Session 23: Private Company Valuation

I mean you can even read the slide. Okay. So, where were you? I missed you last two classes. Yeah, yeah, yeah. Did you catch up with the classes, right? Don't have to explain to me. Okay. I don't think you need a reminder that your next quiz is a week from today, but I'm going to give it to you anyway. So, it is a week from today for 30 minutes of class. I will send you the seating assignments by next Monday or So, you'll have you know So, again, it'll be three I think we'll be back to three rooms again because I you know the two UC rooms in this one. And I'll try my best. That's all I can do to make sure that you rotate fairly. I think 2/3 of the class have already been out of this room. There's another 1/3. They will get first dibs on it. The final, I've no idea how I'm going to do I have to toss a coin. I I really have no idea. I'm Um The material for the third quiz will cover everything in packet two, which we will finish today. So, we'll be done with packet two, which means next Monday, please make sure you download the third and last packet. It's a much slimmer packet. Last packet of the class. So, today we're going to complete our discussion of private company valuation. And I started this discussion already with one of the bigger challenges when you value private companies. You remember I said when you value public companies, you make an assumption. And the assumption is the marginal investor is well diversified. What does that do? When you make that assumption, it allows you to focus only on the risk that you cannot diversify away. And estimate with a beta. The minute you use a beta, whether you like it or not, you're making that assumption. And I said in a private company that might not be true. Because the buyer might not be diversified. In fact, might be completely undiversified. So, what today we're going to go through the mechanics of what to do, but I want you to give me the intuition as to what is going to happen to your cost of equity and cost of capital when a buyer is not diversified. So, when a buyer is diversified, we focus on beta. We come up with the cost of equity and cost of capital, right? Let's say you take the same business. But now you're looking at a buyer who's completely undiversified. They're going to put all of their money in that company. Will they see more risk in the company or less risk? More. Why? Because they're looking at all of the risk. risk that you can eliminate away. So, you've already kind of answered the question, well, so what's going to happen to the cost of equity then? It's going to go up. The cost of capital is also going to go up. Today, we're going to go through the mechanism of how to do that. But to show you why not all private business buyers are made equal or owners are made equal, in on May 9th, I have a an engagement, if you can call it that, to go talk to the Mets management. It's actually a bundled engagement. In the morning, I'm talking to the 0.72 analysts. In the afternoon, I'm talking to the Mets management. You know what binds them together, right? The owner is Steve Cohen on both. So, somebody who's Steve in Steve Cohen's office asked, you know, can you come to talk to the point because I've done that before and I said, "Sure." So, I'm going to go talk to them about narrative and numbers because these are young analysts. They've come through They've made the They've made it to in a sense to one of the peak hedge fund-like places. And I would So, I said, "Sure." And then later, I got a call saying, "Oh, by the way, would you be willing to come to talk to the Mets management?" And I said, "I would, but it has to be on the same It's the day before final start." So, I said, "I've got to be in the same place." So, 0.72 is in Hudson Yards and they said, "We'll get the Mets management down." So, yesterday afternoon, I was putting together my corporate finance presentation for the Mets. It's fascinating to think about how decisions get made for professional sports team. And one of the issues that I ran into, one of the things I was trying to estimate, was a cost of equity for the Mets. First, what currency should I do it in? Let's This is easy one. US dollars. Hey, why go looking for trouble, right? I could do a Japanese yen or a euro, but you know, they you know, what equity risk premium should I use? Same equity risk premium I'd use elsewhere. Price of risk is a price of risk. Which leads me to the question of beta, right? How many publicly traded sports franchises are there in the US? Once actually just one. It's Madison Square Garden is the closest thing you can get and even that is not a pure franchise. It owns the Knicks, but it also is all of the other stuff that happens. The Green Bay Packers are technically owned by the people of Green Bay, but there isn't a single publicly traded sports franchise in the US. There are publicly traded sports franchises in Europe, mostly soccer teams. So one alternative is to go with soccer team betas. So that beta was like 1.16. The other of course is to focus on entertainment companies. After all, once you get to professional sports, yesterday I went to Yankee game. Cost me $100, two people. I bought them stubhub, but even with the price, you know, with I got a decent price. This is like going not just to a movie, but to a concert. So I said it's like entertainment. The The average beta for entertainment companies is 1.10. But no matter which beta I use, I'm focusing only on the risk that cannot be diversified away, right? But is Steve Cohen an undiversified owner? Is Is the only thing Steve Cohen owns the Mets? No, it's one of you know, you He's all I think worth 15 billion, maybe 18 billion. $3 billion or $4 billion, whatever he paid for the Mets might sound like a lot of money 99.99% of the world, but to him it's one of a bigger portfolio. So I'm going to argue for the use of that public company beta there. And I'm going to bring up the Yankees all of the time during this session simply to bug the people in that room. But this is the one place where bringing up the Yankees, it's going to make them feel better. With the Mets, you can use the market beta because the owner is in a sense diversified, right? Who owns the Yankees? Come on, guys. You live in New York. Even if never gone to a baseball game, you should know the answer. The Steinbrenner family. How much of the Steinbrenner family is tied up in the Yankees, you think? Almost all of it. It's a $7 franchise. They're not rich outside of this. They might have a hundred million here, a hundred million there. The Steinbrenner family is almost completely undiversified. So, you know what that means, right? If you think in purely financial terms, the Mets should have a lower cost of equity than the Yankees. Right now. I don't know how this will play out. But, file that away for future reference. It's not that it's a private business, but the buyer of the business is not diversified. That's causing you to adjust that cost of equity. So, we talk about the cost of adjusting. The other big thing we have to deal with is this issue of illiquidity. Cost of buyer's remorse. The example I gave, right? You bought something, you changed your mind, and you sell it back right away. The cost of buyer's remorse is what it costs you to make that round trip. With a publicly traded stock, it might be small, especially if it's a large, widely followed stock, heavily traded. But, with a private business, it can be immense. So, what do people do? They discount the value that they pay for these companies upfront for an expected illiquidity event. So, today I want to talk about how appraisers deal with that illiquidity in private company valuation. And why I think it's wrong. And here's what appraisers do to deal with illiquidity. So, there are far more private business appraisers than publicly traded company analysts in the in in this country. There are thousands and thousands of appraisers. And the way they value private companies, they do a version of a discounted cash flow model. I'll talk about how they adjust for lack of diversification. But, after they do the valuation, they will reduce that They'll take 25% off the top. It's called an illiquidity discount. And they do for every company they value, small, large, money making, money losing. And I think that doesn't make sense. And to see why, I'm going to give you four companies or four transactions, and I want you to to rank these companies in terms of transactions we attach the biggest illiquidity discount and transactions we attach the smallest discount. Here's the first one. It's a profitable cash flow generating company to a long-term buyer, a profitable cash flow generating company to a cash constrained buyer. So, two different buyers. Or you can have an unprofitable negative cash flow company to a long-term buyer or a cash constrained buyer. So, let's focus on on first the money making versus the money losing cash. Which should have the larger liquidity discount, the cash flow generating company or the negative cash flow company? The negative cash flow company, why? What's the essence of liquidity? You want cash, right? If you have a company that's already throwing off cash, it's profitable, you're actually getting liquidity from the company running. If you have a money making cash rich company, it's throwing off cash flows, you feel less of a need to have to sell the company to get cash. I'm I'm not saying the need goes away, but it's less. So, I'd expect the discount to be larger for unprofitable cash negative companies. Should the discount be greater for a long-term buyer or somebody who who's cash constrained? Yes. Why? Because you need the cash flow much sooner, right? You worry about liquidity, you're going to You see already I'm setting up a nightmare scenario