For some time, high-tech, start-up firms have slowed in their progression to an IPO, typically going through multiple rounds of private financings (sometimes six or more). Concomitantly, mutual funds have become significant investors in these later round private placements, in the hopes of stealing a march on those rival funds who wait for the IPO before investing. Finance scholars have noted that mutual funds behave very differently than venture capital firms in this process. While the VC firms focus their negotiations on board representation and monitoring, Harvard Business Professor Josh Lerner and his co-authors in a recent study find that mutual funds largely ignore monitoring rights, but focus instead on contractual protections that protect their expected rate of return. In particular, mutual funds seek two types of provisions: (1) redemption rights that allow them to escape (possibly if the IPO is delayed), and (2) a pricing "ratchet" that entitles them to additional shares in the event that the IPO prices below the valuation reflected in the final private-equity round. See Chernenko, Lerner and Zeng, "Mutual Funds as Venture Capitalists: Evidence from Unicorns" (available on SSRN). Thus, a poor IPO outcome (a "down round" in the vocabulary) may entitle the holders of this ratchet provision to additional shares that place them in the same (or nearly the same) economic position as if the IPO had priced at a level equal to the last private-equity round valuation. Effectively, they are held harmless (or relatively so) from the risk of a "down round," but public investors suffer twice (both when the IPO price falls and again when dilutive shares are issued under the ratchet).

Although these ratchet provisions are often described as "anti-dilutive," the accuracy of this description depends on your perspective—because the issuance of the additional shares can be highly dilutive both to the public investors in the IPO (who may already be disappointed that the IPO fell below the anticipated pricing level) and to those who bought (without a ratchet provision) in earlier private equity rounds. In the case of WeWork's recent spectacularly failed IPO, the principal holder of the ratchet provision was SoftBank, the Japanese investment bank whose billionaire founder, Masayoshi Son, had long been WeWork's principal backer. According to a computation by Renaissance Capital, LLC, which specializes in analyzing IPOs, the ratchet clause held by SoftBank would have entitled it to more than $400 million in additional shares if WeWork's IPO were to come in with less than a $14.5 billion valuation. If the IPO came in as low as $10.5 billion, the shares to which SoftBank (and certain other holders of similar ratchet clauses) would have been entitled jumped to slightly over $500 million. Today, WeWork is probably worth well less than $10 billion, and thus the share issuance would have been even higher.

Still, nothing about this potential dilution was disclosed to the public. Instead, WeWork's prospectus disclosed (way back in its financial statements at page F-115) only that:

The conversion ratio for the Senior Preferred Stock is adjusted on a broad weighted-average basis in the event of an issuance (or deemed issuance) below the applicable Senior Preferred stock price, as adjusted.

This cryptic disclosure told the IPO investor very little. If the investor were sophisticated, the investor might realize that these words implied a partial ratchet. Generally, the shares so issued in a partial ratchet would be modest. But, because SoftBank had made a large investment ($5 billion) in WeWork's final private equity round, the reverse was true here. Equally strange (as Renaissance Capital also pointed out), the prospectus further disclosed that once SoftBank invested the final $1.5 billion it owed WeWork, WeWork would issue SoftBank a warrant exercisable for the company's stock. Again, however, the terms of this warrant and the number of shares that might be issued under it were not disclosed. Investors were simply left in the dark.

The SEC's failure to require fuller disclosure would be less concerning if this were just a one-shot freak occurrence. But it is part of a larger pattern. Anti-dilutive ratchet clauses have become fairly common—apparently being now used in around 15 percent of recent IPOs. Although they only have impact when the IPO is completed at a price below that specified in the ratchet clause, such "down round" issuances have regularly happened. For example, late stage investors in Square, Inc. held a full ratchet when Square went public in 2015, which resulted in the issuance of $93 million in additional shares. Chegg, Inc.'s IPO in 2013 had a similar clause that resulted in $146 million in additional shares, and Box, Inc.'s IPO in 2015 saw an additional issuance of $67 million pursuant to its ratchet clause. All that was different about WeWork was that SoftBank's very large final round investment of $5 billion would have entitled it to a share issuance at a record level (possibly as much as $400 million to $500 million) if the IPO had been completed at a valuation below that of the final private-equity round.

The problem here is not just that IPO investors have been denied full disclosure. Rather, there is a deeper problem with the perverse incentives that such a ratchet clause creates. Such an arrangement could be used to inflate the IPO offering price. Assume an early round investor has bought a large block of the issuer's stock at a cheap price and is hoping for a high valuation in the IPO. In the final private equity round, it might be prepared to buy at an inflated price (for a smaller block) if it thought that this would create "momentum" and encourage IPO investors to buy later at an even higher price. Now, add to this scenario the additional fact that the late stage investor negotiates a full ratchet clause with respect to this final private equity round. As a result, this investor has negotiated a "heads-I-win, tails-I-break-even" deal. Even if the IPO price is below the final round's valuation, the investor will be held harmless. That the issuer grants this dilution protection might also be explained by its own desire for an inflated IPO valuation. After all, the cost of this provision calls mainly on the IPO investors.

Effectively, such provisions create a moral hazard problem, as the investor is guaranteed a minimum return based on the price it paid in the final equity round. This investor faces little downside, and, as a result, this type of transaction should encourage mispricing in IPOs. Put simply, some will rationally overpay in the final private round in the hopes of inflating the IPO price, knowing that the economic risk of a "down round" falls mainly on the IPO investors who are diluted. The harm for the public investor is not just dilution, but the risk that the IPO will be overpriced, only to fall in the aftermarket when the securities analysts finally catch up with it.

To be sure, this stratagem failed in the WeWork case because the IPO was called off, and the inflated value of the final private round ($47 billion) did not benefit those who paid that price. Ultimately, what the WeWork fiasco really shows is the severity of the conflicts of interest that today exist among investors in venture capital deals. Public investors in the IPO appear particularly exposed, although one would have thought that SEC-mandated disclosure would have protected them. At a minimum, the WeWork debacle seemingly illustrates that the usual gatekeepers—underwriters and their counsel—failed to play the protective role that the Securities Act contemplates because material risks were only hinted at, and not disclosed. Indeed, everything about the WeWork offering reveals a profoundly dysfunctional process: self-dealing was rampant, its governance ceded absolute control rights to an erratic CEO, and the non-GAAP metrics that the issuer hoped to use ("community-based Ebitda") were the stuff of cartoons. In Stanley Sporkin's famous phrase, where were the lawyers?

Arguably, that all these symptoms were present in one deal suggests that we could be nearing a "bubble." Personally, I doubt that a bubble is imminent—if only because the combination of Uber, Lyft, and WeWork has chilled the IPO market. Still, a logical prediction is that higher IPO valuations will result when IPO ratchets are used (because the late round private equity price is more likely to be inflated). Here, more empirical research is needed on how "ratchets" and similar contractual provisions affect IPO pricing. Interestingly, one recent, provocative study finds that unicorns have been greatly overvalued (on average at 48 percent above "fair value"). See Gornall and Strebulaev, "Squaring Venture Capital Valuations with Reality" (forthcoming in the Journal of Financial Economics). It attributes this overvaluation in large part to financial guarantees to late round private equity investors. Overvalued IPO stocks will eventually fall in the public market—once the efficient market forces a return to reality. Thus, IPO investors may pay too much, sometimes will be diluted, and finally will often experience a stock price fall. Only because WeWork could not even make it to the roadshow stage were public investors spared this last experience in its case.

All this suggests that the SEC is giving too little attention to practices that overreach public investors and could in time produce a bubble.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law and Director of the Center on Corporate Governance at Columbia University Law School.