More On Direct Listings

Regular long-time readers of this blog might know that I’m not a big fan of IPO pops (I’ve written about them at least four times so far: one, two, three and four). You can think of this as Number Five, though this is specifically about Direct Listings.

In case you don’t have patience to click through and read my posts, what is the big deal about direct listings? And what is the problem with traditional IPOs? To put it simply, companies looking to raise capital through IPOs are playing a one-time game (you only do an IPO once), while companies that are investing in them are playing a repeated game (they participate in pretty much every IPO that comes on the market – ok may be not WeWork).

This means that investment banks, which stand between the buyer and the seller in such cases, have an incentive to structure the deal to favour the (repeated) buyers, and they price the IPO conservatively. This means that when the company actually lists on the market, it usually does so at a price higher than the IPO price, resulting in a quick win for the IPO investors.

This is injurious for the original investors in the company (founders, VCs, employees) since they are “leaving money on the table”. A pop of 10-20% is considered fair game (a price for the uncertainty on how the market will react to the IPO), but when MakeMyTrip lists 60% higher, or Beyond Meat lists 160% up, it is a significant loss to the early shareholders.

Over the last few months (possibly after the Beyond Meat IPO), Silicon Valley has woken up to this problem of the IPO pop, and suggested that the middleman (equity capital markets divisions of investment banks) be disintermediated from the IPO process. And their vehicle of choice for disintermediation is the direct listing.

A direct listing is what it is. Rather than raising fresh capital from the market, the company picks an auspicious date and declares that on that date its stock will list on the exchanges. The opening auction in the exchange on that day sets what is effectively the IPO price, and the company is public just like that.

Spotify was among the first well-known companies in recent times to do a direct listing, when it went public in 2018. Earlier this year, Slack did a direct listing as well. Here is Benchmark Capital’s Bill Gurley (a venture capitalist) on the benefits of a direct listing.

Direct Listing is all well and good when a company doesn’t have to raise capital. The question is how do you go public while at the same time raising capital (which is what a traditional IPO does)? Slack and Spotify were able to do the direct listing because they didn’t want capital from the IPOs – they just wanted to offer liquidity to their investors.

The New York Stock Exchange thinks it can be done, and has proposed a product where companies can use the opening daily auction to price the new shares being offered. There are issues, of course, about things like supply of shares, lock-ups, price support and so on, but the NYSE thinks this can be done.

NYSE’s President Stacey Cunningham recently appeared on the a16z podcast (again run by a VC, notice!) and spoke eloquently about the benefits of direct listing.

The SEC (stock regulator in the US) isn’t very happy with the proposal, and rejected it. Traditional bankers are not happy with the NYSE’s proposal, either, and continue to find problems with it (my main source of this angst is Matt Levine, who is a former ECM Banker and who thus has solid reasons as to why ECM Bankers should exist). In any case, the NYSE has refiled its proposal.

So what is the deal with direct listings?

In a way, you can think about them as a way to simply disintermediate the market. The ECM Banker, after all, is a middleman who stands between the buyer (IPO investor) and seller (company raising capital), helping them come up with a smooth deal, for a fee. The process has been set for about 40 years now, and has become so stable that the sellers think it has become unfair to them. And so there is the backlash.

Until now, the sellers were all independent entities with their own set of investors, and so they were unable to coordinate and express their displeasure with the IPO process. The buyers, on the other hand, play the game repeatedly, and can thus coordinate among themselves and with the middlemen to give themselves a sweet deal.

The development in this decade is that the same set of VC investors invest in a large number of go-to-public companies, and so suddenly you have sellers who are present across deals, and that has changed the game in a sense. And so direct listings are on every tech or investing podcast.

Among the things I wrote in my book (which came out a bit over two years ago) is that one important role that middlemen play is to reduce uncertainty and volatility in the market.

