Finding an Alternative Disclosure Path: IPO Business Model Targets

Key Observations

·         Nearly 40% of IPO firms provide quantitative forward-looking financial information in their IPO roadshows that is not included in the firm’s S-1 filings.

·         In contrast to seasoned public firms who generally provide next-year or next-quarter earnings forecasts, forward-looking metrics in the IPO roadshow – often called “targets” – most often describe the firm’s expected equilibrium business model at an unspecified time in the future.

·         Firms typically provide targets that improve their current financial position: increased profit ratios and reduced expense ratios.

·         Analyst forecasts are less dispersed for firms providing more targets, suggesting analyst use the targets. However, analysts’ forecasted values are generally more pessimistic than firm-provided targets, although analysts typically only forecast about 3 years ahead.

·         Firms frequently do not meet their disclosed targets. Even using the low-end of the target range, a minority of firms ever meet or exceed the target during any of their post-IPO years.

·         Stock returns increase (decrease) as firms’ realized profit (expense) margins grow relative to the IPO targets, suggesting that the targets were used to form expectations of firm value and investors adjust their estimates when realizations deviate from these expectations.

·         Firms that present targets during their IPO roadshow are nearly three times more likely to also issue next-year or next-quarter earnings forecasts after going public.

·         Firms do not continue to disclose targets after their IPO. Thus, target disclosure appears to be part of a broader strategy to provide investors with forward-looking information, with firms using the IPO roadshow as an initial platform before transitioning to more conventional guidance mechanisms once public.

The inclusion of forward-looking projections in Securities and Exchange Commission (“SEC”) filings has a long and varied history. Dating back to the Securities Act of 1933, the SEC initially prohibited the inclusion of such information in SEC filings. The SEC later reversed this prohibition through a series of regulations. Safe harbor rules released in 1979 (Rule 175 under the Securities Act of 1933 and Rule 3b-6 under the Securities Exchange Act of 1934) attempted to insulate financial projections from liability. Then, US Congress adopted the Private Securities Litigation Reform Act (PSLRA) in 1995 that, among other things, provided firms more protection when making forward-looking statements in an effort to reassure firms nervous about litigation risk.

However, IPO communications are explicitly excluded from PSLRA protections. Thus, issuers are exposed to significant liability if forward-looking statements prove inaccurate, and lawyers strongly caution firms against providing such information while marketing the IPO. Although IPO firms are technically allowed to provide forecasts when going public, Rose (2021) writes that issuers “uniformly choose not to.” In a review of IPO filings over the prior three years, Feldman (2021) similarly concludes that “no IPO company has actually provided financial projections, other than vague narrative disclosure.” In contrast, Coates (2023) raises the possibility that firms do provide such information, but through the roadshow presentation rather than in the SEC filing. In light of the debate, and motivated by increased discussion about IPO disclosure rules, we ask whether IPO firms use the roadshow as an alternative disclosure channel to meet the market demand for forward-looking information.

IPO roadshow forward-looking disclosure properties

Using slide decks for 942 IPO roadshows from 2011 through 2020, we find that 37.6% of firms include quantitative forward-looking financial information in their IPO roadshows. These forward-looking metrics in the IPO roadshow are often called “targets” and most often describe the firm’s expected equilibrium business model at an unspecified time in the future. This disclosure style is consistent with legal advice to avoid the appearance of forecasts when fundraising, even if forward-looking information is provided (American Bar Association, 2023).

The most common targets provided are margins; from 13% to 21% of firms provide targets for each of the following items divided by revenue: gross profit, research & development (R&D) expense, EBITDA, sales & marketing (S&M) expense, general & administrative (G&A) expense, and operating profit. Nine percent of firms provide revenue growth targets, but these are typically the expected steady-state revenue growth rate, not revenue growth for next year. Thus, many IPO firms are providing a different form of forward-looking disclosure than mature firms, and through the alternative channel of roadshows. We also find no evidence that these metrics are disclosed in the firms’ S-1 filings.

