the liquidity discount anymore, and I use a market beta, my equity value goes from $453,000 or $454,000 to almost one.
I've almost tripled my value of equity because I've found a better buyer. It's great, right? So you are the restaurant owner. trying to buy. You estimate this on paper, the public, and you have a public company sitting on the other side of the table.
Arc restaurants, they're interested in buying. So you start your bidding at, no, I think my company's worth 1.484 million. Here, Arc, what are you going to push back with as you counter?
You say, I think it was only 453,000. And who's going to win? this battle.
Depends on whether you're the only buyer in town or whether you have multiple people interested. If you're the only buyer in town, guess where we're going to end up? We're going to end up close to $454,000. And you might be generous, throw in an extra $50,000. I'll be generous.
I'll pay you $514,000 or $550,000. And you can see how both sides walk away thinking they've accomplished a win, right? As a private company seller, I thought my company was worth $514,000. because I hang out with people who pay that multiple. You're paying me a premium.
So this is amazing. And you walk away with a win because you got something that you should have paid one. Now, when we talk about M&A, I talk about the sorry history of how much value M&A has destroyed over time. But there's one bright space in M&A where you can get success.
Now, where you have private companies that get rolled up to become a public company, Blockbuster, Browning Fairs. Because essentially you're doing exactly this on private company after private company. And your value creation comes from the fact that you're replacing undiversified owners with diversified owners.
And the other is public companies that go out and buy private businesses at a negotiated value and effectively end up doing the same thing. And this is the basis for where that added value comes from. Yes. So where does, because it's almost, it's more than three times the real estate. So first I'm replacing the 13.25% cost of capital with an 8.76%.
That's a huge shift to the cost of capital, right? That alone pushes up my value from 1.449 million to 2.4 million. Remember, it's a levered firm.
The increase in value more than proportionally increases my equity value. And then remember the last step where I knocked off 12.88%, that's gone too. Because for a public company, there is no liquidity discount.
And because of capital going down so much, it's just because they're invested in the diversified. They look at only the market risk, right? I mean, so basically in a capital budgeting project, we do the same thing in a publicly trading company.
We focus on market pay because our investors can get rid of the company's specific risk. Question back there. Yeah. So like say a private PE firm versus a public, is it because of their fund structure? A private what?
A private PE firm versus a public. Because think of what success looks like for a PE, right? If you're a PE and you're investing in all these businesses, How do you define what do you measure success with? Well, private funds.
But ultimately, how do those funds make money? Those investments you make in individual companies, you collect cash flows while you hold them, but those are not much. You make money when you exit.
How do you exit? You either exit by taking a private company public. Often they take a public company private, they fix it, they take it back public, or they take a public company private and they sell to a public company.
Definition of success for a private equity fund is you buy the company at a low enough price and you flip it to the public market. After you fixed it, you hope to make money. No private equity fund can succeed if it keeps every business it invests in as a private business. You kill yourself as a company. You got to exit and move on.
And that exit has to be to a public market investor. But if you're a public, do you have to do that? You still do that. That's how the KKRs and the Blackstone do it.
That's their business model. Right. So if you think about Coca-Cola making beverage, the way I think about KKR and Blackstonetone is their value added comes from their capacity to create transactions where they buy at a low price, flip at a higher price.
Because if they're getting just a fair rate of return, then I've got to pay much less for these companies. So that becomes a competitive advantage is we can do that. And they might be able to have a competitive advantage against other PE funds that are competing for the same deals.
Yes, I see. But doesn't their necessity of selling at a certain point in time? drive a discount of the buyer because they're very need to sell no but they're investments but but it's not a liquidity issue you're selling because you know it's not it's not because you need the cash you're selling because you fix the company enough that it's ready for a public market consumption let's take a classic pd right you take a public company it's badly managed badly run mango you buy the you buy it at a low price because people think this company is not going to make it right so you buy the company then you spend two or three years fixing the company, right?
Maybe lowering the debt ratio, selling off the unproductive assets. Now the company is ready to go back as a debutante in the ball. You take it to the market.
So it's not a cash requirement that drives the exit. It's when the company is ready. That would at least be have like certain times.
It's a pricing, but it's a pricing game. So it's not a liquidity game. It's a pricing game, which means if you get the timing wrong as a private equity investor, because You're dependent on what the market is willing to pay for the company.
