By Maxime C. Cohen, Aswath Damodaran and Daniel M. McCarthy
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 /zigman2/quotes/220991541/composite SNOW +0.90% and eyewear company Warby Parker /zigman2/quotes/229389137/composite WRBY +5.81% , have done well. But others, such as mattress company Casper Sleep and fashion firm Rent the Runway /zigman2/quotes/208217928/composite RENT +5.56% , 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 Rather, it reflects outdated IPO disclosure requirements – rules that have led to bloated prospectuses but still miss the most important information that investors need in evaluating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
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.
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.