After Slack, the IPO market might never be the same
The traditional initial public offering has lost its luster in Silicon Valley. Startups awash in billions of venture capital are pushing off the day as long as possible. Venture capitalists lament the “broken” IPO process. The average time for US technology companies to go public has risen from four years in 1999 to more than 11 years nowadays.
But startups can’t hide forever.
Early insiders must cash out. Companies need capital to grow. Public markets are still the only game in town capable of funding all those multibillion-dollar ambitions at once. But startups wishing to access a portion of the trillions of dollars sloshing around equity markets, and avoid the traditional IPO, now have a second option: the direct listing.
On June 20, Slack will be the first Silicon Valley darling to try it, following in the footsteps of Swedish streaming giant Spotify. Slack’s direct listing (under the ticker WORK on the New York Stock Exchange) is expected to value the company at around $17 billion.
Slack is in an enviable position. It’s growing fast. Revenues are hefty and predictable. It finished the most recent quarter with $792 million in cash, so at its current burn rate of $136 million a year, Slack has six years of cash in the bank, according to its S-1. And now it’s being celebrated by startup investors looking for a way to ditch Wall Street while rewarding early shareholders.
In a direct listing, the company itself doesn’t issue shares or sell stock.
Rather, founders, employees, and early shareholders sell their shares directly to public investors, avoiding Wall Street’s fees or any lock-up period which traditionally prevents insiders from trading after an IPO. It’s a rarely used but increasingly popular tactic. For a select group of well-known companies, it is the future.
The problem with IPO pricing
For most aspiring public companies, the Wall Street roadshow is a rite of passage. Investment bankers charter private jets and shepherd CEOs before potential investors in dozens of cities. “It’s grueling,” says John Mullins, an associate professor at London Business School.
“You pitch three to four times per day all over the country, all over the world, explaining to stockbrokers why this is the best thing since sliced bread.” Bankers divine an opening share price for the company (“more an art than a science,” as one source told us and others confirmed).
Dealmakers then parcel fers to favored clients, usually institutional funds.
If all goes well, the CEO makes the pilgrimage to the New York Stock Exchange or the Nasdaq to ring the bell on opening day and the company raises millions if not billions of dollars. If the bank managing the IPO prices the stock wrong, shareholders are left holding the bag.
Too high, and employees end up with devalued shares and worthless stock options. Too low, and early investors miss an opportunity to sell at a higher price, while the company issuing the shares has left money on the table. Either way, it’s lucrative for Wall Street.
Even Uber’s disappointing $8 billion IPO reportedly earned bankers $106 million in fees.
Direct listings avoid this. They let companies retain far more control over the IPO process. Insiders can sell their shares at any time, incurring bank fees that are around 1% rather than as high as 7%.
Companies can then issue stock at any time, secure in how the market views the company. Not every startup has the luxury of not raising funds for itself. But for those that can do without the capital, and have the name recognition with investors, it’s a no-brainer.
“Every company would to do a direct listing,” says Mullins. “There aren’t a lot of downsides.”
Assuming Slack’s debut is successful, IPOs once brokered in corporate boardrooms may instead become demo days where anyone with an internet connection—not just Wall Street insiders—can check out the company and make the first trade.
Arrival of the direct listing
Spotify’s successful direct listing last April valued it at $29.5 billion. For the company, the exercise was as much about marketing as liquidity.
“Our focus isn’t on the initial splash,” Spotify founder Daniel Ek told potential investors in an April 2018 blog post saying he would skip the pageantry of ringing the NYSE bell.
“Instead, we will be working on trying to build, plan, and imagine for the long term.”
It didn’t stop there. Spotify CFO Barry McCarthy later wrote, in a post titled “IPOs Are Too Expensive and Cumbersome,” that investment banks were ripping them off. “Bankers told us that they try to price new listings so that they rise 36 per cent once trading starts,” he wrote.
That’s a huge discount for institutional investors who buy early, though banks would argue the porous ceiling is necessary to compensate investors for the risk of buying untested companies.
McCarthy’s conclusion? “The economics makes sense for the investors, but the system penalises successful individual companies.”
Adam Augusiak-Boro, an analyst at EquityZen, says the Spotify model will spread. Rather than the 7% or so fee investment banks may charge for flying planeloads of investment bankers around the world, companies Slack can simply hold a webinar.