If you get the timing wrong, it can kill you as a company. You buy when the market's high and you try to exit when the market is low. It's going to be very difficult for you to make your money back.
So it's less a liquidity issue than a timing issue. Private equity investors are basically traders who add this added ammunition of, I'm going to fix the company before I trade. Yes.
Well, I mean, I was just wondering about the private equity firms. that funds are tied up from investors for five to seven years. And I guess they do kind of have their hands tied that they have to return that capital.
Which is why when you invest in many private equity funds, as a client, what are you often required to do? They lock your money up. You can't take your money out. So basically, they lock in the money so they have the access to the capital.
So if they did not, you'd have a problem, right? Because your clients want to leave, then you need to look, see, you need to be able to time your exit. And if you have clients who can pull out early, then you have a problem.
And that's why they put constraints on when you can leave the private equity. Right, but what if that timing was wrong? You're screwed.
You're screwed. Anybody thinks private equity, so what does the average private equity investor make, you know, on an annual return basis? relative to the S&P 500?
Roughly the same. I mean, that surprises people because you think private equity, they must be more successful because there's a success skew here, right? Because there's a failure rate that you don't even see private equity funds that fall off. The ones that succeed obviously will be the ones that beat the market. We tend to focus on those.
Collectively, private equity is not a great active management model either, right? It's, I mean, it requires work and activity. But if you look collectively at private equity, the reason they earn the S&P 500 is because they often get it wrong.
So let's talk about private company for an initial public offering. Here, basically, you know, you ever valued a company just ahead of a public offering? What's a document that you have to file if you want to make an IPO? It's called a prospectus, right?
It looks just like a 10k or an annual report. It is all the same structure. You have to follow the same accounting standards.
So already your life gets a little simpler, right? because the numbers are easy. And who are you planning to take the company public to?
The market. So who's the potential investor? You know, potentially a diversified investor. It's not your problem they're not diversified.
They chose not to be diversified. Already you can see valuing a private company for an IPO is a relatively simple exercise. A couple of quirks, because you're going to follow exactly the same practices that you do for a public company with a couple of adjustments. We'll talk about the adjustments.
So here's my valuation of Twitter on October 5th of 2013. This was about three weeks ahead of their actual IPO. So they filed the prospectus. I try to value companies right after they filed the prospectus and before an offer price gets set.
Because this is about as close as you can get to an experiment of how much bias does curing a price. have on your valuation. You know what I mean by that?
You value publicly traded companies. Is there a bias? Yes, because you can see the price. When you value NVIDIA, whether you like it or not, the fact that the price is $850 is out there. You can't make it go away.
So this was a valuation I did before an offering price got set. So I valued it as an online advertising company. And the story I told was that it would be a successful online advertising company. Obviously, got the successful part wrong because it's still struggling to make.
money, but it'll never be a Facebook or a Google. So even in steady state, even in success, because people don't spend that, the intensity of users is not as deep. The value that I came up with, with the traditional discarded cash flow model, and this is my FCFF Ginsu spreadsheet, revenue growth margins, reinvestment looks just like a traditional company.
The value that I got for the operating asset was 9.6 billion. So, so far it looks just like a traditional DCF. I subscribe, I added cash. And then there's this one adjustment, and we'll talk about this more.
When you do an IPO, what do you do on the offering day? You actually issue new shares to the market, and you get cash when you issue those shares. So the minute after the IPO, you have a billion dollars more in cash than you did before.
That cash is added on. You're saying, but that cash is to cover reinvestment in the next three years. Absolutely. That's exactly why it needs to be added on. Because in my discounted cash flow valuation, that reinvestment is creating negative cash flows.
You're just raising the cash up front. And there is a bonus you get as a company. Your failure rate before you do this is going to be higher than the failure rate after. You see why?
Because a minute after the IPO, you now have a billion dollars in cash. You can use it to cover your cash needs. but I'm going to add the cash on.
We'll talk about those proceeds because companies, when they issue the offering date, do they have to keep it as cash? What other things could they do? One is you can let owners cash out.
Spotify did that on their IPO. Basically, they're offering some of the owners cashed out. In which case, the cash is, your company doesn't even enter the project.
