By Gitta Amelia (General Partner, EverHaus)

About one year ago, Spotify became the first technology company to undergo a Direct Listing (“DL”). At the helm of the strategy was Spotify’s CFO, Barry McCarthy, also the former CFO of Netflix. On its first day of trade, shares of Spotify Technology SA jumped up 12.9%. Following Spotify’s success, Slack ensued closely behind and listed directly on the NYSE as well. Spotify’s DL was seen as a test case for other companies tempted to list without selling new shares, and for bankers that could lose out on millions of dollars in underwriting fees for future initial public offerings.
Although the theatrics of a Direct Listing and an Initial Public Offering (“IPO”) may be similar in nature, the technicalities of the two are unambiguously different. An IPO is a primary round that occurs in the stock market when a company trades for the first time. A DL is a secondary round that occurs in the stock market when a company trades for the first time. A primary round occurs when a company issues new shares and sells those to an investor. In this process, the shareholding percentages of the existing shareholders are reduced (in other words, diluted). A secondary round occurs when an existing shareholder sells its shares to a new investor. The capitalization of the company remains intact as it did prior to the secondary transaction.
The nature of an IPO yields multiple inefficiencies. The first of many inefficiencies is in pricing the IPO. The IPO process remains highly manual. In a classic IPO, an underwriter determines the price through an elongated process of discussions, due diligence, and number manufacturing to satisfy clients while working to optimize the bounds of the global economy. The price of stocks already listed in a public market is determined by a system of computers that matches the buyers and sellers of a stock. When the stock market opens each day, the current market price of that stock is established by algorithms. However, the initial price of a stock when it goes live on a public exchange is determined by bankers fueled by a concoction of hidden incentives. When a stock’s price increases on the first day of trade, this means that it has been mispriced. The value of the stock determined by the computer’ algorithms deems that it is worth higher than the price set initially by the investment banks.
But why do bankers purposely misprice IPOs? A banker is incentivized to raise as much money as possible during the process. They can do this by increasing demand of the product synthetically, typically targeting 10–20x oversubscription. An oversubscribed IPO or a huge jump in the listing price on day one is usually accompanied by cheers, elaborate IPO parties, and news headlines. Certainly, the surplus in demand makes for a pretty compelling story. On the other side of the coin however, this means the company is underpricing itself by pure economic theory.
Further down the line, IPOs can also be a burden to some companies due to the lack of knowledge and understanding of investors in the public market. Leon Black, a man worth US$6.5bn and CEO of alternative asset and private-equity manager Apollo Global Management LLC, notably mulled regrets of his IPO — “Absolutely. The public market doesn’t understand creatures like us very well,” at the Bloomberg Invest conference in New York. Since going public in March 2011, Apollo stock has risen 69.4%, while the S&P 500 index SPX, +0.56% has risen by 255%, according to FactSet data.
Despite the increased transparency brought about by the regulatory enforcement of the public markets, many traders make bets based on speculation. Most hedge funds nowadays adopt a volatility-only strategy, looking at price fluctuations and imposing statistical methodologies to short and stop trade orders. In a private market, the price of a stock is only revealed during an intimate window of time, and open to an exclusive set of investors who have not only demonstrated interest but also understanding and knowledge of the product and industry. If a Company has demonstrated strong potential for hyper value-creation, stock buyers would need to court the chief executives’ months before the private offering begins, wooing the companies into bed with tall-tales of “value-add” in other ways than simply providing capital. For most of the year and life of the company, the company’s price is buried until another round of financing necessitates its re-evaluation.
Black is not alone in his dirges; many more entrepreneurs have shared sentiments regretting their company’s IPO. Speaking at a luncheon at the Economic Club of New York, Jack Ma said that, “If (he) had another life, (he would) keep (his) company private. Life is tough when you IPO.” Ma believed that Alibaba s record-breaking IPO shall benefit the company, though not much more the way than his previous private rounds did for the company. For a Chinese conglomerate like Alibaba, cross-border listing banking fees surmount quickly. But unlike fees that could simply be paid off in one instance, the headaches of complying to US board regulations, all the while complying with the Chinese government as a monumental on-shore data powerhouse are ongoing burdens the CEO must carry.
