Jan 10 2020
Since Spotify broke new ground with a direct listing in Apr 2018, followed by Slack in Jun 2019, there has been growing interest among startups in the direct-listing option (vs. an initial public offering, or IPO). One survey by The Information in Jul 2019 found that 34% of respondents with a potential IPO the following year were considering a direct listing. More recently on Oct 1 2019, Bill Gurley, a general partner at venture capital firm Benchmark Capital, organized an invitation-only event called “Direct Listings: A Simpler and Superior Alternative to the IPO” – which was financially backed by 25 venture firms. In attendance were a group of 100+ late-stage startup CEOs and 200+ CFOs/investors. The event caused a furor in the industry, re-energizing a conversation that has been underway for the past two years.
Several startup founders have already indicated to Gurley that they plan on a direct listing when it comes time, and Wall Street firms are reportedly being “inundated” with direct listing inquiries. Soon after the event, outlets reported that Airbnb is also “laying the groundwork” for a direct listing in 2020, with about a 70% likelihood. Some industry watchers are saying we may see as many as 5 direct listings next year.
The traditional model for an IPO is not being replaced but rather disaggregated – for instance, there is a growing sense that listing on an exchange and raising capital can be decoupled.
Jump to What It Means
While companies may undertake an IPO for a variety of reasons, the primary ones are to raise capital and/or provide a liquidity event for early shareholders. In a typical IPO, the company will hire investment banks to serve as underwriters – in essence, to buy shares and sell them to investors and the public at a set offering price. They undertake a roadshow to meet with large experienced investors one-on-one and build a book of orders, selecting investors (hand-allocated, sometimes through subjective means) and establishing a price range through that process. The process involves built-in controls such as audits from accounting firms and active price stabilization by the banks in the early post-IPO period (which can be a substantial profit center for them). Banks (particularly the “lead-left” firm) drive the process to set the price and terms of the deal, in return receiving substantial fees, upside from its own holdings, and the ability to allocate shares to favored clients.
Before 2018, listings on an exchange without an IPO were possible but largely limited to spin-offs and transfers from another exchange. While Spotify’s initial foray in Apr 2018 repurposed a process that already existed, a set of changes to the NYSE’s rules – which began in Mar 2017 and went into effect Feb 2018 – has made it easier to list without an underwritten IPO, spin-off, or transfer from another exchange.
What is a direct listing
In a direct listing, outstanding shares held by existing shareholders are listed on an exchange – such as the NYSE in the case of Spotify and Slack – without a preset price or underwritten offering from an investment bank. Employees and investors have the choice to participate in selling their outstanding shares. New shares are not issued to raise capital (unlike in an IPO). Since banks are not building a book of orders, the “roadshow” is limited in nature and the company may meet with investors without bank advisers. Lock-up agreements are not sought by the investment banks, which means large shareholders do not have to wait the usual 3-6 month period post-IPO to sell and the vast majority of shares (e.g. 90%) are available to trade. A reference price is provided by the exchange but the actual opening price is set based on an auction the morning of the listing. Banks do not engage in price stabilization – i.e. buying and selling to reduce volatility – during the initial period.
What stays the same: Many of the required registration forms and processes are the same, and the timeline is similar (and potentially longer in these early days of direct listings). Banks are still involved in an advisory role. The company still conducts some investor education – such as an investor day and recorded videos (16 hours’ worth, in the case of Spotify) for the public and perhaps select meetings with investors, and its advisers might hold an event for their clients. The company’s shares are publicly traded after the listing, with all the associated advantages (e.g. market pricing, shares are more attractive as currency for M&A), as well as the responsibilities/disadvantages (e.g. it is still subject to the Securities Exchange Act of 1934’s reporting requirements).
Advantages & considerations of a direct listing
The advantages of a direct listing versus the more traditional IPO:
- Direct listing does not require new share issuance and the resulting dilution to existing shareholders.
- It can reduce the substantial fees paid to investment banks (typically 3.5% to 7% of the amount raised). While Spotify still paid $35M (€29M) in advisory fees to Goldman Sachs, Morgan Stanley, and Allen & Company, they would otherwise have paid somewhere between $98M (for a larger raise over $500M) and $196M for an IPO. Slack paid $22M to the same 3 firms as well as a slate of associate advisers.
- Prices are set by the market, rather than an underwriter who may set the price conservatively to avoid the risk of a failed IPO. The often-seen “pop” after the IPO suggests that the underwriter set a price that included an “IPO discount” (36% according to Spotify’s CFO, 22-34% among the top banks according to research and 18% on average) – i.e. underpricing the allotment to achieve a 10-20x oversubscribed offering. The difference in value when it “pops” accrues to the underwriter and its favored clients (on the 10-15% of market cap being issued), rather than those who took on risk in the startup’s early years. This one factor is likely the most significant in terms of economic impact to early shareholders, far exceeding the fees paid to banks.