It's almost like a conduit. You could use the cash to pay down debt, right, if you have existing debt. So basically, there are choices. We'll talk about what to do with each of them.
This is the most common, though. You raise the cash, you keep it in a cash balance to cover your reinvestment. So I added that cash. And then I subtracted debt to get a value of equity.
And here things get a little messy, right? Because remember, this is a company that's just debuting in markets. I mean, it can have seven or eight or nine different classes of shares at the time of the offer.
You can actually tell how many VC rounds a company has gone through by looking at the classes of shares they've created, because each VC round often creates a unique class. Facebook, when it went public, had 13 different classes of what they call preferred stock, which is a really common stock issued to Vc for different jobs. Luckily, in IPOs, most of those preferreds get converted into either a single class or two classes.
In this case, I got lucky. Twitter had only one class of shares. We'll talk about what to do if you have voting shares and non-voting shares like Facebook did, but I don't want to buy the shares.
I subtracted out the options that had been created along the way, because remember, they don't go away. Vc and employees have got options. Those options get rolled over, restructured in the new company. It looks like... a traditional valuation, but let's focus on the things in an IPO that can make them quirky.
First is the use of proceeds. How will you know what the proceeds are going to be useful? Read the prospectus. It has to be there.
Legally, you have to tell investors what you plan to do with the proceeds. And as I said, and that's going to drive how you deal with the cash. Second, look for any warrant special deals that the company has entered into with VC because they could get carried over because you have to factor that in. So those are the valuation issues.
And there are a couple of pricing issues. The way most IPOs are brought to the market is you have an investment banking syndicate. Usually a syndicate because there's a lead investment banker, but you get it because you want to sell through as many investment bankers as you can.
That investment banking syndicate actually guarantees. guarantees and offering price. You see, that's amazing. We'll talk about the consequences of having that underwritten price because it changes the way investment bank has actually priced IPOs. You give me a sense of direction.
You're an investment banker. You want to guarantee a price. Are you going to underprice the IPO or overprice the IPO?
You're going to underprice it. We're going to look at what that underpricing is on average and why it still might not be enough for an investment banker to do that. cover your mistakes over the long term. And second, when you have an IPO, remember, this is not the end of the game.
You don't issue 100% of the shares at the time of the IPO. You might have other things coming down the pipe. One is what's called the unlocking, which is Vc often are not allowed to sell their shares at the time of the IPO.
You have to hold for six months or a year. And this becomes this big thing. Stocks unlock next week. What's going to happen to the stock price?
We'll talk about the consequences. So let's talk about the valuation issues. You got these proceeds. What do you do about them?
Again, here are the choices. They can be taken out of the firm by the existing owners, the Spotify case. In which case, what should you do with that billion in cash?
Ignore it. It's got nothing to do with the company. It can be used to pay down debt. Where would that show up in your valuation?
But the only place we have debt in our valuation, our cost to capital, the debt ratio used and the cost to debt should reflect the fact that now you're going to become a safer firm and maybe a lower failure rate. So you don't have that debt hanging over you. Or it can be held as cash for future needs, which is the most common scenario, in which case you should add that. In VC investment, this is the distinction between pre-money and post-money value.
The post-money value is the pre-money value plus the cash infused into the company. And this is a post-money valuation because that's what you're buying shares in. So just be consistent.
Check to see what's going to happen to the proceeds. Ignore it. Add it on. Lower the debt ratio, whatever's going to happen, and let it flow through. In the case of Twitter, one of the things I was uncertain about is how much they plan to raise on the offering day.
But the answer is usually in the public domain. They kind of roll these numbers out. It comes out usually as the investment bank expects to.
And at least based on the stories, that billion dollars came from a story. Because remember, on October 5th, I don't know exactly what price you're going to offer at, but I have a rough sense of how much you're trying to raise. That's critical because I need that billion to add on to my cash. So I've added the billion to my estimated value because I plan to raise a billion and keep it as cash. to meet reinvestment needs in the near future.
Any questions about how to deal with proceeds in an IPO? Yes, David. So when they say they want to raise $1 billion, let's assume it's for three of those, the three things you said, like the correct one.
Let's say there's, does that mean there's, let's say a thousand shares and they only... The share count is not set yet. That's why share counts are kind of floating when an IPO with a...
prospectus comes out because there's a loop here. If you expect the price to be 25, you've got to issue 40 million shares. If you think you can get 40, you can issue 25 million shares. So it's almost like the share count will shift.
