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.