- Management can avoid some of the distractions associated with an IPO – e.g. a full roadshow in favor of, say, an investor day and recorded videos.
- The more transparent and open nature of direct listings can be appealing to some founders – e.g. “one-to-many” Investor Days rather than “one-to-one” roadshow meetings, setting of the opening price via auction, more democratic access to early shares at market prices, no artificial mechanisms to manage/stabilize the price. Currently, only about 10-20% of share allocation is directed to individual investors, often preferred clients or “friends and family” of the banks. In a direct listing, management is also able to provide forward-looking guidance before the listing (as long as the S-1 registration is effective), unlike in an IPO.
- With the recent memory of tech IPOs that didn’t “perform" (at least in terms of stock appreciation) such as Uber and Lyft, as well as The We Company’s recent withdrawal from the IPO process, some companies are eager to avoid the risk of a failed IPO. For a direct listing, there is not as much stigma associated with later price declines (which Spotify and Slack have faced). In contrast, after an IPO, the company’s stock performance is often compared to the (typically discounted) IPO price established through the book-building process.
- For companies with a sizable amount of convertible debt obligations (e.g. Spotify), the direct-listing option may not trigger the same provisions as an IPO, offering more negotiating leverage with counterparties.
A direct listing is not for every company:
- Companies looking to raise substantial capital will generally consider new share issuance through an IPO. While those that go through direct listing still have fundraising options like a pre-IPO round, convertible bonds or selling additional shares, an IPO can serve as a splashy capital-raising vehicle that is hard to match. Spotify and Slack were not looking to raise substantial capital through an offering, but rather were seeking to offer employees and shareholders a path to the open market for their equity.
- Well-known brands have an easier time selling to retail and institutional investors without the help of underwriters and a roadshow. Companies with less established brands, who lack institutional investor relationships, and/or have hard-to-understand business models may want the hoopla and press that comes with an IPO and be willing to pay the premium for it as a marketing cost to attract buyers. The press – in addition to promoting the offering and bolstering the price – could also help with selling to large enterprise clients.
- Companies not able to forecast and disclose a full year’s worth of financial projections may find a direct listing challenging without the ability to provide guidance to investors and analysts.
Industry players circling around direct-listing opportunities
- While part of the rationale for direct listings is to reduce the fees and value captured by investment banks in the IPO process, banks like Goldman Sachs and Morgan Stanley are positioning themselves as forward-thinking leaders who can play a variety of roles in a direct listing. They are reportedly the two banks that Airbnb may hire for its own direct listing. With fewer banks involved, advisory fees could be as much as a small to medium-sized IPO, with the potential for greater volume from the middle market. Roles could include: Advising the designated market marker on the floor, helping the company change its restricted-stock agreements to allow employees to sell stock and cover taxes, and advising on registration, positioning, metrics, and investor day. Soon after the Gurley event, Goldman held a session on direct listings at its Private Innovative Company Conference with 500 investors and tech companies in Las Vegas; Morgan Stanley is organizing its own closed-door direct-listing summit on Oct 21 2019 in San Francisco at the NYSE’s offices, with Spotify and Slack among the speakers.
- Among the exchanges, the NYSE is promoting a position that it is the only real option for direct-listing, with its more “hands on” approach and human designated market maker (the trader who serves as the central point of contact on the floor for a security). Nasdaq wants a piece as well, and in Feb 2019 filed notice on a set of rule changes that were “substantially similar” to the NYSE’s, making direct listings easier. In Jul 2019, radio-station owner iHeartMedia returned to public markets through a direct listing on the Nasdaq. (Industry watchers have noted iHeartMedia’s situation is different from Spotify or Slack, however, since it had just emerged from bankruptcy and undertook the listing from a position of weakness.)
- Market-making firms are vying to be the designated market maker (DMM) of choice for direct listings. The DMM is important in discovering price in the early auction, and maintaining a balance of orders and relatively stable price. For the likes of Citadel Securities (who served as the DMM for the Spotify and Slack listings) and GTS, taking on the role can help build relationships with corporate clients and open the door for other businesses and revenue streams.
What It Means
While the current trajectory is that direct listings will be at least part of the new normal, the impact of the change may be somewhat overstated in some respects. Direct listings have not only existed for some time, but the activities and timeline associated with direct listings have a lot in common with IPOs. Banks are even still actively involved, though their roles are shifting to more advisory. The traditional model for an IPO is not being replaced but rather disaggregated, with the different elements – such as capital-raising, setting the opening price, and investor education – being reshaped. The biggest impact is to the early shareholders. With large tech startups staying private for longer, direct listings can help early shareholders avoid leaving an enormous amount in the hands of underwriting banks and their preferred clients (without them taking on proportionate risk), in addition to giving them access to gains immediately.