I posit that the role of ‘going public’ will undergo a fundamental and conceptual shift. On top of shareholder and regulatory demands, and mispricing by the market, the largest pressure that will ultimately crack the IPO for the coming years to come is the unforeseen growth of the Private Capital Markets. Previously in the past, companies looking to raise US$100 million can only rely on going public. It’s not bound by geography; globally, Private Capital Markets are outpacing growth in Public Capital Markets. It is now a common occurrence for companies to raise US$100 million and even billion-dollar financings. Therefore, going public can no longer be about raising capital. Either the benefits of going public must increase in value or bankers and regulators must find a way to reduce the implicit and explicit costs of doing so.
When we trace back the reason for the rapid growth of the Private Capital Markets, we find planted in the earth, a strong root tapping into a symbiotic relationship between the growth of democratization of angel-to-early-stage venture financing and pre-IPO institutional financiers. Money in the early stages chase after money in the later stages that promise valuation multiples far greater than any other asset class. Money in the later stages come hungry for the stronger deal flow. The Cap Tables (list of shareholders) for businesses less than five-years-old have increased from just one to a group of co-founders, to relatives, family and friends, venture capital investors, and corporate-backers. Furthermore, in the spirit of employee retention, the Cap Tables are further squeezed by Employee Stock Option programs. Ultimately, shareholders will generate a return by way of exiting their shares, without causing commotion or worry to the company and other shareholders. Only astute investors can exit via a trade sale or secondary transaction. Going public gives all non-managing owners an easy way out. Increasingly, going public becomes less about raising money, but about providing liquidity to investors and employees.
Direct Listing is the future of the Public Markets; as a new financial product that addresses many of these issues. DLs provide ways for companies to price themselves more accurately using algorithms, reduce banker fees, and raise sufficient capital needed without suffering excess dilution. When it comes down to the technicalities, the DL is different from the IPO in a few important ways. First, there is no lockup. In a classic IPO, insiders and pre-IPO buyers (often institutions) are restricted from selling for the first 180 days, in order to prevent negative pressure on the stock price, while in a DL, insiders can sell immediately. Some attribute Slack and Spotify’s decline in the first semester of their listing to this feature. The downside of this is the slide in prices as the larger volume of trades gives way to increased volatility. However, as the DL gains popularity, a market correction for the variance in the DL’s mechanics is foreseeable. Second, in a classic IPO, a small float, such as 15% of full-diluted company shareholding, trade on the exchange. In a DL, all shares are available to trade and all holders — management, investors, or employees alike — determine the price they are willing to trade. Because the float is larger, institutional investors may be happier with direct listings because they can buy much larger positions in names they are excited about. Whereas in a classic IPO, they might be able to buy $5M of allocation, in a direct listing, they could buy hundreds of millions.
The third reason a DL is optimal for the venture-fueled economy is also the main reason for its under-popularity. A banker is disincentivized to promote the Direct Listing route because it will yield them reduced banker fees. Instead of a roadshow, which usually involves flying bankers around the world in elite-class suites, a DL’s roadshow can be done via webinars in the name of attracting retail investors and fund managers alike. This direct access to management is in stark contrast to the case of the classic IPO, where management is veiled by a curtain of analyst reports and pages of PowerPoints and excel models. Simply put, the value of the Investment Bank’s prized relationships with investors and prized research divisions simply diminish.
Companies’ needs and objectives are changing. Technology has caused companies to scale much faster than in the past. When those needs and objectives change, it makes sense that people would seek out new ways to enter the public markets. In its stride, the DL is a new financial product for taking business public that recognizes the important changes in the private capital markets. Benefits will accrue not only the earliest believers and employees of the startups who will capture more of the value created but also retail investors who will be able to access public offerings on the same playing level and terms as fund managers.