for you. Because if I'm a private company owner and I come to you and say, "Can you estimate what my liquidity discount should be?" You can't answer the question until you deal with two things. One is, what kind of company am I? Am I money making or money losing? Do I have cash flows that are positive or negative? And the other is, you can't tell me the discount is unless you know who the potential buyer is. Already that's going to create a layer of uncertainty about the discount to apply. Let's build on this illiquidity discount. So, it's going to be very different across different companies, depends on the buyer. Let's say you estimate these discounts at different points in time. First time you estimate it is in 2008, market is in turmoil, you're in the middle of a crisis. Second time you estimate is 5 years later, market is doing well, the economy is doing well. Do you think the discount is going to vary across time? And if so, when is it going to be higher? When the market is in a crisis or when it's buoyant? Yeah. And tell me why. Everybody wants cash, right? Everybody wants liquidity. Essentially, illiquidity discounts are not only going to be different depending on the company and the buyers, they're going to be different across time. So, we'll actually set up the framework for thinking about illiquidity today. One final point. Given what I've said so far about potential buyers and diversification. Let's say you owner of a private business. You're thinking about selling your business and you want the best possible buyer. Best in what sense? You want to get the highest price. And I give you three different choices. Another private individual is willing to buy your business. The second is a private equity fund. And the third is a publicly traded company. Which one do you think is likely to offer you the highest price? A private buyer, a private equity fund, or a publicly traded company? Isha, you want to try that? You one in three chance this time. Usually I give you 50-50 shots. You you can pass if you want. Yeah, okay. Go ahead. And tell me what it is that makes it the same business, right? So, what is it that makes your business more valuable to the publicly traded company? They can't do this. Well, that's kind of that's deceptive reason, right? What What's the first thing I started with? We talked about discount rates. What did we say the when you look at risk, what is the risk you look at? The risk you If you're a publicly traded company, remember your investors are diversified. All they care about risk. You can focus on a traditional market beta, come up with the cost of equity. A private buyer is usually like much more likely to be undiversified. So, holding all else constant, I would expect the public company to offer the highest price, the private buyer to offer the lowest price, and the private equity fund to fall somewhere in the middle. Today, we're going to quantify that impact and let it play out. Deep had a question. It's the same the same thing. Private equity funds are there to make money. Because it because private equity funds are there to try to make money, right? How do they make money? They arbitrage the difference between what the private company thinks it's worth to a private buyer and what the private company's worth to a That's how private equity funds make their money. They buy it somewhere in the middle, and they either take the company public or they sell it to a public company. That's their exit. So, let's go back to where we were in the notes and kind of fill in the details. I think we were on page 134. Let me take you back to page 134. So, let's I'm going to set up the example. So, let's say you guys are graduated, you're working at investment banks. Sorry while I blow my nose. But, you're getting tired of the grind. So, you're planning to quit. And here's what you're going to do. You're going to take all of your wealth, and this is critical to the story, and you're going to buy this upscale French restaurant. Why? Cuz you've been watching Kitchen Confidential on in the Food Network and you say, "This sounds like so much more fun than working on spreadsheets." I'm the owner of the restaurant. I'm also the chef. This restaurant is a world regarded. It In the most recent year, and I'll show you the income statement, they made $400,000 in pre-tax operating profit on $1.2 million in revenue. So, I'm going to give you 3 years of financials. The company has no debt outstanding, but it does have a lease commitment of $120,000 each year for the next 12 years. The restaurant sits on a lease. So, what we're going to do is value the restaurant for you, the investment banker. Remember, all your wealth is going into this restaurant. And I'm going to start by showing you the financials for the restaurant. Last 3 years of numbers. Big jumps, 800, 1.1 million, 1.2 million. But there's a catch here. The restaurant has been growing, but it's now at full capacity. What does that mean? Every table is taken for every meal, so you can't be growing anymore unless you you know, unless you decide to build a second restaurant. Here is the operating lease expense. I'm doing what accountants used to do pre-2019, treat it as an operating expense. I wages, material, other operating expenses, but I one thing I want to mention about the wages is remember, I'm the owner chef. I don't pay myself a salary. Why not? Cuz what's left is going to come to me anyway. What's the problem of you valuing this restaurant based on this Even if you there are no no I'm not pulling any shenanigans here. The numbers are what they are. If you buy this restaurant based on what you see on this income statement, you look that seems like a lot of money. What's the problem you're going to run the day after you buy the restaurant? The chef. Well, give me the So, the next day you're going to walk in the restaurant. It's now your restaurant, right? But you notice there's nobody in the kitchen. So, why isn't anybody cooking? You know what happened, right? I was the chef. I sold you the restaurant. So, what do you have to do? You have to bring your cooking skills to play and be chef. You know how quickly the capacity is going to go from 100% to 0%, right? Cuz all he can make is peanut butter sandwiches, and I think that's the only thing on the menu. You're not going to last as a restaurant. So, you know what you have to do to actually make this restaurant work. You're going to have to hire a chef. And it's going to cost you. And you're going to build in that cost into your income statement. So, already you can see the work coming into play. To value this restaurant, you need to bring in all the pieces you will need to run the restaurant. So, let's go through the process of valuing the restaurant starting with a discount rate. What do we need for a discount rate? I need a beta and a risk It's a risk-free rate and risk premium going to come there. Your share. Oh, thank you. So, let's talk about it. Is it It should be on on right now, so they should be Let's talk about estimating discount rates. I need a beta, right? So, I go to a Bloomberg terminal, enter the name of this restaurant, and type in beta. What am I going to get? Nothing. Can't find the company. Valuation ends right there saying I can't find a beta. But, we don't give up that easily, right? Because if you can't find a regression beta, you can still get a beta for your company by looking at publicly traded companies in the same space. So, initially, that's what I did. I went and looked up publicly traded restaurants. And I came up with a beta, but it wasn't the kind of beta that you're going to you're going to be happy with. So, here I'm going to start exactly the same way that I start with public companies. But, I still have to deal with that problem of lack of diversification. But, the beta that I got by looking at restaurant companies reflected a mix of restaurants that were not similar to the restaurant I was planning to buy. It's an upscale French restaurant. What I see on my restaurant list are Burger King and Chipotle and I mean I mean they're they're restaurant chains, but they're not the kinds of restaurants. So, I decided when I value this restaurant to actually use the betas for specialty retailers. Now, luxury retailers is arguing that the people who come to my restaurant are the kind of people who shop at those retail stores. Be creative when you think about betas. I know our tendency is to look at other companies in the same sector and stay focused. Sometimes you might want to shift that focus because you want to get look at other companies that do well when you do well. And do badly when you do badly. And here I'm going with a group of companies that I think is closer to my business in terms of up and down movements than looking at just restaurants. So, I got an unlevered beta. So, that part of the process was pretty similar to what I do with public companies. I'm just looking at other publicly traded companies in the space coming up with the beta. We'll have to deal with the lack of diversification, but I have an unlevered beta. Now, what's the second step? I have to bring in the fact that that captures only the market risk in the company. And what did I say about this about you as an investment banker? You took your entire wealth and you put into this restaurant. You're the exact opposite of diversified, right? You're over concentrate. So, what risk are you going to see? Let me set it up in a very simple way. If you look at the total risk in a company, there's units of market risk and units of firm specific risk. If investors are diversified, all they care about is the market risk it's captured with a beta. If you're not diversified, what do you see? You see all of that risk and you need to bring all of that risk into your cost of equity. You