Not surprisingly, firms typically provide targets that suggested improved expectations relative to their current financial position: increased profit ratios and reduced expense ratios. For example, the median firm predicts a 44-percentage point improvement in their operating profit ratio. These targets exceed not only the IPO firm’s current operating performance but also most industry peers.

IPO roadshow target accuracy

Firms frequently do not meet these targets. Generally speaking, firms are less accurate for target metrics farther down the income statement; 23% of firms are more than 10 percentage points off their gross profit targets while 88% are more than 10 percentage points off their operating profit targets. When we limit to firms still operating five (ten) years after IPO, 79% (59%) are more than 10 percentage points off their operating profit targets.

Further, this inaccuracy tends to be optimistic; firms make less revenue and have higher expenses than they target. Even using the low-end of the target range, only 13% of our sample firms ever meet or exceed the targeted operating profit ratio during any of their post-IPO years. Thus, even when firms provide long-term business model targets rather than short-term performance guidance, they seem to respond to incentives to provide a more positive outlook of the firm’s prospects, similar to optimistic performance forecasts documented in other settings.

IPO roadshow target disclosure effects

We examine the relation between target provision and IPO price formation. We find a positive and significant correlation between the number of targets firms provide in their IPO roadshow and both the absolute and signed price change around the IPO. If investors are incorporating firm-provided business model targets into their expectation of firm value, long-run returns should adjust if firms fail to meet the targets. Consistent with investors allowing IPO firms some time to reach their targets, we find no relation between target distance and market-adjusted returns from the IPO through the filing of the firm’s first 10K. However, we then find a significantly positive (negative) relation between the profit (expense) ratio target distance metrics and adjusted returns from IPO through the second and third years, except for the operating profit margin.

To more fully assess the effects of providing these disclosures, we turn to analysts as market participants with observable expectations. We find that analysts’ forecasted values are generally more pessimistic than firm-provided targets, although analysts typically only forecast no further than 3 years ahead. While analysts do not seem to naively rely on the firm provided targets, we find significantly reduced analyst dispersion for one-, two- and three-year-ahead earnings forecasts when firms provide more targets in the IPO roadshow.  This suggests that analysts use the targets to inform their earnings forecasts about the firm. The combined evidence indicates analysts find firms’ targets informative.

Post-IPO forward-looking disclosure properties

In our final set of tests, we seek to validate our belief that firms use roadshow targets in place of the more traditional forecasts commonly provided by public firms. Specifically, we examine the relation between target disclosure during the IPO roadshow and the decision to issue forward-looking guidance in the first year as a public company. We find that 82.5% of firms that present targets during their IPO roadshow also issue forward-looking guidance within their first year, compared to just 29.6% of firms that did not provide targets. This strong association supports the idea that target disclosure is part of a broader strategy to provide investors with forward-looking information, with firms using the IPO roadshow as an initial platform for such disclosures before transitioning to more conventional guidance mechanisms once public.

Implications

Our study provides new evidence of forward-looking disclosure by IPO firms at a time of renewed calls for regulators to encourage forward-looking disclosure from IPO firms. For example, Rose (2023) says “it is an apt time to reflect on the wisdom of the IPO safe harbor exclusion,” and Damodaran et al. (2022) says “preventing companies from forecasting the future only allows others, less scrupulous and informed, to fill in the empty spaces with their own details.” SPACs became a popular alternative funding path in part because of the common perception that IPO firms couldn’t (and thus didn’t) provide forecasts without substantial legal risk. We provide large-sample evidence that more than one-third of IPO firms provide business model targets in the roadshow, and that investors and analysts appear to use them. This confirms the desire of firms and investors for more forward-looking disclosure, yet reinforces the legitimate concerns of IPO firms’ tendency to optimism. We also highlight the roadshow’s importance as a supplemental IPO disclosure, and we deepen researchers’ understanding of firms’ forward-looking disclosure choices in the face of significant information frictions and litigation concerns.

The full paper is available for download here.