The intensive debate around direct listings is partly due to disagreement on what success looks like – some are advocating for other measures of listing success than “pop” or substantial price appreciation, such as volume, analyst coverage, or whether the price is above the last financing. Industry players also disagree on the underlying assumptions – e.g. that long-term investors are preferred, the company shouldn’t upset certain investors such as hedge funds, going below the listing price should be avoided at all costs, pricing needs to managed and stabilized, a book of orders and a “pop” are needed to build a market, a post-IPO dip can create a negative narrative and challenges down the road, a lock-up helps avoid bad behavior on the part of executives and employees, employees may leave without a lock-up. Some naysayers also believe that direct listings could be a backdoor for overhyped consumer brands with poor economics or inexperienced management teams that wouldn’t hold up well in an investor roadshow (where they may get tough questions from hard-nosed investors and hedge funds).
Most, however, agree that one of the key challenges of direct listing is how to build volume and liquidity – and it’s one of the most well-repeated arguments against it. Companies that lack sufficient assets to ensure confidence that enough investors will participate – e.g. recognized brand, institutional investor relationships, an active secondary market, a compelling narrative – will likely steer away from direct listing. The importance of these assets, however, may diminish if direct listings become more popular and new channels emerge for companies to market themselves and for investors to educate themselves.
Ultimately, companies will need to decide why they want to list. If the direct listing can be executed successfully, companies get all the advantages of “being public” without some of the disadvantages of “going public.” Assuming the company is cash flow-positive and does not need to raise capital, direct listings are often better for founders, investors, and early shareholders. There are not enough data points, however, to know whether it is better for the company in the long run. There is an argument that an IPO is a unique opportunity to share a startup’s narrative and value proposition with the market and potential customers, access institutional investors and other relationships, and raise capital for future growth – one that may not be fully available later.
There are, however, a range of alternatives available outside of an IPO if companies do want to raise capital. They can do a pre-listing round at a slight discount using, for instance, using law firm Latham & Watkins’ term sheet. They can sell shares (at a 2-4% discount and 1% advisory fee, according to Spotify’s CFO), convertible bonds or other debt after direct listing, as a public company and “seasoned issuer.” Many institutional investors are already meeting with promising startups, rather than being introduced for the first time at a roadshow. An IPO should be evaluated against the available options and in the context of the company’s cost of capital (in an IPO, companies typically pay 40%+ on the capital they raise). As the NYSE president noted, there is a growing sense that listing on an exchange and raising capital can be decoupled.
Well-known startup brands usually already have an active secondary private market for their equity before listing, though these are more like marketplaces than true markets with volume and liquidity. This means pricing is typically at discounts relative to eventual IPO or direct-listing valuations. There are investment firms that focus exclusively on this market, acquiring “pre-IPO” securities for institutional investors, family offices, and high net worth individuals. If direct listings are on the rise, we may see more energy from investors earlier in the cycle who might otherwise have been in the IPO share allocation.
This market is continuing to change – the current energy around direct listings might be viewed as the next evolution from the 2004-2007 auctions in the IPOs of Google, Morningstar, and Interactive Brokers Group. Goldman Sachs bankers recently suggested that “a traditional IPO with market-based pricing or a direct listing that will allow capital raising” or even a “customized hybrid approach” may be future possibilities. Morgan Stanley, the Nasdaq, and Latham & Watkins are already lobbying the SEC to allow firms undertaking a direct listing to raise capital through the process. The SEC’s mission is in line with encouraging the growth of public companies and its current management is viewed as “deal-friendly.” Its chairman believes the trend of firms remaining private longer is barring individual investors from growth opportunities, and is focused on good disclosure under any approach. Citadel Securities is also betting on the rise of special-purpose vehicles – publicly traded “blank check companies” – which raise money for yet-to-be-named acquisitions. Then, there are those that advocate for a more customized mixing-and-matching of IPO and direct-listing features – e.g. capital-raising, roadshows, lock-ups, price stabilization – based on the company’s needs, desired tradeoffs, and regulatory constraints.
There are also new approaches that are even further outside the box. Marc-Andreessen-backed Long Term Stock Exchange, for instance, became an alternative listing option this year with approval by the SEC as the 14th stock exchange in the US and the only one in California. It rewards long-term decision-making, such as voting power that scales up for longer-term investors, a ban on tying executive pay to short-term performance, and a long-term product & strategy committee at the board level. UK tech startup SquareBook, on the other hand, wants to connect listing companies with investors and allocate shares, taking over these roles traditionally held by banks. It aims to cut the listing cost up to 50% through automation, though potentially in partnership with the investment banks. It received approval from the UK securities regulator, the FCA, earlier this year.
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