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Commentary

Confidential IPO: Good for Companies, but What About Investors?

Morningstar sat down with Pitchbook analysts Cameron Stanfill and Kyle Stanford to discuss what investors can expect from IPO changes.

By Julie Bhusal Sharma

For the individual investor, tapping into the success of startups may be like tapping for maple syrup in the fall. In 2016, 58 issuers withdrew IPOs, after 2015's 62 withdrawals. And, on top of that, there have been only 30 U.S. venture capital exits resulting in IPOs year to date, which hits the trough of a steady decline since 2014.

Since June, however, companies of all shapes and sizes are now allowed to confidentially file for an IPO with the Securities and Exchange Commission's new ruling. The benefits for the filing company have been made clear: by confidentially filing for IPO, companies no longer risk a bad appearance if they back out on the IPO. Just take HelloFresh as an example. The company filed for an IPO in 2015, but backed out, giving a taint of undesirability and causing a drop in investor Rocket Internet's shares. Thus, by saving companies from potential embarrassment, it's expected the broader confidential IPO option will drive more IPOs.

Yet, how a flux in confidential IPOs will affect the investor is not so straightforward.

"The confidential IPO process has given especially individual investors the mindset that there's more information asymmetry on those types of offerings as opposed to the ones that are just normally filed," says Pitchbook analyst Cameron Stanfill.

He says this asymmetry can stall the first couple of weeks of participation for individual investors in IPOs. A study by the Washington University Law Review showed that the JOBS Act, which allowed confidential filing on IPOs for emerging-growth companies, led to reduced trading by individual investors, signifying that individual investors prefer too much information as opposed to too little. But it may not be the worst thing. Stanfill and Pitchbook analyst Kyle Stanford note that for long-term investing, getting in a few weeks earlier will make little difference.

While there has yet to be a company that has taken advantage of the new confidential IPO ruling, Stanford suspects that Airbnb, Dropbox, and SoFi, a lending and wealth management startup, could be the first ones to do so. Yet with the immediate departure of SoFi CEO Mike Cagney due to claims of harassment, an IPO could be on hold for quite some time. Another startup that could be ruled out of the IPO watchlist is co-working space startup WeWork.

"WeWork has raised so much private capital they probably aren't looking at a debut anytime soon either," Stanford says.

Whether on the radar or not, for those startups that do IPO confidentially, continuation of stock overpricing will continue to hurt the individual investor, even if a lag buy time does not.

"I think the difference in private versus public [valuations] is larger today because companies are simply staying private longer, and raising more capital or rounds that lead to a higher discrepancy in actual value," says Stanford. With higher discrepancies of valuations on the private versus public market that means more room for IPO failure, prolonging the life of a startup before it goes public, resulting in potentially higher losses for individual investors that buy IPOs of late-stage startups.

With startups not getting the public valuations that they are getting on the private market, is it fair to compare apples to oranges?

Stanford says no. 

"The way [IPO] deals are structured with preferred stock … has led to overpricing, different share prices, diverging exit preferences for different investors and more," he says.

A Stanford Graduate School of Business study titled "Squaring Venture Capital Valuations" shows that a new stock's price across all classes is often determined by finance professionals using the company's latest series' price. That pricing does not consider promises made to investors that involve payment if an IPO flops, which can lead to valuations over 100% fair market value. Datto, had a valuation of $1 billion in its last funding round, when the study gave it a fair market value of $300 million, leading to a discrepancy of 205%.

This leads to a sticky IPO situation. While more confidential IPOs could result in the SEC's new ruling, individual investors won't be able to truly tap into the success of new public offerings until shares are heavily debited from final-round valuations, turning empty tapping into maple syrup.