Everybody’s writing about this idea that Spotify might go public not through a traditional IPO, but rather through a direct listing. Direct listings are rare beasts, and so in order to understand them, reporters phone up bankers who work in equity capital markets. But the problem is that bankers who work in equity capital markets hate direct listings, because they mean they get much lower fees. And so they start spreading misinformation.
So let’s go through some of the assertions.
With market forces determining the share price from the outset, the company’s public debut could be more volatile and unpredictable. Also missing would be the large blocks of stock underwriters typically allocate to investors they believe will hold the shares for the long term and promote trading stability.
The fact is that market forces determine the share price of all companies from the minute they’re listed on the market. That’s the beauty of a stock-market listing: it’s a price-discovery mechanism based on market supply and demand. The only thing missing from a direct listing is the IPO price: the price that shares get issued at before the market forces take over. The further the IPO price is from the market price, the greater the first-day volatility. Which means that, in general, if there’s no IPO price, volatility will be lower, not higher. (It’s true that IPOs also have something called green shoes, which serve to dampen volatility at the margin, but not so much that you’d ever really notice.)
As for the idea that buy-and-hold investors “promote trading stability,” that’s just weird, since by definition those investors aren’t trading. The amount of volatility in the market is entirely a function of the actions of traders; the non-actions of non-traders are utterly irrelevant. And if buy-and-hold investors effectively reduce the free float so that shares become scarcer, that’s only going to increase the volatility of the stock.
The move carries a lot of risk: First-day trading performance is particularly crucial for high-profile listings of consumer tech brands like Spotify, and a direct listing leaves the share performance entirely to chance. There’s no “deal support,” i.e. no guarantee of a nice, healthy first-day pop engineered by careful banker maneuvers. No CNBC commentators gushing that the deal was “priced to perfection.”
It’s true that most IPOs have a “pop” from the IPO price to the first trade, a/k/a the amount by which the IPO was underpriced. But it’s not clear why that pop should be “particularly crucial for high-profile listings of consumer tech brands”. No one’s going to buy a Spotify subscription because a bunch of institutional investors got rich on their IPO allocation. And while there is a tendency to conflate companies with their share price (see: Twitter), the important thing there is the performance of the shares over time, not the amount of the IPO pop. (Do you remember how Twitter shares performed on their IPO? Me neither.)
Moreover, the IPO process is designed to make it easier for big, long-hold funds to buy into the stock. Companies want their stocks in “safe hands,” aka, the funds that have a long term view and “won’t puke it” at the first earnings miss, an IPO banker explained to me. Big funds like to invest in IPOs because they can get a “starter position” via share allocation and then buy in the open market to get to a full position size. Beyond that, a banker explained, “building a full position from zero takes a long time, especially if 25 of your biggest competitors are doing the same thing. Some funds will just buy the stock like a jerk and push it up, some will just pass completely.”
All of this is good for the share price of a company which goes the direct-listing route! There are a lot of big long-only funds which will want to have some kind of position in Spotify, and which will be starting at zero. Some will “just buy the stock like a jerk,” while others won’t buy it at all. None of them will be selling it. That’s a fantastic structural support for the share price, which lasts much longer than a green shoe.
There is also no “lock-up” period to prevent early-stage investors and employees from selling shares in the months following a listing. Without that, a stock could experience heavy turnover and price fluctuations just as the company is getting its public market footing.
The way that markets work, high prices attract sellers. If you own a stock and it’s trading at a low level, you won’t feel much desire to sell it, but if someone is offering you a lot of money for it, then you’ll be more inclined to accept their offer. So the higher that Spotify shares trade, the more early-stage investors and employees will be inclined to sell into the public market. To a first approximation, the free float will increase as the shares rise. That’s a great dynamic!
By contrast, in a traditional IPO, the company and the underwriters spend a lot of time trying to work out just how many shares the market has an appetite for, and the degree to which altering the number of shares being sold might change the price at which they end up trading. Then, when the IPO finally happens, investors spend even more time second-guessing the lock-up period, and trying to work out how many shares are going to flood the market in six months’ time when insiders are finally allowed to sell.
Going the direct-listing route solves both these problems. Precisely because there’s no lock-up period, investors know that anybody who wants to sell has every ability to sell. There’s no shadow overhang out there. That gives them more confidence to buy. And on the other side of the ledger, the company doesn’t need to worry about issuing more shares than the market has an appetite for, because it’s not issuing any shares at all.
Effectively, the direct-listing route creates market-driven supply, rather than company-mandated supply. Which, again, should decrease, rather than increase, “heavy turnover and price fluctuations”.
Spotify is betting that its strong name recognition would help make a drawn-out and costly initial offering process unnecessary.
The implication here is that the IPO roadshow is necessary to get the market familiar with the company, and comfortable with the idea of buying its shares. That’s true, when there are lots of shares the company is trying to sell in an IPO. But when there are zero shares that the company is trying to sell, that concern goes away. The market just becomes a market between willing buyers (presumably, people who are familiar with the company, however few of those people there might be), and willing sellers (insiders who are being offered so much money that they’re OK with parting with their stock). In that sense, it’s a bit like the pre-IPO trading that we saw on Second Market with Facebook. You don’t need name recognition for that, and of course most listed companies have little to no name recognition anyway. No matter how drawn-out and costly their IPO.
Should Spotify list directly, it probably would do so at a valuation of about $13 billion, one of the people who had been briefed said.
It’s really hard to know what this means. In an IPO, the IPO price (pre-pop) is the official valuation you go public at. With a direct listing, there’s just trading, there’s no official valuation which the company can control. Often, as part of the IPO process, bankers will try to anticipate how much the shares will trade for, on the open market, and sometimes they’re even right. So maybe the $13 billion number is just someone’s guess as to where the market will value Spotify. But that’s all it is: a guess.
Spotify couldn’t use going public the way most companies do: as an occasion to raise more money. The company would simply be valued at its most recent private-market valuation (currently $13 billion), and new investors would start buying shares from current stakeholders.
It’s true that a direct listing means that the company can’t raise new equity capital. That’s the main downside. But the whole point is that it would not, any longer, “be valued at its most recent private-market valuation”: instead, it would be valued the same way every other public company is, according to the market’s price discovery mechanism.
It’s possible that some existing shareholders, as well as some other potential buyers, would use the most recent private-market valuation as an anchoring mechanism: they might be reluctant to sell above that level, or keen to buy below it. But those anchoring mechanisms tend not to last very long, and realistically it’s quite improbable that the initial public-company valuation will, by astonishing coincidence, turn out to be exactly the same as the most recent private-market valuation.
I really like the idea of direct listing, especially for companies which don’t need to raise additional capital (or who don’t mind doing so on the secondary market). It helps to marginalize Wall Street investment banks, for one thing, which is generally a good thing. So let’s not listen to their parade of horribles when it comes to reasons not to do it. And let’s hope that Spotify both goes the direct-listing route and is very happy with the results.