So what bankers target on that first day is not the number of shares, but to get the proceeds you're looking for. And how many shares you'll have to issue on the date will depend on the offering price that the banker actually sets. So the share count, in a sense, has to stay kind of fuzzy until that happens. Yes. For debt, when you also have to change all the cash, what's your film for?
For six months? Remember, this is the nice thing about working with free cash flow to the firm, right? It's a pretty dead cash flow. And with IPO, stay with free cash flow to the firm.
You don't want to go free cash flow to equity precisely for that reason. We have no idea what debt payments are going to look like. If you're an equity investor, you don't have to buy it.
like risk the domination of the cash flow the only reason you might it matters it might affect your failures right as an equity investor you can value the firm and subtract our debt right you should get the same value for the equity but the fact that your debt might mean your free cash loss equity can be negative might mean that your failure risk that you've got to factor in that in fact is evaluation your failure risk does right But that's not a cash flow effect. It's a failure risk effect, which is I might not have the cash flows to service my debt and become a going concern. That's why I said keeping the cash and having it as a cash balance changes that failure risk.
Using it to pay down debt changes that failure risk. So your choices that you make after have consequences for failure risk. Now, as I said, there are claims from prior investors. You've got to clean up for them, whether they're option claims or traditional stock claims, restricted stock. I mean, prospect.
I mean, this is to me one of the most nightmarish things in an IPO is actually getting the share count. And you say, why can't I go on Yahoo Finance? It's amazing how many different numbers you would see as a share count for a company at the time it goes.
But it's a huge issue, right? Because you get the share count wrong, your value per share, everything gets thrown off. So here's what I did on Twitter. I looked at their prospectors. They listed out the fact that they had seven classes of convertible preferred shares, which is Vc.
favorite security. It allows them to have their cash and control and all the recent stuff. But it also tells you there have been seven rounds of VC because each VC round creates its own convert.
They had 86 million restricted stock units, mostly given to their employees. Why? Because they didn't have the cash to pay their employees.
They had 44.16 million of employee options. Again, why? Because that's the way they kept employees.
And they'd agreed to pay in an acquisition, this company called Mopub that they're going to bring into the platform, 14.791 million shares. They hadn't issued them yet, but remember, as an investor, I've got to factor them in. So I counted everything but the options in my share count, restricted stock units of 14.791 million. Now I could have finessed it because those restricted stock units, some were not vested yet, and you can play a game of probability.
I usually don't. I just count all of the RSUs because the big grants tend to go to people who are going to stay around. The tiny grants, they might walk away, but who cares, right?
So all shares are not options. The options I keep separate because I can value them as options. So this is not that different from a publicly traded company. It just takes a lot more work to get to that share count because it's still in the process of being created.
Which brings me to that investment banking guarantee. This is the history. For the last century in the US, this is the process that companies have fallen.
And 60 years ago, 50 years ago, even 30 years ago, investment bankers were keen to go in public. Why? Why were private companies so dependent on having investment bankers at the center of the process?
Let's list out all the things that investment bankers provide as services that private companies value. Before that, even when you went in, most private companies, I don't know what my value is. They thought investment bankers actually knew how to value things.
It's a delusion. But no, investment bankers actually said, you're worth it. We have these analysts who've been looking at stocks.
We can tell you. So they thought investment bankers could price their company better than they could. Second, you need the selling, right? You don't have the people.
Because in the old days, people would get on phones, call investors. special clients and say, well, do we have a deal for you? IPO coming up, they're selling services.
Third, there was a credibility story, right? Most private companies, you'd never heard of the company as an investor. Goldman Sachs was the investment bank. Goldman Sachs is saying that it must be the companies that offered credibility.
And then you offered what we'll call post-market services. What does that mean? After the company went public, the investment bankers would come in and provide support services.
Your price started dropping and buy the shares. This is so generous of investment bankers. In return, what would they take?
That 100 million you raised in the offering day, they would take 6%, 8%, 10%. So this isn't a freebie. And you paid a price for it. And that model is breaking down.
We'll talk about, first, this investment banking pricing guarantee and why it's close to worthless. Now, let's suppose I'm a realtor. And I said, look, I'll be a realtor and I can guarantee you a price.