know, might say how do I know what all of that risk of the risk looks like? It's a very simple number and it is a number that you get anytime you run a regression that I think you can use to adjust your beta. So, here's what I did. I went into my bottom-up beta page. Remember, I got the publicly traded companies and betas. And if you remember when you when you look at a regression page for your company, in addition to a beta for your company, you have an R-squared for your company, right? What does the R-squared tell me that market regression? How much Let's be specific. How much of what which in this case is the company. So, basically, how much of the volatility in the company is explained by the market, right? So, R-squared tells me that. What does 1 minus the R-squared then tell me? How much of the risk in that company is not explained by the market? In other words, every regression you run tells you how much of the risk in your company comes from the market and how much is company specific. We don't use it usually because we have publicly traded companies, we ignore that. Here, I'm going to bring it into play. In addition to looking up the betas, I also looked at the average R-squared across these high-end retailers. The average R-squared was 25%. There's a little statistical tangent. R-squares measure the proportion of variance in your stock that is explained by the market. Beta is a standard deviation measure. Sounds have no idea what I'm talking about, right? So, anybody remember the full equation for a beta? You might have seen it in one of your foundations class. What's in Beta is equal to row JM, correlation between the stock and the market times the standard You know, you look mystified. You've never seen this. Actually, that's that's that's how the regression slope is computed. It's rho JM * sigma J, standard deviation of stock, divided by sigma of the market, standard deviation of market. Even if that went completely over here, it's a standard deviation measure. So, I'm going to take the R squared, which is a variance measure, and take the square root of the R squared. I won't insult you by asking you what the square root of the R squared is. It's ob It's obviously going to be the correlation coefficient, which is the R. So, here what I'm going to do is I'm going to take the correlation coefficient, which is 0.5. And I'm going to play a little algebra again. The 1.18 that I computed was a market beta, captured the market risk in the company. And if I were diversified, I'd stop there, but you're not diversified. In addition to bringing that risk in, you want to bring the rest of the risk in the company into your beta. So, dividing the beta by the correlation gives me what's called a total beta. The reason I call it a total beta is I'm capturing the total risk of the company rather than just the market risk. It's going to give me a beta of 2.36, twice as high as the market beta. And the only reason I'm doing this is because the buyer is not diversified. So, work it through. 2.36 beta is going to give me a much higher cost of equity. The much higher cost of equity is going to give me a much higher cost of capital, and it's coming from the fact that the buyer is not diversified. But, this is still an unlevered beta, right? So, what's a in publicly traded companies after you came up with an unlevered beta for your company? What did you have to do to come up with the beta to use for your stock? You had to lever the beta, and to get lever the beta, you needed a debt-to-equity ratio. And that debt-to-equity, was it a book debt or market debt-to-equity ratio? After two quizzes, I hope you get the right answer. It always is market debt-to-equity. And with a private company, we have a problem. Do you see what the problem is? There is no market equity. That I could dance around perhaps use book debt, but there is no market equity. You can't use book equity. It's completely irrelevant. She's saying, "What do I do now?" There are two choices. The first choice is an easy one, but you might not like it. You can assume that if I can you can get the debt to equity ratio for a publicly traded companies in the space, which is 14.33%. You can assume that private companies also operate with roughly the same debt to equity. You're making the assumption that there's something about this business that leads companies to pick the debt to equity ratio they do. You put the 14.33% in, you come up with the levered beta of 2.56, and a cost of equity of 14.5%. But that's assuming that private businesses borrow roughly the same as public companies in that space. What if you don't want to do that? Is there another way I can come up with a debt to equity ratio for a private company where I don't assume that it moves to the industry average? What do I not have? A market value of equity, right? Why am I doing the value at the end of the valuation? What do I arrive at for your company? An estimated value of equity for your company. Could I use your estimated value of equity as the equity in your debt to equity ratio? I don't see why not, but there's one small problem, right? Do you see what the problem is? I'm going to have circular reasoning because I need the equity to get the debt to equity. I need the debt to equity to get the equity. Have you ever checked the iteration box in Excel? You had to for my FCFF case. If you do that, you can actually make the debt to equity ratio for a private company a function of your own estimated value of equity. So, I'm not doing it here, but if you want do it in the spreadsheet, you can. But just make sure the iteration box is checked, otherwise you're going to get lines all through your spreadsheet about circular reason. So, two choices with that equity, where you can either use the industry average, which is what I've done here, or you can go with this debt to equity that came from your own estimated value equity. I'm almost there. I have a cost of equity, I need a cost of debt. And here I'm going to follow much more conventional route. With public companies which did not have a bond rating, remember how I computed the cost of debt? I compute an interest coverage ratio, went to look up table, I came up with a rating and a cost of debt. I can do that private companies as well. And here I compute an interest coverage ratio based on the lease expenses, I came up with a default spread based on the rating. I gave them a double B+ rating and a cost of debt of 7 and 1/2% pre-tax and 4 and 1/2% after tax. So, I've got a cost of equity from the total beta, a cost of debt from the synthetic rating. My cost of capital for the company is 13.25%. I've got my discount rate to use in a private company valuation, much higher than the discount rate for for an otherwise similar public company because I'm using that total beta. Second stop, I had to clean up the income statement. Cleaning up your basically meant paying for a chef who's actually going to cook. 150,000 that pushes up my expenses and I capitalize leases because that's the right thing to do. Now, starting in 2019, accountants have done this with public companies, but in many private companies, people still can expense operating leases, so I'm capitalizing and treating it as debt. So, there's my restated operating income. My operating income is 370 million instead of 400 million. So, I've got number I've got a discount rate, I've got my earnings. Step three, I'm going to stop and check to see how much of an effect the chef leaving is going to have. I've replaced him with a new chef, but remember one reason the restaurant is at capacity is because people coming in like the chef, they like the food. And I don't know how what percentage of those people will not show up next the next day if I buy the restaurant with a new chef. So, I estimated that loss of revenue that I'm going to get if the chef leaves to be 20% of my operating income. So, I'm going to take 370,000 and knock it down by 20%. This is the key person discount we talked about towards the end of each class. It's low amount lowering my operating. So, I've got a discount rate. I start with the operating income. Adjusted it for the loss of a key person. And again, as a chef, you might try to figure out ways to reduce this loss because it shows up as a lower value for you. And you might stay on for a year or two, maybe have some kind of adjustment process where the loss is lower. But, if you don't do that, there's going to be a 20% loss. Step four, just because you're doing the private company, it doesn't mean you can forget all those rules we had in evaluating public companies. Like what? To grow, you have to reinvest. How much you have to reinvest depends on your return on capital. In this case, I've estimated a return on capital of 20% for this privately owned restaurant. And I'm going to give them a very low growth rate. Why? Cuz they're already at capacity. They can't grow more than a certain number because you have you know, every seat is taken. So, I'm putting in a 2% growth rate. 2% divided by 20% gives me a reinvestment rate of 10%. So, I've got my discount rate. I've got my income. I've got a reinvestment rate. I bring it together in my valuation. So, there's the key person adjusted operating income growing at 2% next year. 1 minus the tax rate times 1 minus the reinvestment rate. So, that's expected free cash flow of the firm next year divided by cost of capital minus the growth rate. I come up with a value for the restaurant of 1.449 million. I'm almost done. Cuz there's one final step. I have to subtract out the debt, which is in this case the present value of the leases, the value that I get for the restaurant is $521,000. That's the value of equity in this restaurant, 521,000. What's the final adjustment? For illiquidity, right? If I buy this restaurant as the investment banker and I put all my wealth into it, what if I change my mind? It's going to be very difficult to back out. So, to estimate that discount, let's talk a little bit about illiquidity. So, I'm going to reinforce what I said at the start of the class today. I mean, the standard practice for illiquidity discounts is to knock a fixed number off. I call this the bludgeon approach. Take 20% off every private company valuation. But, I think the right practice is to allow it to vary across companies. Some companies should have bigger discounts than others. Healthy companies over unhealthy companies. Money-making over money-losing. Should also depend on when you're trying to do this. Is the market in a crisis? Is the market doing well? And should also reflect the buyer. Is the buyer a long-term buyer or cash-constrained buyer? So, now, I want that intuition to be acceptable. That that discount should vary across companies, vary across time, vary across buyers. Cuz then, we can talk about how to estimate that discount. So, let's start with that bludgeon discount. 