How to Read an S-1

What to Focus on, What to Ignore

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There is a hallowed tradition in markets, where every time the IPO window opens, a bunch of companies file to go public, the people who have used the product check out the prospectus and find worrisome stuff like "We have incurred losses each year since our inception, we expect our operating expenses to increase, and we may not become profitable in the future" and start to wonder 1) why this company can't find a way to make a profit, and 2) why investors are so excited to buy it anyway.

IPO volume has taken a dive recently, with the number of offerings dropping 83% from 2021 to 2022 and, so far this year, tracking at close to the lowest annual levels since the financial crisis. But there are green shoots: Cava (Diff writeup here ($)) went public earlier this month and doubled its valuation—every $1 of hummus sales produces more than $10 in market cap!—and companies that scotched their IPO plans early last year are revising their documents, updating their shareholder letters to remove most of the bombast, and getting ready to give it another shot.

When a company plans to go public, they'll file a prospectus with the SEC, usually a form S-1.1 The structure of an S-1 is somewhat consistent across the board, but the exact content is always a compromise between two forces: the company and the underwriters who want the deal to go as smoothly as possible. The underwriters want to write a sales letter for a product the way to sell as quickly as possible, but the SEC wants to limit the extent to which investors, especially small ones, can get ripped off by unscrupulous operators. The end result looks something like a pharmaceutical ad, the design of a pack of cigarettes, or basically any physical object sold in California: there's a delirious alternation between efforts to convince someone to buy something littered with strenuous warnings about all the bad results that could ensue if they do.

So your typical S-1 is a back and forth between these, and we see that starting on page one: it always opens with a straightforward summary of the business, and is often followed by a letter to shareholders. For context, the shareholder letters are a rather new phenomenon; Google kicked off the trend in 2004 with its "Owner's Manual for Google Shareholders," as a way for them to contextualize what they're doing. These letters vary quite a bit, from sentimental notes (DoorDash's opens with "We started DoorDash to help people like my Mom") to proclamations that demand other companies to choose a side in geopolitical conflicts (Palantir’s quickly jumps to "Americans will remain tolerant of the idiosyncrasies and excesses of the Valley only to the extent that technology companies are building something substantial that serves the public interest. The corporate form itself — that is, the privilege to engage in private enterprise — is a product of the state and would not exist without it... We have chosen sides, and we know that our partners value our commitment. We stand by them when it is convenient, and when it is not.")

Once you’re past the letter, you’ll find a summary of the prospectus, and then a lengthy recitation of "risk factors." Some risk factors are quite reasonable, and can contain helpful information. (Coinbase lists "A particular crypto asset’s status as a “security” in any relevant jurisdiction is subject to a high degree of uncertainty...") But many of them are tedious, redundant, or bizarre. Basically every company, for example, will disclose that terrorist attacks are bad for business.

Why do they do this? If something causes shareholders to lose money, and the company didn't disclose that this could happen, then they'll get in legal trouble. As a wise man once pointed out, everything is securities fraud. An imperfect defense against this is to enumerate all of these risks. And once one company does it, it looks irresponsible for other companies not to include the same risks in their list. But the practical effect of this is that someone reading the S-1 all the way through is very likely to give up somewhere in the middle of a long litany of things that could go wrong. So the S-1, as it's experienced, is basically like a Coen Brothers movie: in the beginning, someone has a clever but risky idea for making a lot of money, and then every possible thing goes wrong.

The meat of the S-1, and the part that's worth dwelling on, is the "Business" section, and the "Management’s Discussion and Analysis" bit that precedes it. The business description will include some stats that the company plans to regularly report2 , but many that are one-time, especially things like cohort analyses and unit economics.

And this is often when the question that led to this piece gets answered. A typical explanation for why investors want to own shares of a money-losing company is that it has some mechanism whereby it pays $1 and gets, say, $0.50/year, growing 10% annualized. One can't say this grows "indefinitely," but some companies will produce cohort metrics showing that their earliest users are continuing to spend more over time, and how their margins evolve in tandem. This is what analysts are thinking about when they build a long-term model and put a price target: how many customers can DoorDash get, what do their gross margins look like year to year, what's the marginal cost of acquiring them, and what's the fixed cost of running the service? For Palantir, they want to think about how the size of contracts explodes over time while costs creep upward more slowly, so they can look at a pilot project and see it as some probability of eight or nine figures of revenue rather than seeing it as an immaterial six figures with a materially negative cost profile.

So one way to answer the "why buy unprofitable companies?" question is to invert it: if a company is growing fast, and has great unit economics, how can it justify turning a profit? There are two cases where growth companies go public while reporting accounting profits: in the first case, they're mature enough that growth is slowing down and operating margins are expanding. In the second case, they simply can't grow their spending faster than they grow their revenue; Google and Facebook (disclosure: long the latter) were both profitable at IPO, in part because they didn't have many inorganic avenues to grow users, and in part because their standards for employees were so high that it was hard to hire them fast enough. This, to be clear, is a great problem to have. But it's rare, and it usually means that the investor who found the company in its pre-profit infancy was a VC—and they made an absolute killing.

The other part of the meat, the Management's Discussion & Analysis, is useful for a different reason. It's a detailed look at how the company's numbers changed over the last year, which means it provides a sense of: operating leverage, economic sensitivity, how lumpy various costs are, where they're staffing up, and generally what stage they're in. MD&A will be reiterated in every quarterly and annual report with roughly the same amount of detail. So if the "Business" section is a look at where the company is going long-term, MD&A is a look at what it's like to own shares at any given time.

There are other useful sections of the S-1, but they're a lot closer to gossip. There are executive bios, for example, which can be interesting for historical reasons—sometimes when a company gets close to IPO, it hires a bunch of experienced CxOs out of the same company, or out of a cluster of companies, so this can be a bit of a preview of what the business wants to be when it grows up. And later in the S-1 there's some disclosure about current investors and prior funding rounds, but that’s mostly just so you can have fun figuring out how much money the VCs made.

If there's one thing not to do with an S-1, it's to skim the P&L, look at how much money the company is losing, and dismiss it as a boondoggle. Companies typically go public when they're net consumers of capital, and that capital consumption either takes the form of capital expenditures or as an expense. In the smokestack industries, capital expenditures aren't treated as an expense; they're depreciated over the life of the asset. But the present value of future revenue from a customer is just as much of an asset as a steel mill, it’s just one that gets a different accounting treatment. So the real goal of the S-1 is to start with the "steelman"—why are the executives of this company, who are compensated primarily with equity, very excited for the business to be publicly-traded and subject to continuous evaluation by the market? From time to time, the reason genuinely is that they think the market is dumb and want to take everyone's money. But usually, there's a bull thesis there somewhere, and the first step to figuring out why a company won't work is to figure out why someone might think otherwise.

Read More in The Diff

The Diff has written extensively about IPOs, both as a general concept and in the case of specific companies. For example:

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1. For the completists: an S-1 will also be filed ahead of follow-on offerings, whether that involves the company issuing more shares or a major investor selling their stake. Foreign companies may file a form F-1 instead, and small companies doing a crowdfunded offering will use form A-1. When a SPAC merges with a company to take it public, they'll do a blizzard of different filings, but the one that looks basically like an S-1 is usually a Form S-4. The only people who really need to know the finer distinctions between these already know this, though; for the rest of this piece, assume "S-1" means "the prospectus a business files ahead of beginning its life as a public company.

2. And they better choose them wisely, because they’ll be judged by them in their future filings. This is actually a bit of an art—Meta doesn't like to give a time spent metric for Facebook, for example, even though this is a very important data point; there's too much competitive intelligence at risk.

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