And you say, what's the price? I'll tell you later. But you pick me, I guarantee you a price.
What's the value of a guarantee where I don't specify the price before I guarantee it? I could deliver a price of $1 for a million dollar house. Guess what?
I could deliver the dollar. A price guarantee is meaningless unless you tell me at what price. And not surprisingly, investment bankers underprice IPOs.
By how much? By about 15%. And the key word is they price it. They don't value it.
Why? Because their job is to sell the shares. So I don't blame bankers for pricing IPOs.
I blame them for using DCF models and acting as if they mean something. They price the company. The context of Twitter.
What does this mean? Remember we talked about how much the market was paying per user in 2013? I showed you that table, about $100 per user.
If you're a banker pricing Twitter, the best pricing you could probably get is take the 215 million users multiplied by $100 per user, and you'd have got a closer number to what you could price the company at. IPOs are all about pricing and coming up at the price per share. But let's say you come up with a price per share that you think is a fair price, given what people are paying.
You can't guarantee that price, right? Why? Because if you guarantee that price and something goes wrong, you've got to cover the difference. And something goes right, you get none of the upside.
So, again, it's understandable that IPOs get discounted. This is a study that looks at what happens on the offering day. Because remember. When you start trading, all you know is the offering price, $20.
But on that first day, all hell can break loose. You can go to $45, you can go to $15 because the market sets a price. This looks at the return on that first day of trading across IPOs.
And no surprise, across IPOs, most IPOs, you see a jump in the price, roughly 15%. Now, as an investor, what's your next thought? I should just buy a thousand shares in every IPO that's coming for the next year because this 15% is a great return.
So what's the catch there? Why is it so difficult? So the evidence clearly indicates that across IPOs, there is this jump on the offering day. Why is it so difficult to monetize that as an investor? Yes.
One is there is this client effect, right? Only private. I remember when Roy Smith, who used to be Goldman Sachs'managing director, used to teach here.
And he came to me the day of the Twitter offering and he said, I got a call from Goldman asking me, have you got a call yet? I'm not on the list. Roy, you're on the list, right?
There's a preferred list and you got this at a discount. So that list has become much wider now. So you can, if you want it, apply for shares.
So let's say you apply for a thousand shares in every IPO that's going to come. the next year. Will you get a thousand shares in every one of the IPOs? You're going to get a portion.
You will get a thousand shares in some of the IPOs. You know which ones you're going to get all of the shares? In the IPOs you did not want a thousand shares, right? You're going to get a thousand shares in every overpriced IPO and the more underpriced an IPO is, the fewer shares you get.
This is why historically people have looked at, can you make money in IPOs? When you look at those frictions, It turns out that you don't make that much money after you've taken into account all those. Doesn't stop people from trying.
I know mutual funds that are built around, oh, we're going to make money in the IPO studies. But what they haven't done is what does that mean in practice? Why is there such a slip between the cup and the lamp?
Now, the other, the original in this study, these studies first came out, it's called the IPO pricing puzzle. The first puzzle was why do bankers price? The answer is obvious because that's in their incentives. The other puzzle was, why are companies OK with this? As the issuing company, what's happening when you get underpriced?
I mean, imagine a stock that doubles on the offering day. You should be really pissed off as the Vc and owners of the company, right? Because those people who bought the stock got the doubling of the price. It's not coming to you. So how come companies are OK with this underpricing?
Larin, do you want to try? But what is it that makes lead? You're the founder of a company.
I'm your banker. I've underpriced you by 15%. You're a $10 billion company. That's a billion and a half I've left on the table, right?
Right. Is that true, though? There's an uncertainty to it.
It's not just that. What exactly have you left on the table? Is it on all your shares?
It's the shares that actually got issued on the offering day that you left the 15% on, right? So when you think about the fact that only 10% or 15% shares are offered on the offering day, you're giving up some of the money. But what do you hope to get in return?
What happens the day after Wall Street Journal has a headline? What does it say? Stock jumps 30% in offering. Other people read it. And then what do they do?
They go and buy. And then they push the price up. And then you're hoping and praying that six months from now, a year from now, when you have to unload that bigger offering, the price stays high. This is this collective.