25% or 20% or whatever people use randomly. Those discounts come from two sets of studies, both of which are hopelessly flawed in my view, but people keep using them over and over again. Now, private company appraisal kind of got its build-up from a guy called Shannon Pratt, who in the early 1980s wrote the first book on valuing closely held companies. He was a legend in the space. The first It's It's a thousand-page book about all the It's a manual on what to do to value private companies. And one of the things, of course, he had to deal with was the illiquidity discount. So, he set up uh you know, he set up a firm in Oregon called Willamette, and they started doing research on the illiquidity discount. and the first sets of studies that backed up the discount was studies of what are called restricted stock and studies just before IPOs. And to see why they give you a sense of what the liquidity discount is, let me describe what restricted stock is. It's publicly traded companies that issue shares with restrictions on you being able to trade the shares. Let's take an example. Let's suppose you have a stock that's trading at $10 per share. So I come in and offer you a a 100,000 shares, but I said, "By the way, you can't trade for the next 2 years if you get those shares." Price right now is 10. Would you pay me $10 per share? Yeah, you'd pay less than that number, right? How much lesser? Depends, right? How much you care about liquidity. But the advantage is I can observe how much of a discount I get. So to estimate the liquidity discount, I need to observe what the price would be without the discount and the price with the discount. With restricted stock, I get to observe this. And there are dozens and dozens of studies of restricted stock and they seem to find a discount of about 30 to 35%. It's a pretty big discount. The second set of studies look at transactions before an IPO. So the way these studies are structured is they take all companies that go public and then they look at the 2 to 3 months or even 6 months before the IPO to see how much of a price people charge for selling each other shares. So if a VC is selling a share to another VC, how much of that they pay relative to the IPO price? And there they find discounts of 40, 50%. This is great news for appraisers if the discount is so big. You know why? What happens if you apply a big discount? You get a lower value. You say, "Why would that be good?" What are most private company appraisals for? Tax purposes, divorce court, you want as lower a number as possible. So for decades, private company appraisers used these studies to back up these discounts. They said, "Look, private companies, you know, you should attach a 30% discount. We'll talk about the flaws with it, but you can see the basis to these studies. Now, when you look at the restricted stock studies, many of the early studies just looked at the median discount. They'd look at 15 or 20 or 50 different restricted stock offerings. There aren't that many each year, so it's got to be a small sample, and they compute the median discount, but they stop there. That's a 30% 25%. In 1988, Bill Silber used to teach a foundation class. He was a legend at Stern. Did a Did a paper. It's a paper that I think he did over the summer. He He laughs about it. He says, "I never expected to catch on." But basically, he took these restricted stocks offerings, and he said, "Rather than give you a median, I'm going to look at why they vary across companies. Why are the discounts bigger at some companies and smaller at others?" And he ended up the paper with a with a regression. All right? So, as you If you look at the left-hand side of the regression, he looked at what the restricted stock price was as a percentage of the market price. So, it's 1 minus the discount. So, if the restricted stock price is $8, then the stock and the actual the market price before was 10, 8 / 10 is 0.8. So, think of the left-hand side as 1 minus the discount. And he threw in three variables. One is he threw in the level of revenues. His hypothesis was bigger companies should see smaller illiquid illiquidity discounts than smaller companies. And he He He backed that up. Secondly, he looked at you know, what how big that restricted block was. His argument was the larger the restricted block is relative to the number of shares outstanding, the bigger the discount has to be. So, there are a million shares outstanding, and I'm trying to put a restricted block of a half a million, I should see a much bigger discount than if I'm just selling 50,000 shares. And he found that that was backed up as well. He found that money-making companies, so this B E R N is a dummy variable. Is the company money-making or money-losing? He found that money-making companies had smaller discounts in money-losing companies. And finally, even through end, just to see if there were any any deviations from arm's length arm's length transactions, whether the person buying the restricted shares was a customer of the companies. Argument being, you're trying to put restricted shares with a customer, maybe they're getting side deals and they're willing to pay a higher price. So, you ran this regression and I, you know, it basically became a paper. But, a few years later, I decided to steal Bill Silber's regression and use it to kind of come up with a way of coming up with different illiquidity discounts for different companies. It's still within the restricted stock study, so it's got its limitations. But, here's what I did. I looked at what the if using that regression, what the discount would be for a company as a function of its revenues. The larger the revenues, the smaller the discount. And whether it's a money-making or a money-losing company. So, let's say I'm an appraisal firm. You come into my office and they look, I want you to value my firm. I value your firm and I'm trying to estimate the discount to apply. You have 25 million in revenues and you're a money-making you're a money-making firm, my discount for you is going to be about 23%. If you have 25 million revenues and you're a money-losing firm, my discount for you is going to be 32%. If you're a billion-dollar revenue firm, your discount is going to be far lower. So, in effect, I'm not giving everybody the same discount. I'm giving smaller discounts to bigger companies. And I'm giving smaller discounts to money-making companies. A way of discriminating across companies. But, here's the problem with restricted stock studies that you cannot run away from, no matter how much you finesse. What did I say has to happen in a restricted stock offering? I've got to offer a big discount, right? 20%, 30% on the table. What kind of healthy company is ever going to do that? So, if you look at these companies that issue restricted stock, it turns out that you have a sampling bias. The kinds of companies that issue restricted stock are small companies and trouble companies because they have no choice. The kinds of people who sell their shares before an IPO there's an IPO in 2 months. Why do you sell it your shares at 30% discount? Because you're desperate. That's a sampling bias. And it took 20 years for the IRS to figure out how to use the sampling bias. Because for 20 years I now appraisers had gone to court and said, "Look, there's a 35% discount restricted stock studies." Finally after 20 years the IRS actually hired somebody who knew enough statistics to take a look at these restricted stock studies and separate out how much of the 35% discount you were saying came from the sampling bias. There's actually statistical ways of doing this. And at the end of the study concluded that about 20 to 25% of the 35% came from having a bad sample. Only about 10 to 15% was the illiquidity discount. It was a huge moment in private company appraisal because now when appraisers went in front of the court and said, "We're going to use a 35% discount." You actually got pushed back from judges saying, "But 20% of that is a sampling bias. Why are you using such a big discount?" So, no matter how you slice it, there's only so much you can do with restricted stock studies or IPO studies. There's too much There's too much sampling bias. I'm not that interested in illiquidity discounts. It's not it I don't work with private companies that much, but I struggle with is there a better way to estimate illiquidity discounts? And I think there is. And to see what it is, remember what I said about buyers remorse with a public company? I said there isn't illiquidity discount, right? It's called a bid-ask spread. You say, "How big can it be?" For an Apple it's tiny, 0.1% the bid-ask spread divided by the price. But if you decided to do this with a small Nasdaq stock, likely traded, you know how much So, it's a $2 stock. The bid-ask spread could be 50 cents. In other words, if you buy the stock, it'll cost you $2. 