On March 29, 2019, the popular ride-sharing startup Lyft officially debuted on the Nasdaq Stock Market, capping off more than a year of speculation and supposed investor fervor over access to the next tech unicorn. Opening at a price of $87.24 a share – 21 percent above the initial public offering (IPO) price of $72 offered to pre-IPO investors – the market gave the company an approximate valuation of $30 billion. Within the next few days, the stock tumbled more than 12 percent, before briefly recovering. But as of this writing, the stock is down more than 31 percent from its first day of trading. Meanwhile, Lyft has threatened litigation against Morgan Stanley, alleging that the bank helped create special financial instruments that allowed pre-IPO investors in the company to short the stock. Those investors would typically be subject to lock-up agreements that prohibit them from hedging their risk by shorting the stock or directly selling it.
The IPO debacle and subsequent lawsuit illustrate how investor speculation over the public debuts of tech companies – particularly ones like Lyft that lose nearly a billion dollars a year – may have caused the market to overvalue tech unicorns, startups that are valued at more than a billion dollars. In taking advantage of this, one bank may have courted legal trouble by creating a market for pre-IPO investors wary of the company’s fundamentals.
Background on Lyft and the Initial Public Offering
For most investors, Lyft’s IPO was the first chance to invest in ride-sharing, a technology that has taken the world by storm and is set to revolutionize transportation. Publications reported that demand for the company’s shares exceeded expectations; Lyft’s last private valuation was $15.1 billion in 2018, indicating that people buying into Lyft’s IPO believed the value of the company had nearly doubled to $30 billion in just one year. Market observers – particularly Lyft’s main competitor Uber, which similarly aims to go public later this year – were keeping a close eye on Lyft’s IPO experience. Given that many pre-IPO investors have now presumably lost money (as of April 10, the stock was trading at around $60 a share) Uber and other unprofitable tech startups with Wall Street dreams may have a tougher time selling themselves to a skeptical public.
Despite the company’s IPO problems, Lyft exemplifies two features common to many well-known Silicon Valley companies going public: the company is both unprofitable and founder-controlled. Though the company’s revenue has more than doubled since 2017, its losses have also increased. In fact, Lyft’s own management has specifically stated, “We have a history of net losses and we may not be able to achieve or maintain profitability in the future.” Of course, companies trying to limit their future liability will disclose as much as possible in the risk factors section of their prospectus. Still, the statement represents how much Lyft investors are betting on the future by investing in an unprofitable company.
Additionally, like other tech unicorns that have gone public – Snap, Inc., for example – Lyft maintains a dual class share structure that gives its founders Logan Green and John Zimmer nearly 50 percent of the company’s voting rights despite retaining only 7 percent of the total equity. This leaves the company firmly in the hands of its Silicon Valley originators but without any shareholder check on the company’s management. Dual class share structures are perfectly legal under both corporate law and the rules of the major stock exchanges as long as the company creates the structure before offering itself on the public markets. That way, informed investors can evaluate whether the risk of control being concentrated in the founders outweighs the potential returns and act accordingly.
Despite both these risks, Lyft supposedly received positive feedback from investors during its IPO roadshow, causing it to raise its price even more just before its market debut.
Behind the scenes, however, not all investors were confident in Lyft’s path to profitability. On April 1, 2019, the New York Post reported that Morgan Stanley was marketing a “short” product that allowed pre-IPO Lyft investors to hedge against the risk of the stock declining. The article claimed that the bank was capitalizing on a loophole in Lyft’s lock-up agreements with early investors; those contract clauses reportedly prohibited owners from “reduc[ing] their economic interest” but not from locking in the profit they made between their purchase and the first day of trading on the secondary market. One investor told the Post that Lyft made a mistake in drafting the lock-up clause by using the words “economic interest” instead of broader language. Rather than actually betting on the stock’s decline – which might require directly shorting the stock and is more likely a violation of the agreement – the investors are “protecting against a decline in an amount identical to their stock holdings” which does not necessarily mean they are reducing their economic interest.
Naturally, this news did not sit well with Lyft, which quickly threatened Morgan Stanley with legal action. Of course, Lyft would like to attribute the decline in its stock price to “tortious interference” (which would require a finding that the pre-IPO investors actually breached the lock-up clause) rather than the market souring on the company’s fundamentals. But the bank’s short sales reportedly constituted only about 1.3 percent of total trading volume, so it is unlikely that it alone caused the price to drop. At the same time, Lyft has indirectly accused the bank of purposefully marketing these short products to make Uber’s upcoming IPO look like a better investment in contrast.
For its part, Morgan Stanley has released a statement saying that it “did not market or execute, directly or indirectly, a sale, short sale, hedge, swap, or transfer of risk or value associated with Lyft’s stock for any Lyft shareholder identified by the company or otherwise known to us to be the subject of a Lyft lock-up agreement.” And the legal situation regarding whether the lock-up clauses actually prohibited investors from buying the bank’s products is unclear given the reported wording of the clause and the fact that multiple agencies may have jurisdiction over the dispute.
In any case, the institutional investors that purchased Lyft’s stock before it hit the secondary market may have underestimated the public’s antipathy toward founder-controlled tech startups in light of Snap’s recent failings. The failure of Lyft’s IPO raises questions as to whether unprofitable tech unicorns with unconventional voting rights structures can survive a skeptical public investment community.