You know, in retailing, there are these loss leaders where you basically sell things for below cost. And then you keep sucking people deeper and deeper into the store. So by the time you're done, you're in the Ralph Warren section.
and you're paying way more than you should, and they hope to make up the money. Think of what happens in the offering debt. These charts were not in the original slide, but I decided to put them in because the IPO market is changing. It's changing in ways that I think are going to change the way IPOs get done.
This is actually a look at what a typical public company raises, looks like, look like in 1980, 1990. And so it looks at two statistics. One is the revenues of a company when it goes public. And the second is the percentage of companies that are profitable.
So if you look at 1980, the typical company in public had revenues of 50 million and almost 90% were profitable. Microsoft, Apple were profitable companies when they went public. You look at, especially in the last decade, the companies when they go public are much, much bigger in terms of revenues, but they're much, much less.
likely to be profitable. Yes, David. Why do you think that's happening, though? What's happening behind this that is causing the shift?
So in the early 1980s, what caused companies to go public? Vc had limited capital. Your business model got built.
The only way you could scale up was to go public. Well, you could even if you adjust for inflation, that difference is too large to be explained by inflation. There's a gray space now, right? In the 1980s, it was you were private, you got money from venture capital. You were public, you got money from investors.
But think of an Uber and think of the decade that they stayed private. And during that decade, who did they raise money from? They ran out of Vc very quickly. they went to the Saudi Investment Fund and T.
Roy, Private and Fidelity, you actually have this gray space in the middle that allows companies to stay private, raise capital at public market rates pretty much because those investors, investors of their public market investors, have none of the disclosure requirements and corporate governance restrictions of public companies. We're creating some monsters in this gray space. And then they go public. And the problem is They've had so much capital coming in, they've had no incentive to build a business model. Nobody's asking, can you make money?
Because everybody's thinking about the exit. We're going to go public. We're going to cash out. Who cares whether you make money?
Let's just scale up. You know, it's, to me, a very, very destructive development because it's allowed these companies to scale up with our business models. David?
But it's all a cycle because here it stops at 2020. 2022 was when the cycle stopped. You know when? Risk capital kind of pulled back, right?
But that was a cycle that creates long-term damage because during these 15 years, while we fed these companies capital, Uber, for instance, what did they go out and do? Destroy the status quo, right? Let's say we made a mistake that Uber and ride-sharing is a terrible idea.
What the heck are we going to do now? How do we put the genie back in the bottle? If tomorrow Uber and Lyft went public, how the heck are you going to get from the airport back home? There aren't enough taxi cabs to get you home. You can't start the taxi cab business up from scratch by giving this much capital to private companies before business models.
When did disruption become a good word? I mean, I remember when I was in school, you know what happened to the disruptors in my classroom? Well, finally, they went to jail. But when you're seven, they were put in the corner.
Ten, they were sent to the principal's office. Now, disruptors were not exactly glorified, right? Because they got in the way of getting things done. Somewhere 15 years ago, Silicon was a disruptor.
I'm a disruptor. My reaction is go sit in the corner, put a dunce hat on. But we celebrated disruption for the sake of disruption.
That's the worst part of it. And we supplied capital to disruptors, not as it was. Does this make sense?
So that's the first thing. And the second thing, and so as these IPOs change, you're also seeing the traditional model breakdown. What does a bankers do for you?
First, they price companies. What have we learned about bankers? They're not that good at pricing. They screw up really badly. If your price doubles on the offering day, you're not even doing a basic pricing job.
Second, you add credibility. There was a day when Goldman Sachs was credible. And today, I'm not sure whether adding Goldman Sachs to my name makes me more credible or less credible, right? 2008 broke that trust that bank, investment bank knew what they were doing.
And if you have Facebook going public, more people had heard about Facebook in 2013 than Goldman Sachs. Many of these companies going public have. higher profiles because they live in an online space where people recognize them. I don't need your pricing.
I don't need your credit burden. You say, what about the selling? Who gets on a phone and calls people anymore?
Your biggest selling might be happening on social media and people picking up the buzz on your stock. You say, what about the post-market stuff? Remember, what bankers can offer in the post-market is very limited.
They don't have the capital to support your price if it's dropping 20% a minute. Bottom line is, I'm not sure what bankers are offering you for the 6%. And especially in the last decade, you've seen two alternatives to the banking one. One is what Bill Gurley has pushed for, which is, why do we need bankers?