1 second later, you try to sell the stock, you're going to make back a $1.50. That's a 50-cent spread on a $2 stock. That's like having a 25% illiquidity discount. If I'm willing to define the bid-ask spread as an illiquidity, think of how much bigger my sample is. Every publicly listed stock has a bid-ask spread and a stock price. I can compute that spread for every single stock. My sample size is 7,500 publicly traded companies. And about 15 years ago, I decided I wanted to see why the spread as a percent of price varied across companies. The very fact that I haven't done it since shows you how painful it was that first time. I said, "Never again am I coming here." But if you're a private company appraiser, you might want to go there, right? I don't care that much, but if you care, you could go and look at this. So, I have 7,500 companies in my spreadsheet. I have the spread as a percentage of the stock price for every single company. I did what Bill Silber did with the small restricted stock study. I tried to figure out why the spread was higher for some companies and lower for others. And here were the variables that I threw into my regression. I threw in how much the company had in revenues. Higher revenue companies had much smaller bid-ask spreads than lower revenue companies. Size The size of the company mattered. I threw in how much whether the company was money making or money losing. Turned out that money making companies have much lower bid-ask spreads than money losing companies. I threw in how much cash the company had as a percentage of firm value. Why? Because companies with a lot of cash are already liquid. They don't need a liquidity discount. Assume a company is 90% cash. Why would you ever discount that company by 20 or 30%? They had much smaller spreads than companies with very little cash. And I did throw in a trading variable, and not surprisingly companies which have high trading volume have much smaller bid-ask spreads than companies that don't trade as much. You see, what's this got to do with private companies? These are public companies. We're explaining differences differences in bid-ask spreads across public companies. Take a look at this regression. Okay. Could I get these numbers for my restaurant? I have the revenues, right? 1.2 million. I can plug it in there. Is it a money-making restaurant? Yeah, surely it's money-making, but I put in one. I can look at its balance sheet. I can get cash as a percentage of value. And how often does this restaurant trade? Zero. I'm just going to put in a trading volume of zero. That's basically what I did. I still took my bid-ask spread regression, plugged in the values for the restaurant in here, and I got a predicted bid-ask spread for the restaurant, 12.88%. So, what does it even mean? I'm extending the concept of bid-ask spreads into the private business space, and that now becomes my estimate of the illiquidity discount given how public markets are being priced. It doesn't have sampling bias. It's a huge sample. Of course, I can I'd love to keep redoing it. This is a 15-year-old regression, so it's it's aged. But if you made if this was at the center of your practice, you could update this every year. The data is there. It's easy to do. And you'd have an updated way of estimating what the illiquidity discount is at any point in time, and you can vary it across companies based on the characteristics. To show you how different these numbers are going to be than the traditional approaches that come out of the restricted stock studies, if I do the Blodgett approach, where I just take 25% off, as opposed to the refined Blodgett approach, where I use the Silber regression to kind of adjust it, I get 25%, 27%, 28% as my discount. If I use the bid-ask spread approach, you you get a much much smaller, in my view much more reasonable discount on value. So, that 12.88% is what I'm going to use as my liquidity discount. Which means that my 521,000 that I estimated the value of equity, you take 12.88% off, gives me a value of 454,000. Took a long journey to get there, but in a buyer to buyer, private buyer to private seller transaction, this restaurant is worth about 454,000. You can see why already private to private transactions are so massive. First, you can't use beta. You've got to adjust for the lack of diversification. You've got to come up with this illiquidity discount after you're done to reduce value. And every dark force in valuation is working against you as you go along because you've so many things that you feel uncomfortable about. So, that's private to private. Any questions on private to private transactions? So, doctor is selling his practice to another doctor, you'll run into all of these issues. Yeah. Yes. Right. The R-squared is about 35%. It was not I mean, I could have made it better. I stopped after four variables because I just got tired. Now, because the sample size was 7,500, I could have had seven or eight variables. The only thing to remember is you put those variables in they've got to be variables you can get for private companies as well. So, you don't want to bring in any market-based variables. Like a dividend yield wouldn't work because you don't have a market price. So, you can use any kind of book value-based number, anything that comes off income statements and balance sheets. And if you wanted a higher R-squared, you could get there because spreads are pretty explainable. And the other advantage is if you do this on an updated basis, they'll reflect the market you're in right right now. If you're in a crisis, the spreads for all companies go up, it'll show up in the intercept. So, it's a kind of a dynamic, constantly adjusted approach. We can get spreads that reflect the time you're in. So, that's private to private. Let's go to the other end of the spectrum. You're a private business and you're thinking of selling yourself and there's a public buyer interest. So, you play the role of a public buyer now. Public buyer in what sense? You're a public company interested in buying my private business. First, let's go back to the beta. You know, remember the private to private? I adjusted the market beta to the total beta. If you're a public buyer, which beta should you go with? You're a company, but you're investing other people's money, right? Your investors in your company, are they diversified? Yeah. Public to private to public, I go back to a market beta because I don't have to worry about this diversification issue. So, instead of using the 2.36 beta, I'm going to go back to the 1.18 beta. Second, on the liquidity discount issue. You're a public company. You're buying this illiquid private company. What happens after it becomes part of your company? Well, people can still trade your shares. Liquidity comes from people having to trade their shares. A public company does not have to discount value for illiquidity because its investors can get liquidity by buying and selling shares. They're not for buying sell assets. So, the market beta is going to go back to a total beta. I'm sorry, the total beta is going to go back to a market beta. The illiquidity discount will disappear. So, we need make the beta adjustment. You can already see the drop-off in my cost of capital. So, instead of 13.25%, I'm going to go with a public company cost of capital of 8.76% and my value, which is 454,000, will now go to 1,483. So, notice the illiquidity discount is gone. I'm using a market beta. This is very much like every valuation we've done so far in this class. So, if you have a private company being sold to a public company, you can pull up the template you had for valuing public companies and get away with it. So, you have two values, right, for this company, as for this restaurant. 453,000 to a private buyer, but 1.483 billion or million to or 453,000 or 1.483 million to a public buyer. So, let's say I'm the public buyer and you're the restaurant. So, you have two numbers ready for it, 453 3,000 1,483. Which one are you going to start your negotiation with? Let's see if you're, you know, whether I'm going to get an easy buyer. So, you're selling your company, you have both these numbers, you computed both. Which one are you going to start? You're going to start with the 1,483 and you're going to tell me the story, right? Which is I'm a public company, I should think about market beta, liquidity doesn't matter. How am I What am I going to counter you with? Which is I don't care what I look like, you're a private company and your next best alternative is a another private buyer, so I'm going to start at 453,000. And if I'm the only game in town, I'm the only public buyer and everybody else is a private buyer, guess who's going to end up winning this game? I'm going to end up getting it for close to 453,000. But if you can get a second public buyer interested in you, then we might start bidding against each other and push the value up to 1,483 million. Next week, we're going to No, a week after next, I'm going to talk about acquisitions. And I have a very cynical view that most acquisitions destroy value at companies. So, when companies try to grow through acquisition, there's but there's a there's a big chunk of the process that's going to make it more likely that you will lose value than increase value. But I'm going to point to one of the few cases where doing acquisitions can be value creating. It's when a public company private businesses either to create a roll-up business. You know what a roll-up business is? You basically buy a bunch of private companies, you roll them up into a public company. Blockbuster Now, of course, it's gone. Built itself up as a company by buying