What I've learned about IPOs and Direct Listings
Today is the anniversary of Spotify IPO, which was the first direct listing of a technology company. It was championed by Barry McCarthy, the former CFO of Netflix and the current CFO of Spotify. Since then, Slack has also listed directly. And the combination of these two events has created a groundswell for more of them.
In the past few months and quarters, I’ve been learning as much as I can about this topic. Here are my notes and sources.
Before we start, let me define four terms. A primary round occurs when a startup creates new shares and sells those to an investor. A secondary round occurs when an existing shareholder sells their shares to a new investor. An IPO is a primary round that occurs in the stock market when a company trades for the first time. A direct listing is a secondary round that occurs in the stock market when a company trades for the first time.
An IPO pop is a negative. If a company pops by 30 or 40% on their IPO, this means it has been mispriced. Imagine I sell you a doughnut for a dollar. Then you turn around and immediately sell it to the person sitting next to you for a $1.40.
Would you feel excited that your doughnut is now worth more? No. You should feel fleeced. This is exactly the same dynamic for a pop at IPO, but instead of doughnuts, we are talking about shares and instead of dollars, we are talking about hundreds of millions of dollars.
The IPO process isn’t computerized. How does the stock market start every day? There is a computer system that matches buyers of stock with sellers of stock. They each specify the amount and the price at which they are willing to buy or sell. And at the open, or quickly after, the current market price of that stock is established by algorithms.
In a classic IPO, this process is done by hand which creates lots of inefficiency. And, typically all of the IPO is allocated amongst a group of 10 large institutional investors, which reinforces this inefficiency.
Computers are much better at making markets than humans.
During the IPO process, bankers target 10-20x oversubscription. When a company goes public, it goes on a roadshow. It’s very similar to raising capital in any other round. after briefing different investors, each investor submits a demand curve of sort:their preference of buying a certain number of shares at a certain price. This goes into a book (an Excel spreadsheet today). The book contains the total demand for the offering. In many IPOs, bankers advise startups to achieve 10-20x oversubscription, in order to get that pop.
On one hand, that sounds pretty compelling because there’s so much demand. On the other hand, this means the company is under pricing itself.
Imagine you had a doughnut and you have 20 people willing to bid on it at a dollar. Would you stop there, or would you start auctioning it to the highest bidder?
The role of the IPO is changing. It used to be that the only way to raise $100 million was through an IPO. the private capital markets were not large enough to support these kinds of round sizes. In the last 15 years, the private capital markets have become much larger and it’s a common occurrence to read about $100M or $500M financings or even billion-dollar financings.
So the role of the IPO must change. It’s no longer about raising capital. It instead it is about providing liquidity to investors and employees.
The direct listing is a new financial product for startups addresses many of these issues. Direct listings provide ways for companies to price themselves more accurately using algorithms, reduce banker fees, and only raise the capital they need without suffering excess dilution.
The direct listing is different in a few important ways. First, there is no lockup. In a classic IPO, insiders are restricted from selling for the first 180 days, in order to prevent negative pressure on the stock price. In a direct listing, they can sell immediately. Some speculate this is the reason for the decline in the share prices at Slack and Spotify since their IPOs.
Second, in a classic IPO, perhaps 15% of all outstanding shares might trade. This is called the float. In a direct listing, all of the shares are available to trade. Each holder of shares including employees determines at a price they’re willing to sell.
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.
Third, instead of a roadshow, companies host investor days, which are online webinars that brief any number of people. It might be hundreds or thousands were millions of people who might be interested in the direct listing. This means you can buy shares in the direct listing on the same basis as a big bank or hedge fund, which isn’t the case in the classic IPO.
Fourth, the dynamics of the investment bank change because the research department has less privileged access to the business than they would have with the classic IPO. In a classic IPO, the startup briefs a small number of investors, and the analysts at the bank have terrific access to the management team. The analyst then summarize this research and share with everybody. But with an investor day, the analysts lose this access and the value of the research diminishes.
The direct listing is an important innovation for startups. The new financial product for taking businesses public that recognizes the important changes in the private capital markets.
We are going to see many more of these direct listings. Importantly, they will benefit not only the employees of the startups who will capture more of the value created, but also retail investors who will be able to access IPOs; something they haven’t been able to because of the old structure.