One concern with direct listings is that there can be a wide variation in the valuations by different players in the market, and the opening auction is not an efficient enough process to resolves all these variations. The thing with the Spotify and Slack listings was that there was a broad consensus on the valuation of these companies (more in line with public company valuations), a set of investors who wanted to get in and a set of investors who wanted to get out. And so it all went smoothly.

But what do you do with something like WeWork? The problem with private market valuations is that with players like SoftBank, they can be well divorced from market realities. In WeWork’s case, the range of IPO valuations that came up differed by an order of magnitude. And that kind of difference is not usually reconcilable in one normal opening auction (imagine a bid of 8 billion and an ask of 69 billion, and other numbers somewhere in between) without massive volatility going forward. In that sense, the attempted traditional IPO did a good job of understanding demand and supply and just declaring “no deal”. “No deal” is usually not an option when you do a direct listing.

OK I’ve written a lot I know (this is already 2X the length of my usual blog posts), so what do I really think about IPOs? I think all this talk about direct listings will shift the market ever so slightly in favour of the sellers. Companies will follow a mixed strategy – well known companies (consumer brands, mostly) with stable valuations will go for direct listings. Less well known companies, or those with unstable valuations will go for IPOs.

And in the latter case, I predict that we will move closer to a Dutch auction (like what Google did) among the investors rather than the manual allocation process that ECM bankers indulge in nowadays. It will have the benefit of large blocks being traded at time zero, at a price considered fair by everyone, and hopefully low volatility.

Direct listing

So it seems like Swedish music streaming company Spotify is going to do a “direct listing” on the markets. Here is Felix Salmon on why that’s a good move for the company. And in this newsletter, Matt Levine (a former Equity Capital Markets banker) talks about why it’s not.

In a traditional IPO, a company raises money from the “public” in exchange for fresh shares. A few existing shareholders usually cash out at the time of the IPO (offering their shares in addition to the new ones that the company is issuing), but IPOs are primarily a capital raising exercise for the company.

Now, pricing an IPO is tricky business since the company hasn’t been traded yet, and so a company has to enlist investment bankers who, using their experience and investor relations, will “price” the IPO and take care of distributing the fresh stock to new investors. Bankers also typically “underwrite” the IPO, by guaranteeing to buy at the IPO price in case investor demand is low (this almost never happens – pricing is done keeping in mind what investors are willing to pay). I’ve written several posts on this blog on IPO pricing, and here’s the latest (with links to all previous posts on the topic).

In a “direct listing”, no new shares of the company are issued, the stock gets listed on an exchange. It is up to existing shareholders (including employees) to sell stock in order to create action on the exchange. In that sense, it is not a capital raising exercise, but more of an opportunity for shareholders to cash out.

The problem with direct listing is that it can take a while for the market to price the company. When there is an IPO, and shares are allotted to investors, a large number of these allottees want to trade the stock on the day it is listed, and that creates activity in the stock, and an opportunity for the market to express its opinion on the value of the company.

In case of a direct listing, since it’s only a bunch of insiders who have stock to sell, trading volumes in the first few days might be low, and it takes time for the real value to get discovered. There is also a chance that the stock might be highly volatile until this price is discovered (all an IPO does is to compress this time rather significantly).

One reason why Spotify is doing a direct listing is because it doesn’t need new capital – only an avenue to let existing shareholders cash out. The other reason is that the company recently raised capital, and there appears to be a consensus that the┬ávaluation at which it was raised – $13 billion – is fair.

Since the company raised capital only recently, the price at which this round of capital was raised will be anchored in the minds of investors, both existing and prospective. Existing shareholders will expect to cash out their shares at a price that leads to this valuation, and new investors will use this valuation as an anchor to place their initial bids. As a result, it is unlikely that the volatility in the stock in initial days of trading will be as high as analysts expect.

In one sense, by announcing it will go public soon after raising its last round of private investment, what Spotify has done is to decouple its capital raising process from the going public process, but keeping them close enough that the price anchor effects are not lost. If things go well (stock volatility is low in initial days), the company might just be setting a trend!