small video rental stores around the country, bundling them up, and becoming a public company. Browning-Ferris, which is a garbage disposal company, went around the country buying small privately-owned garbage disposal companies and bought. You see why there's a potential for value creation? Because what do I do as a public company then when I when I I I offer you a a premium over the 453,000. You feel you're winning, right? Cuz your next best offer is 450. I offer you 550. You think you're, you know, you walk away from the table feeling good. But I walk away from the table feeling good as well because I paid you 550,000 for something that's worth 1.48 million. I'm not ripping you off because your next best alternative would be in a private transaction. But you can see how this process plays out where if you're looking for the best potential buyer, that best potential buyer for you as an owner of a private business is often going to be a publicly-traded company. So again, let me emphasize, it's not that publicly-traded companies are diversified, it's that the investors in these companies are diversified, so they don't have to worry about total beta. It's not that illiquidity doesn't matter, but illiquidity doesn't matter to them because their investors can buy and sell shares, they get their liquidity a different way. And that's where the increase in value is coming from. So, I've looked at two extremes here, right? I've got a private business that's completely undiversified, or a private buyer that's completely undiversified, or a public company that's completely diversified. You see where a private equity fund falls between these two spectrums. A private equity fund is never completely diversified. They have a sector focus or regional focus. So, you're partially diversified. So, I'll take an example. Let's say you have a software business, you sell it to another individual who's completely undiversified. You compute the correlation of your company with the market and you come up with like 0.2. So, that gives you a high total beta. In contrast, you take that same software business and you sell it to a software VC who is invested in 25 software companies. So, here's my question. One software company, your correlation is 0.2. You take a portfolio of 25 software companies and you look at the correlation with the market. Is it going to be higher than 0.2, lower than 0.2? What's going to happen when I create a portfolio of software companies? It's going to be a bit higher because some of the risk in a software company is very company-specific risk. So, when I create a portfolio of software companies, the correlation I'm going to get might be 0.4 or 0.5. You see what's going to happen? The venture capitalist is now going to have a lower beta than the individual buyer and the and the venture capital beta will be lower than will be higher than the market beta that is offered by the So, you can see this process where you start off with a completely undiversified buyer, then you get partially diversified buyers, and it ends with fully diversified buyers either because you go public or you get acquired by a public company. So, it's a process that plays out almost all of the time. There are a few private companies that stay honest private, right? I remember they uh they used to have this auction at Stern. I don't know whether they still have it, but if they have it, I've kind of withdrawn from it. But, they always come to professors and I'd say, "Can you offer something we can sell?" What am I going to offer other than I'll value a company? So, I put that into the bid and usually people bid a couple of hundred dollars or three hundred dollars, they get a business valued. They walk away happy, I walk away not unhappy. So, we're we're both okay. So, one one auction ends up that this particular thing goes for a couple of thousand. I said, why would somebody pay a couple of thousand dollars for just have a company value? So, I you know, I wait and this MBA comes in. He's a first-year MBA and he's got this big stack of financials with him and he says he says that your company's financials. He says, yes. And what does your company do? He says it makes rum. So, where are you from? He said, Miami. You know what the company who wanted me to value was? Bacardi. Still a privately You say, why is it privately owned? You drink enough of your product after a while, you forget about diversifiable risk, non-diversifiable risk, total risk. I mean, they stayed private for 100 for I know, 150 years. It's actually a fun company to value. Because I mean, you have corporate governance issues, obviously, because you have multiple It was like the third or the fourth generation family members all over the place. But, obviously, a niche product. It's got a brand name. So, that was a case where a private company stayed private, notwithstanding these pressures. Most private companies do buckle at some point and either become part of public companies or go public themselves. So, I want to be make sure everybody gets a private-to-private use total betas, put in an illiquidity discount, you're going to get a low value. Private-to-public, use market betas, there's no illiquidity discount, it looks very much like a public company valuation. Private-to-venture capital or private equity fund, you're somewhere in the middle. You're not your betas are not as high as they were with the private buyer, then they're not as low as they will be with a public buyer. But, effectively, it captures that transition from being a privately owned company to a publicly traded company. So, then let's look at the third scenario. Private company valuation as a leading to an initial public offering. So now you're valuing the company not because you want to sell to a private buyer or a public buyer, but cuz you want to go public. So I want to talk about the issues that come up when you value companies ahead of IPOs. Is everybody familiar about the process of IPOs? A company wants to go public. What's the first thing they need to do? They need to file a prospectus with the SEC. And around the world there are variations, same thing, but you file a prospectus. What's a prospectus? It looks like a 10K for a private company, right? So it has all of the information that you have in a 10K. So one of the nice things about valuing private companies ahead of an IPO is you're now looking at financials that covered by GAAP and IFRS. So if you have to capitalize leases, you got to do it in the prospectus as well. They'll give you the history of the company. So to start with, you're looking at num at at data very similar to what you would do to value a public company. But there are issues that are specific to private companies that I want to talk about in the context of an IPO valuation. This is a valuation I did of Twitter ahead of their IPO in 2013. Usually when companies file their prospectus, if the company I'm interested in, I value the company right after the prospectus is is filed. I did this with Alibaba, I did it with Twitter. I do it right after the prospectus is filed because there's no bias in the process. There's no market price out there, there's no banking price out there. I have a clean slate, I can come up with the number. It's kind of you know, unsettling because you have nothing to compare it to, but I came up with the value of about $17 per share for the company. And if you look at the valuation, it looks very similar to a public company valuation. It's got reinvestment rates and cash flows. Basically, it's a three-step approach, revenue growth, margins, sales to capital. So you can take that FCFF Genji, plug in the numbers for any prospectus as you can you can come up with evaluation of the company. But there are a couple of twists with IPOs that you have to build into the valuation. So if you want to use my spreadsheet to value an IPO, here's the first thing you have to think about. One is when you go public on the offering day, you issue shares to investors and you get cash in return, right? You need to tell me what you plan to do with the cash. You say, "What do you mean? What do you mean?" What are the different choices a company has when it comes to cash raised in an offering? What can it do? Yep. One is you can set it aside for future reinvestment. Obviously, you don't reinvest the day after, but after the IPO, you can put it into your cash balance and use it to cover those negative free cash flows to equity you had that you estimated are now going to be covered with that cash balance. So it increases your cash balance. Okay, so that's one choice. Raise capital, put into your cash balance, use it to cover future reinvestments. What else can it do? You know what Spotify did in their IPO? They issued shares, they got money, and they let existing owners cash out. So Sony was an investor in Spotify. Sony wanted not to be an investor in the public company, so they let So So owners cash out. So cash comes in, leaves almost instantaneously. So second thing you could do is let existing owners cash out. The third thing you can do is use the cash to pay down venture debt or debt you might have taken on as bridge financing to get it off the books. You need to tell me what you plan to do with the proceeds in evaluation. And every prospectus, there will be a section on what a company plans to do with the proceeds. So pick up a prospectus of a high-profile company, read through the prospectus, get to that section because you need that section. So we're going to talk about what to do in the case of Twitter. The IPO proceeds were a billion dollars. You will notice that it gets added on to the value. Why? Because the day after the IPO, your cash balance is going to increase by a billion. And Twitter told me that they were going to keep the proceeds in the company. Everything