At its live-streamed “Investor Day” on May 13, Slack executives presented on the company, addressed questions, and posted materials for investors to review. “Management is not distracted for a whole week and you’re not hauling bankers across the country and expensing hotels,” says Augusiak-Boro, a former New York investment banker.
It helps that products Slack or Spotify are easy to understand and already installed on many potential investors’ laptops and smartphones. Their global reach means the tech world’s brightest stars are already household names by the time they want to sell shares.
Direct listings aren’t for everyone
Jai Das, president of Palo Alto-based Sapphire Ventures, says direct listings still don’t make sense for most companies. “I think it’s a way to go out in public markets if you don’t need to raise any capital,” he said.
For most money-burning startups, he argues, not raising capital during an IPO is not an option. Overall, says Das, “we’ll probably see 1 to 2 [direct listings] every year but it’s going to be the exception, not the rule.
Alex Castelli, a managing partner at tax firm CohnReznick, agrees that “there is very little threat of direct listings replacing IPOs.” Only for a certain slice of “well-known companies that don’t need capital and who can tell their story to potential investors” will direct listings make sense.
But are other companies really better served by the traditional IPO process? Bill Gurley, a venture investor at Silicon Valley firm Benchmark, cites recent IPOs such as Crowdstrike and Zoom as cautionary tales.
Both tech firms saw their stock prices spike by as much as 80% after their shares began trading, suggesting they left more than $1 billion of potential capital on the table. A price “pop” isn’t always a bad thing.
Employees, for example, can cash out rather than be stuck with underwater stock options. But that’s meager compensation to Gurley.
“CrowdStrike (and other way underpriced deals) are the true definition of a ‘broken’ IPO,” he tweeted on June 12. “Imagine if a CFO/CEO gave away a half a billion dollars? Or simply squandered it. How would that be viewed? This is similar, but it’s institutionalized, and therefore everyone is numb to it.”
Gurley predicted Slack’s direct listing would spark a new era for startup financing. “There is no reason whatsoever equities cannot be priced in a blind auction,” Gurley wrote, referring to how investors in a direct listing set the price by buying stock rather than relying on banks to set the price for them. “This is how 100% of IPOs should be done. And hopefully will one day.”
Whoever is right, change is coming to the exchanges. Conditions are shifting in ways that favor direct listings.
For starters, exchanges that provide secondary markets for shares of private companies are getting more liquid.
These exchanges, which allow accredited investors to buy and sell shares before they are publicly listed, and give public investors a clearer view into the value and workings of the company, are exploding in volume. EquityZen says it has placed 7,500 transactions in the last five years.
Meanwhile, for a company with enough buzz to consider going public, there’s a good chance that large investors such as institutional funds have already poured hundreds of millions of dollars into transactions of the company’s privately held shares, as they did with Slack. This price transparency means the company can have far more confidence in how to price its shares on the public exchanges.
Spotify, for example, chose to sell shares through a direct listing at $132, very close to its then-recent secondary share pricing. The stock rose about 26% during the first day of trading (it’s now down about 8% since its April 2018 listing) and the company saved millions on underwriting fees.
Rather than a rite of passage, the IPO may soon become just another fundraising round. Six months after its own direct listing, Spotify is promoting its path as the future for all companies, even those that need growth capital.
“Raising money from an IPO is an entirely tactical decision and should be weighed against all the other funding alternatives for private and public companies,” its CFO wrote last October. “Companies have more flexibility than they may realise when it comes to raising capital.
And the same is true when it comes to going public.”
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Spotify starts trading at $165.90, up 25% on NYSE reference price
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Spotify’s stock soared today after making its hotly anticipated and highly unusual debut on the public markets. The $165.90 opening price of the stock valued Spotify at around $29.5 billion, well above its most recent valuation of $19 billion.
The New York Stock Exchange (NYSE) issued a reference share price yesterday of $132, translating into a valuation of $23.5 billion. This wasn’t an official offering price, but served as a guide for Spotify’s eventual pricing, which was set by the market maker ahead of trading.
The stock sale represents a major milestone for a company that pioneered the shift away from sales of digital downloads toward subscription-based music streaming. But in choosing to make a direct listing rather than pursuing a more traditional initial public offering (IPO) of stock, Spotify took an enormous gamble.
