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A growing number of companies with high potential for growth but little or no immediate revenue or profit have hit the stock market in recent years. Some, like data warehouser Snowflake
SNOW,
and eyewear company Warby Parker
WRBY,
have done well. But others, such as mattress company Casper Sleep
CSPR,
and fashion firm Rent the Runway
RENT,
have been disasters for investors.
We believe this divergence reflects more than just the usual risk of investing in the stock market and IPOs in particular. Rather, it reflects outdated IPO disclosure requirements – rules that have led to bloated prospectuses but still miss the most important information that investors need in evaluating unprofitable companies.
As we discuss in detail in a recent paper, the Securities and Exchange Commission could fix this with two simple measures: triggered disclosures and common standards for investment metrics. But before we explain the measures and why they will help, this is what to know about the problem is and how we got here.
There are two things that create a path to profitability for a company:
- Sound unit economics
- Revenue growth
That’s it. Just those two things.
Sound unit economics means, simply, that companies make more in variable profit after acquiring a customer than is spent to acquire the customer in the first place. If you spend $50 to acquire a customer, you had better be making more than $50 (and ideally, $150 or more) from that customer over time.
Companies can have sound unit economics but still be deeply unprofitable – because the investment to acquire customers happens today while the value derived from customers materializes in the future, and because of fixed overhead expenses needed to get the whole customer acquisition engine going in the first place. And this is why companies also need revenue growth. If unit economics are sound and those overhead expenses truly are at least partially fixed, then with enough revenue growth, the company eventually will be profitable.
Without adequate revenue growth, a company with great unit economics can never be profitable.
Likewise, without sound unit economics, a company with strong – even infinite – revenue growth can never be profitable.
Disclosure rules were written decades ago, when most companies going public were already profitable. The rub is that most companies going public these days are not, making disclosures that inform investors about these two areas more important than ever before.
Triggered disclosures
We recognize that certain metrics may be highly relevant and informative for some businesses but not for others. For example, the churn rate matters for subscription-based businesses, but not for transaction-based businesses.
Rather than advocate for a one-size-fits-all set of disclosure, we recommend triggered disclosure. This means that any company that wants to build its story around certain disclosures will trigger disclosure of a more systematic, business type-specific collection of “base disclosures” that are required to understand the economics of businesses of that type.
This table summarizes our proposed triggered disclosure requirements for four major business models: subscription-based, transaction-based, advertising-based, and lending-based.
Triggered disclosure requirements
| Trigger | Value effects | Information needed |
| Subscriptions/ Subscribers | Value of subscription-based company = Value of existing subscribers + Value of new subscribers – Deadweight costs | Subscriber count and churn/renewal rates Contribution profitability of a subscriber Customer acquisitions/drop-offs Cost of acquiring subscribers Cohort data, breaking down revenue/renewal rates by cohort tenure |
| Transactions/Users | Value of transaction-based company = Value of existing transactors + Value of new transactors – Deadweight costs | Active customers on platform Total orders to estimate order frequency/value per customer Contribution profit on marginal transaction Customer acquisitions and cost of acquiring customers Promotional costs to add customers and increase transactions Cohort data, breaking down transaction value by cohort tenure |
| Advertising/Users | Value of advertising-based company = Present value of expected cash flows from advertising | Number of active users on platform Intensity of platform use by active users Information collected about users Advertising placement/fit on platform |
| Lenders | Value of lender = Present value of net interest income from loans minus expected cost of defaults | Total value and average duration of the loan portfolio Loan volume and default rates by loan type (e.g., subprime versus prime) Average yield and the company’s own cost of raising capital A valid measure of capital buffer Information on how and when loan-related fees, including commissions, are assessed/booked |
Common standards for investment metrics
The sort of metrics summarized in the table are currently voluntary; companies can decide whether to include them. What’s worse, SEC rules provide companies significant leeway in defining the metrics. As a result, companies not surprisingly only disclose data that paint themselves in the best possible light, under the rosiest of definitions.
For example, many companies report lofty estimates of their “total applicable market” or TAM. This is supposed to represent the available revenue or customer opportunity, but there is no standard on how to define it. Perhaps the most absurd example is Uber
UBER,
which reported a TAM across its three business units equal to 15% of the world’s GDP.
What investors want to know is what sort of revenue growth is achievable and over what time frame. Caricatured TAM figures like Uber’s don’t provide any insight.
Rather, we need common standards around investment metrics to improve their validity and to create some degree of comparability across companies.
For example, because the contribution margin is supposed to be the profit margin associated with an incremental dollar of revenue after variable costs are deducted, all variable costs should be deducted. Clothing companies cannot omit the cost associated with clothes. Software companies cannot omit their contribution margin, then suggestively point to their gross margin as if it were their contribution margin. Direct-to-consumer businesses cannot leave out credit-card-payment processing, store-related expenses and fulfillment costs.
Yet we have seen examples of all of this happening at companies like Rent the Runway, Allbirds
BIRD,
and Thorne (now part of Thorne HealthTech
THRN,
).
The lack of common standards as well as shortcomings in IPO disclosure rules make it hard to fault companies for the current IPO disclosure mess. It is for this reason that we hope the SEC steps in to bring disclosure rules into the 21st century. Until they do, many investors – especially individual investors, who are increasingly participating directly in the IPO process through their Robinhood accounts – will get burned.
Maxime C. Cohen is a professor of retail and operations management at the Desautels School of Management at McGill University in Montreal. Aswath Damodaran is a professor of finance at the Stern School of Business at New York University. Daniel M. McCarthy is an assistant professor of marketing at the Goizueta Business School at Emory University in Atlanta, and co-founder of Theta, a valuation analytics company. They are the authors of the paper “Initial Public Offerings: Dealing with the Disclosure Dilemma”.