Why don't you just directly list without an offering price and let demand and supply on that day set the offering price? You don't have to pay the price. You don't have to. pay people to price it. It's demand and supply.
After all, that's all that happens. Why create this artificial price? The problem right now is the way SEC looks at direct listings.
If you make a direct listing, you're not allowed to keep the cash on your balance sheet. You have to pass it through. So it's a regulatory restriction.
So direct listings have not quite taken off. The other one. Yeah, go ahead. Previous. Yeah.
I just wanted to. Oh, you want to write something? You can download. I put the slides into the new.
No, no, nobody has it because I just put it in before class today. So if you go, but I downloaded the updated version. So if you go back and download the same slides, they should now show up.
The two pages will show up. But I also have a blog post on the IPO process talking about these developments over time. So direct listing. There's another development that started about five years ago.
There is. I thought of horrendously badly thought through called SPACs. What does a SPAC do?
I create a SPAC. Chamath Palapatiya, he creates like 50 SPACs every 15 minutes. A SPAC, basically what I do is I take your money first. I plan to buy a company.
What company? I don't tell you. So why would you give me the money? Because you're greedy.
Let's face it, that's a big factor. And because I'm Chamath, I've done this before. I used to work at Facebook. Did I mention it? I'll mention it again.
I've done it. So basically, I sell myself as... So what I'm doing is I'm saying, with your money, I can do magical things.
I'll find private companies and I'll take them public for you. And in return, I'll keep 20% of whatever I raise from you. That's a typical cut off the SPAC.
That 20% should make you vomit. You collect 100 million, you keep 20 million. I don't care how great you are at picking stocks.
You've dug a hole for yourself you can't get out of. But for about five years, SPACs kind of ruled the roost of collecting billions of dollars. That scam is now exposed.
I mean, it is a scam. Is there a version of a SPAC that could survive? Yes, but can't be 20%.
Bill Ackman created a SPAC with a 5% cut. I can live with that, right? You can say, okay, you know, I trust the person, they can find the company for, think of it as scouting fees.
You're paying the money for these people to go out and find promising companies to take up. Yes. There is also that you get one share, one option, you invest in SPAC, so people risk out, sell the share, and keep the offer.
Yeah, there are all kinds of little games you can, but the fundamental problem with the structure is the 20% cut. You can think about different ways you can structure the SPAC to reduce risk or increase liquidity. And you can do that. But the minute I take 20% of that initial process, the original sin's been committed.
I can't get back from that. And that's been historically the problem. So I'll leave you with this slide, right? So we've talked about public market investors and private company buyers. Think of the contrast.
You're a public market investor. You have no illiquidity risk, no diversification. Private company buyers don't have that.
And you can think of the variation. And- We talked about Vc and PEs, they fall in the middle. Where in the middle depends on the PE. A Blackstonetone or a KKR falls closer to the public company domain.
A less diversified PE might fall a little further down. And if you're a VC that specializes only in the sector, you are starting to move towards. Do you see where this is going?
If you have a company that is expected to go to a VC, let's say you're doing a discarded cash flow valuation, you're privately owned, owner provides all the capital debt. Two years from now, you're going to go to a venture capitalist. It's already built into your forecast.
And then five years from now, you go public. When you estimate the cost of equity for this company, do you see what's going to happen to it over time? When you start, you're going to use a total beta.
Two years from now, when the VC enters, your beta is going to adjust, not because the unleveled beta is different, but the VC has a higher correlation in the market, a more diversified portfolio. And then five years from now, when you do your terminal price and you're taking the company public, you're going to use a public market beta, market beta. So your company is not changing, but its cost of equity is changing because the marginal investor is shifting over time. I mean, I always look at the startup company valuations where people leave the required return at 20%. How the heck do you ever find something cheap?
I mean, I have a discount rate of 20%. Now, there is nothing I will be able to do with the cash flows that gets me a value that's close to what I paid back. So you want to do intrinsic value, right? You've got to build in that flex in your margins of who's the margin investor, what is happening in my beta.
And you now have a mechanism, right? Unlevered beta, the correlation, and ultimately how that plays out. into a total bait and the cost of that.
So we'll end with that and I will see you on Monday for the quiz. Monday we will actually start the third packet so if you can download that that'll be great.