With the number of IPOs stagnating in recent years, the tech industry will be watching the performance of Spotify’s stock in the months ahead to see whether its move should be duplicated or avoided by other overvalued unicorns searching for some kind of exit. While a direct listing saved Spotify millions of dollars in banking fees, it also meant that the company itself did not raise what could have potentially been billions of dollars for its own use.
With Spotify continuing to lose money, it certainly could have used that cash as it faces rivals such as Apple Music, which has been growing rapidly since its launch in 2015. Un Spotify, Apple Music faces no pressure to be profitable while having almost unlimited corporate cash to invest in its service.
Spotify sparked big speculation when reports first emerged last May that it planned to carry out a direct listing on the stock market, effectively bypassing the traditional IPO process. The tech and investor communities had eagerly speculated on how, when, and where this unusual listing will take place.
In June 2017, the New York Stock Exchange (NYSE) made a request to the Securities and Exchange Commission (SEC) to alter its listings standards so as to accept direct listings. The SEC approved this request in February, which is lucky for Spotify, as it had already confidentially filed documents with the SEC at the end of December.
In summary, Spotify started trading at $165.90 under the ticker name SPOT on the NYSE.
Above: Spotify on the NYSE
Image Credit: NYSE
Why choose a direct listing?
By choosing a direct listing, Spotify is breaking away from the traditional IPO process so many other tech unicorns have chosen to take.
One advantage to a direct listing is being able to bypass the costly underwriting fees of investment bankers involved with pricing the shares. The Wall Street Journal reported that Alibaba paid $300 million in bankers’ fees. paid $176 million, Snap ponied up $98 million, and spent $68 million.
Banks that advised Spotify throughout its process — Goldman Sachs, Morgan Stanley, and Allen & Company — are therefore losing out in this deal.
Another reason to choose a direct listing over a traditional IPO is to avoid a dilution of shares resulting from newly issued stock.
In a traditional IPO, the underwriters gauge new investors’ interest throughout the pre-IPO period or “roadshow,” which gives them an indication of how to price the shares.
The newly issued shares are then sold to new investors on the exchange to raise capital.
Bypassing this process is risky, however, as there is no period of price discovery or equity research from the underwriting banks, which can open shares to price volatility. What’s more, Spotify has not raised any new capital through this process.
Typically, a company chooses the IPO route to raise money. Snap, for instance, raised $3.4 billion in its IPO last year.
raised a whopping $16 billion, which it was then able to use to buy Instagram and WhatsApp.
So even though Spotify says it doesn’t need the money, it is still losing out on the chance to rack up billions of dollars, which it may need down the line to compete with giants Apple.
A final argument in favor of the direct listing is liquidity, which is music to the ears of every investor and employee.
In a traditional IPO, there is a certain lockup period (usually 180 days) during which existing shareholders aren’t allowed to sell their shares on the public markets, which effectively delays the “cashing out” process.
With a direct listing, however, everyone can start selling shares on day one of trading, at least in theory (this depends on the shares’ restrictions).
Bloomberg recently reported that Spotify cofounders Daniel Ek (CEO) and Martin Lorentzon (vice chairman) own a class of stock that assures their hold on the company after the shares begin trading. These dual-class structures have been used by other tech giants, and Snap, and have been criticized by the SEC as unfair to other shareholders.
Spotify: the road to (no) IPO
Spotify’s path to today’s public listing has been 10 years in the making, if we begin with the company’s launch and first major institutional funding way back in 2008. That $21.
6 million series A raise, while modest by today’s standards, was actually a significant chunk of cash when you consider the following: Spotify was a European startup that had yet to launch, and it was going up against mighty music-tech incumbents such as Apple with a novel “access over ownership” model.
After two years of development, Spotify officially launched in a handful of European markets on October 7, 2008, alongside a swathe of “groundbreaking licensing deals” with labels that included Universal Music Group, Sony BMG, EMI Music, Warner Music Group, and Merlin.
Above: Spotify app
Image Credit: Paul Sawers / VentureBeat
In the early days, Spotify managed the growth of its platform by making its free ad-supported tier available on an invite-only basis, meaning users who had found their way onto the free tier could invite their friends to join them. This was similar to the way Google managed its initial roll Gmail a few years earlier. However, Spotify also introduced its premium access tier at the time for those willing to take a punt on the fledgling platform.