else about this valuation, I've kind of done pretty much what I'd done with the public company. But let's talk about the issues that are IPO specific. Two of these issues are valuation specific. One is, and I talked about this already, the proceeds. What do you plan to do with the proceeds? The other is the way private companies are built up often requires them to go to venture capitalists over and over again. Twitter had had seven VC rounds before it went public. You're saying, "So what?" Each time you have a VC round, you raise capital from venture capital, you often create a new class of shares. Twitter had seven classes of convertible preferred shares, reflecting their seven rounds. Pain in the neck, right? What are you going to do with seven seven class of shares? They'd also, because they were a young company, use restricted stock and options to reward their employees. So, by the time they went public, they already had built up this backlog of drain things that could drain your equity value. That's going to be true in any company, but with with young companies going public, it can be a particularly problematic issue. Those are the valuation issues. There are also pricing issues. Which means that in a typical IPO, here's how it works. You want to go public, what's the first thing you do? You hire a banker. They find one. And what does a banker do for you? At least what does a banker claim he will do for you or she will do for you? They'll first help you write the prospectus, so they have the infrastructure for doing that. They'll help They'll tell you they will value your company, when in fact they will price your company, but that's okay, we'll let them use the word value. What else do bankers do for IPOs, for young companies planning to go public? They will do a road which means the bankers will wear expensive suits, go around the country, do nice-looking charts, multiple font sizes, different colors. But along the way they might give you some information about the company. What else? They will basically get on the old days get on the phone and get on to clients or portfolio managers and look, we're going public with Twitter, you know, would you be interested? And they'll frame it in a way of this is your last chance to get into this deal at the ground floor. You've heard it right? You go to an electronic store, you basically get getting the banking pitch in a lower form, but it's the same kind of thing, you know. And then they give you one final it looks out they actually guarantee the price they will take you public at. That's amazing, right? What if I were a realtor and I said I can guarantee the price I can sell you sell your house at? You know why you should pay nothing for that guarantee? What did I forget to tell you? I forgot forgot to tell you the price. Can I sell your price? I guarantee I can sell you house at 20% below the market. Anybody can do that. And that's what bankers do. They they offer an underwriting guarantee, but the guaranteed price is often 15 or 20% below what you what they think the price should be. And there's one final thing they do, which is after the company goes public, at least in theory, they offer what's called after-market support, which means if somebody's trying to sell your shares, they'll often come in and buy the shares to offer support to a limited extent. They don't have unlimited resources. So those are the services that bankers claim to offer. And in return for that, what do they get? 6 to 8% of the proceeds. So if you raise 100 million, that's 6 to 8 million dollars. That is the process companies have used for the last century. The process is getting frayed. We'll talk about why, but that is the process use. But a key part of that process is an underwriting guarantee. So, let's talk about the valuation issues first, then we'll come back to the pricing issues. As I said, there are three things you can do with the cash. One is you can keep the cash in the company as part of your cash balance and use it to cover future CapEx. The second is you can let owners cash out, and the third is you can use the cash to pay down debt. If you decide to take the cash out of the company, let owners cash out, I can completely ignore the cash. You see why? Cuz I raise cash through one window, it goes out through the other window, it doesn't change my value of the company. So, in Spotify, the proceeds from the IPO net don't even show up in your valuation. They're just gone. If you keep the cash on the balance sheet, there's going to be an immediate augmentation of your value by the amount of cash you've raised because that's cash now that increases your cash balance. And if you use the cash to pay down debt, how does it show up in your valuation? What happens when you pay down debt? Your debt ratio goes down, your cost of capital is different. So, it might affect your discount rate. It might affect your failure rate. Remember we talked about failure rates and how they can affect the value of young companies. Might affect your failure rate. So, what you do with the proceeds depends very much on what the company plans to use the proceeds for. Second stop. Oh, in the case of Twitter, they actually in their prospectus told me that they were going to use the billion dollars in proceeds to hold as cash. It is required as part of the prospectus to specify what you plan to do with the proceeds. And Twitter's No, Twitter's as judgment was they would keep the cash balance. Second, clean up, right? You have all these different claims. I can't value the equity in a company when there's seven different classes of convertible preferred stock to deal with. Luckily for you, when companies go public, one of the things that happens is all these different classes of stock will get converted to common shares. In the case of Twitter, what made my life easier was all seven classes got converted into common shares. They still had restricted shares that I had to deal with and options outstanding. But they did clean up at the time of the prospectus. And that too should be specified in the prospectus. They'll tell you how many shares there will be outstanding after all of these convertible preferred shares get converted into common shares. But in the case of Twitter, there's there's two things that I think they left us loose ends, which I tend to find in most prospectuses. One is there tons and tons of restricted stock that for whatever reason they excluded from their share count. They're actually pretty open. They say, "There are 337 million shares outstanding in the company. Oh, by the way, we have excluded these 73 million restricted shares." Why? Just because you feel like it? Sometimes they say because they're non-vested. You know what the keyword vested here means, right? You've got to stay on long enough to get those shares. We're going to ignore them because they're non-vested. That doesn't mean they'll never get vested. Here's my advice to you. Don't take the share count that you see in the prospectus that the company gives you. Look through the excluded shares because many of those restricted shares I took all of the restricted shares and add them on to the share count. So, my share count is actually very different from the investment banking share count that went out that day. Because I counted the restricted shares. They also had 44 million options. What do we do with options in publicly traded companies? What's the right way to deal with options? We value them as options, and that's exactly what I did. Here with one catch. When I valued options in publicly traded companies, I used the market price to value the option because I had one. Here I don't have a market price. I used the intrinsic value per share I estimated the $17 to value the options. That value for the options was 805 million. I'm going to subtract that from the value of equity. In fact, you saw that in the big picture to get to the value of equity in the company. So, I'm doing exactly the same thing I do with public companies, just more work with private companies because you don't have a market price. And finally, the investment banking guarantee. As I said, it sounds too good to be true, right? Somebody guarantees a price. But the promise because the guarantee it's an investment banking guarantee that affects how bankers set offering prices on shares. So, let's play a game. Let's suppose you price shares in a company, come up with $20 per share. Let's say you've done it reasonably well. You feel pretty comfortable that that's the right price, $20 per share. You're going to offer me a guarantee on that price, right? Because you're offering a guarantee, you want to discount the price you give me or add a premium to that price? What's going to make your life easier? Right? You set the price at zero, think how much easier life would be. You can't do that, but you're going to try to discount it. By how much? It's amazing. If you go on to work for an investment bank in the IPO section, if you look at manuals, it's actually written right there in the manual. Value the company or you know, price the company, take 15% off. It's like a discount that applies all the time. And it's okay. So, you price the company, and how do you price the company? We talked about the Kabuki dance. You can go through of acting like you're doing a DCF, but in pricing a company, you look at a metric, use a multiple, you come up with the pricing. In fact, I showed you my Twitter pricing was based on how many users they had and applying $100 per user. Where did I get the $100 per user? By looking at publicly traded companies in the space and looking at what the market was paying per user. It's my pricing of the company. And then, once I get the pricing, I'm going to discount that price. But that discount creates a little bit of a potential