Fast-forward five months, and Spotify had notched up its millionth user. By September 2009, it had graduated from the desktop and onto smartphones with its first mobile app for iOS and Android.
However, the big news came two months after that, when Spotify was made available on Nokia’s Symbian platform, which then dominated the smartphone market with more than 50 percent market share.
Yes, a lot can change in 10 years.
In August 2009, Spotify closed its second round of funding, a $50 million round led by Horizon Ventures. This preceded a $14 million (€11.6 million) tranche of cash from Founders Fund in February 2010; a $100 million fourth round led by Accel in June 2011; a $100 million fifth round in November 2012; a $250 million sixth round a year later; and a $526 million seventh round in June 2015.
The company later went on to raise $1 billion in debt in March 2016 in a deal that stipulated investors could convert the debt to stock during the public offering at a 20 percent discount. However, the longer Spotify waited to go public, the bigger that discount grew, while the interest rate on the debt has also increased over time.
All in all, Spotify has raised well over $2 billion in funding, including equity and debt. As a private company, it was valued at about $19 billion.
Sandwiched between all this money-raising, Spotify expanded globally into nearly 70 markets, including the U.S., where it has plied its trade since July 2011.
Spotify now claims 73 million paid subscribers globally, adding 10 million new subscribers on average every five to six months.
Its overall user base is more than 168 million, and the company recently revealed that it expects its paid-to-free user ratio to hit 46 percent by the end of 2018.
Taking nearly 10 years from its first institutional raise to enter the public markets is a long time.
For context, took around six years from its first equity raise to IPO; took a little under eight years from when Peter Thiel first plowed $500,000 of his own money into the social network in 2004; and Snap took less than five years. Blue Apron, another of 2017’s tech IPOs, also took around five years to get from first funding to IPO.
Spotify’s near-decade long journey to going public isn’t unprecedented — Dropbox recently went public after nearly 11 years — but it is indicative of how carefully it has considered the timing of this step.
Rumors circulated last year that it had been planning to IPO in 2017; however, it became clear that Spotify wanted to improve its balance sheet before wooing public markets.
The company has also had a rocky relationship with the record industry over the years, and so it has set about building bridges with artists and record labels leading up to this transition.
Many artists and record labels would still Spotify to ditch its ad-supported free tier altogether, but the company has always maintained that the best way to onboard new paying users is to let them initially access the service for free (with some restrictions). As a compromise with the music industry, Spotify started renewing licensing deals last year with major and independent record labels that would allow them to limit new album releases to premium subscribers for the first two weeks.
With Spotify now gearing up to become a hardware company and ly compete with the s of Amazon, Apple, Google, or all three, it will need all the capital it can get, although it won’t benefit financially from this IPO at first. If things go well, however, it could decide to pursue a secondary offering at a later date, which could be used to fund its battle against its rivals.
Breaking with tradition
This is the first time a big tech company has carried out a direct listing. A niche group of large public real estate investment trusts (REITs) and biotech companies, including OvaScience and BioLineRx, have done direct listings on Nasdaq. But this was a first for a large private company, and a first for the NYSE.
OTC Markets, an operator of public markets that provides liquidity and trading for over-the-counter equity securities, also does a type of direct listing, which it refers to as a “Slow PO.”
“In contrast to the traditional IPO process, a ‘Slow PO’ through OTC Markets enables companies to enter the public markets by making previously restricted shares available for public trading by brokers on the OTCQX, OTCQB, and Pink markets,” said Jason Paltrowitz, OTC Markets Group’s executive VP of corporate services, in an interview with VentureBeat. “The Slow PO is akin to a ‘direct listing’ on an exchange, where a company goes public without raising money and without underwriting as in a traditional IPO.”
Examples of companies or institutions that have opted for this direct to market route include the Bitcoin Investment Trust and various community banks.
Google had also chosen an unconventional framework for its 2004 listing on Nasdaq, opting for a version of a Dutch auction — in which a company accepts bids and then auctions off the shares. This did not prove successful for Google, however, as it ended up pricing below its target and lost millions of dollars.
Going public is risky no matter how you do it, which is why so many tech unicorns — Uber and Airbnb — are choosing to remain private for now. But if this direct listing proves to be successful, traditional IPOs could soon become a thing of the past. Either way, Spotify will be remembered for it.
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