People look at it and say, "The original papers on IPOs actually called it the IPO puzzle." I'll explain in a minute minute why they called it the puzzle. And here's what they found. So, you have an offering price, and on the opening day of trading, you have a starting price for the stock, right? So, the offering price is set at $30, market opens for trading. It doesn't open at 30, it opens at 34, 35, 36. On the offering day, on average, the IPO stock price increases by about 15%. Sounds like a way to make money, right? So, tell me how you how you would you exploit this to make money. Start a mutual fund for me. That takes this graph and say, "I'm going to make money in this guy." What are you going to do? Yes, I mean, sh- short it when? After it's gone public? Because that would require the price to drop. You have the price is jumping. You short it at You can't First, you can't short at the offering price. It's not traded. So, you'll have to wait till it's traded. And so, maybe there's a shorting strategy down the road, but I want a strategy for the opening day. What might you do? Yeah, start it I- in a mutual fund. Here's what you're going to do. You're going to buy a thousand shares in every IPO that comes up in the next year. Just make money hand over fist, right? And mutual funds have tried this, and they don't make money. So, tell me what the slip is between the cup and the lip that leads these this 15% that you see on paper to kind of dissipate. So, let's play this through. You have 100 IPOs coming up. You write to each banker and you ask for a thousand shares in each IPO. Are you going to get a thousand shares in every IPO? No, because bankers have to ration. Based on what? Demand and supply. So, if you have an offering which is over subscribed by 500%. This has nothing to do with playing favorites. You're going to get only one in five shares that you asked for because there are five times my more money. So, you're going to get 200 shares in in company. If a subscrip- if an offering is under subscribed, you're going to get all 1,000 shares. Do you see what's going to happen, right? At the end when you look at your portfolio, you're going to have 200 shares in all the most underpriced companies and 1,000 shares in the most overpriced companies. So when you look at the returns on your fund, you say, "What happened?" What happened was you didn't get an equally weighted portfolio. Yeah, you got a portfolio that's overweighted with stocks that were overpriced and underweighted. It So if you're planning to make money in IPOs, you can't just buy every IPO. If you have a way of discriminating across IPOs to figure out which ones are underpriced and which ones are overpriced, maybe but that would require actually pricing the IPO to see which ones are most likely to see this picture. So making money in IPOs is not easy because of this fact that you don't get all of the shares you want in the companies you want you want to get them in, but you get all the shares you want in the companies you don't want to get them in. And that's not a good end game to be as an investor. But there's another aspect of this discount that troubles people. And this is where the puzzle comes in. You're the founder of a company. You've spent the last 5 years working 20 hours a day building up this company. Along the way you accumulated venture capitalists who took a lot of risk as this company built up, right? You decide to go public. And let's say your fair price is $20. And I take put a 15% discount on that price when I set the offering price. That's money coming out of your pockets. And the question that people often ask is, "Why do founders go along with this? Why do they allow bankers to knock 15% off?" So let's say you have a $10 billion company. 15% of 10 billion is 1.5 billion, right? That they leave on the table. Or is it? That's if you issue all of the shares at the offering. But in a typical offering, you offer only about 10% of the shares. That's still 15% of that. But you might be okay with it. Why? Because the day after the offering, what do you see as a Wall Street Journal article on your company? Stock price jump on offering day. What do you hope will happen? Other people will read the story. And then what will they do? What human beings have done through the history of investing, which is they will now try to buy the stock. You know what a lost leader in department store is? Lost leaders are those things they put in the table to suck you further and further into the store. Yeah. Socks at 20 cents. You don't need socks, but 20 cents, you know, might as well buy them just in case. They're not even your size. So, cheap. So, a lost leader, you're basically selling stuff for below cost because you want me to get to the Ralph Lauren section, which is near the fifth table, and in a moment of weakness, buy a $200 sweater that I don't need, right? This is like a lost leader. You're willing to accept it as gone because you hope it'll draw more people into the stock and push up the stock price. So, if you're wondering why this existing process has survived the way it has, it's because nobody in this process actually has that many problems with the process as long as you discount about 15 or 20%. If it stock price doubles on the offering day, clearly you're going to be much more upset as a founder. But for a long time, people got along with this process. But in the last few years, people have started questioning the process. Let's go through the services bankers claim to offer. Okay? First is they help you write the prospectus. Chat GPT could do it for you. Have you ever read prospectuses? They come out of a template. It's almost like the same guy writes every prospectus. They use the same language. So, there's not There's not rocket science. I could, you know, you don't need a banker to do it. They price your company. Really? This is what they do when the price doubles on the first day. That's not great pricing. I'd probably have asked my doorman to price the stock and it would be better pricing. So, that's not very good. Or they sell your company. They you know, get investors to buy a company that they don't recognize because Goldman Sachs is backing it. That might work for a company nobody's heard of. But on the day Facebook went public, I'll wager more people had heard of Facebook than of Morgan Stanley, the lead investment banker. I don't need Morgan Stanley to tell the world who I am. Everybody already knows who I am. You see what I'm saying? All those services that bankers used to offer as special services have essentially become less and less valuable. And I'm paying 6 to 8%. So, a few years ago Bill Gurley said, "Why don't we cut the banker out of the equation?" It struck terror in the hearts of bankers. This is These are not words they want to hear. Cut the banker out. What do you mean cut the banker out of the process? He said, "Why don't you just go directly to the market?" It's called a direct listing. In a direct listing, you know what you do? You specify the opening day. We're going to start trading on May 15th. There's no offering price. You're saying, "What? What are we going to do?" How do markets set prices? Demand and supply. They open up, there's demand, there's supply, there's There's no discount on the price. It's much fairer because nobody's getting the the shares at a special price. It's called a direct listing. The only problem with direct listings is right now the the status quo doesn't like it. The SEC believes that direct listings are potentially unfair to investors because they have this feeling that investors will be taken advantage of by fly-by-night companies that go public. They feel They actually believe that bankers are your defense against getting scammed. I don't know what the the SEC is drinking, but I don't see bankers as my defense. So, their view and the way they constrain direct listings, in a direct listing today, you're not allowed to keep the cash you raise in a direct listing. That's why Spotify actually had to let owners cash out because they made a direct listing. It wasn't a traditional IPO. So, the direct listings have not taken off the way they could have without those constraints. And in the last 3 years, there's been a third way to go public, right? What are SPACs? What do you do in a SPAC? Do you want to tell me describe what what what you do in a SPAC? So, you start a SPAC. So, first do you have to be a high-profile or a low-profile investor? It has to be a SPAC creator. Yeah. Chamath Palihapitiya, right? High-profile. So, what do you do? You raise money from people to do a public offering of whom you don't specify. Say, "Trust me. I'll find a company for you." So, you trust him. You trust him. Why? Because they have a track record. They know technology. They find a company for you, and they negotiate on a price for you. Trust me, I'll negotiate a good price for you. And for all of this trust, what do you have to pay Chamath? 20%. SPACs take 20% of the money. So, they raise 100 million, 20 million Chamath goes and This is a great Now, you see why he started what? 16 different SPACs. You take the 20% off and take the remaining 80 million. With that 20% cut, it's never going to take off, but the process is getting shaken up. And I don't know how it will evolve, but I think we're going to see change in the IPO process because the existing way of going public is not working. And the new ways are not good enough yet to make the switch. So, on Monday, please bring your last packet. So, I'll send you the link so you can download it because we're going to talk about option pricing on Monday. So, if you want to look at your option pricing notes from foundations, that's good, but I assume nothing. We'll start with a very quick review and then go into real options. Yes.