Spotify’s Direct Listing Won’t Change the IPO Landscape
Spotify’s direct listing in lieu of an initial public offering (IPO) brought forth some renewed speculation that a democratization of public offerings is finally approaching. There are several reasons for Spotify to have chosen to list directly, much as a traditional offering makes more sense for the organization in other cases. From the perspective of financial literacy, I think it is great that we have things that cause people to question the hows and whys of what might otherwise remain unnoticed. Spotify’s direct listing can be best understood in comparison to how companies traditionally make themselves available for purchase by the general public.
Reasons to Become a Publicly Held Company
Organizations seek to become publicly held for a variety of reasons. The biggest reason to transition from a privately held organization to a publicly held and traded one is to raise capital. In the life cycle of an organization the ability to raise capital can be a major determinant of growth. Capital is the lifeblood of capitalism.
Small and mid-size organizations often seek out capital in order to scale and to achieve their full potential. After the company’s initial capital — typically supplied by the owners, their families, or others close to them — come the venture capitalists. Small organizations will seek out venture capitalists to purchase a portion of the organization in exchange for an infusion of capital. This infusion of capital is generally the amount needed to go the next level in scale, but not enough to maximize the organization’s potential. Without outside capital, many organizations would either remain very small or grow incredibly slowly. Outside capital can allow an organization to move forward at a far greater rate.
Once an organization has achieved what it could from the venture capitalist’s resources (or other resources), it may need to look at other options to raise additional capital. This can be used to further expand, to pay back venture capitalists or other early investors, or both. A major factor in doing this may be the relative ease of raising capital later, when additional capital can be raised in a far less cumbersome process through offering additional company shares.
But going public comes at a high cost. Privately held firms are not subject to the same intense financial scrutiny as publicly held institutions are.
Publicly held companies have a lot of obligations to create financial statements and disclose detailed financial information. The traditional process of going public through an IPO is also an expensive process.
Traditional Initial Public Offerings
In a traditional IPO, an investment bank acts as an underwriter for the offering. Basically, this means that the investment bank runs the show. They help determine the appropriate value for the organization and the price for the initial offering.
There is a lot to do in order to meet rules and regulations. And there needs to be sufficient market for an organization to sell its offering, in spite of the organization being relatively unknown. The investment bank helps create a market by working with institutional investors and its own retail division to secure interest and prop up demand and price. While the investment bank’s marketing activities help to ensure a successful IPO, they are frequently targets of criticism, as favored groups may have access to IPOs that most investors don’t. Individual investors may not be able to obtain IPO shares, especially for high-demand offerings.
The Dutch Auction Alternative
An alternative to the traditional underwriting approach is a Dutch auction-style IPO. Google (now Alphabet) used this method for its IPO in 2004. This method is theoretically more democratic.
The reason organizations use it is not, however, their interest in smaller investors’ participation. In truth, the traditional underwriting method often misprices offerings, and any mispricing in which shares are sold below what they could have been is a lost opportunity for the organization and its early investors. As such, organizations may use the Dutch auction method in an attempt to reduce the risk of underpricing by the underwriters.
The Dutch auction process has investors bid on shares, offering to purchase a quantity of shares at a specific price. The company may offer some guidance as to where it expects the price to land; and when all the bids are in, the highest ones are chosen until all of the shares being offered are taken. But of those selected bids, everyone gets the lowest price. As a purchaser, you may end up getting shares at the price you bid, or perhaps at a lower price. But you won’t get shares if the final price is higher than your bid.
Considerations When a Company Goes Public
When Google used this technique to go public, it didn’t seem to get what it was looking for. A lot has been written on this, and I won’t veer off into a whole case history, but the rapid price increase immediately following the offering indicates that they may have been able to sell the offering at a higher price.
The traditional method is very expensive. The underwriters will do well, and their close clients and institutional investors will have easier access to the opportunity. The value of the underwriter creating a market amongst its clients and institutional investors is a big cost, but it’s weighed against a big risk of not selling your offering. If no one knows about your company they’re not going to buy it. Especially not at an IPO. By 2004, Google was already a household name. Everyone wanted in. They didn’t have the same risk of insufficient market. They had an opportunity to try something different in an attempt to achieve the highest possible price for their shares.
The fact that Google didn’t hit a share-price home run is significant. Not many organizations will go into an initial public offering with that level of name recognition.
For many organizations, the risk of not being able to sell enough shares at a reasonable price would outweigh the potential upside of getting more money from an auction. For many, the upside potential is not worth the downside risk.
Spotify’s Direct Listing Approach
Spotify skipped the normal IPO process, instead going with a direct listing. Its goals, however, were different. The company wasn’t looking to issue new shares and raise capital. It was looking for a market for its shares — a way for investors who wish to sell their shares to find buyers who would like to purchase them. This isn’t the normal IPO situation.
Sure, a few other companies may do this now. But the same reasons why the Dutch auction style didn’t take off after Google’s IPO in 2004 still apply here. Organizations looking to sell a significant number of shares through an IPO can’t afford the risk of not selling those shares. That risk is reduced when companies take the traditional underwriting route.
Final Thoughts on IPOs
Pricing in IPOs remains somewhat of a mystery. Some highly anticipated IPOs fall flat, while other, seemingly mundane ones do quite well. The hype can help, but it isn’t enough. An organization eventually has to make money and provide a good return for its shareholders.
Informational asymmetry is a factor, as well. Smaller investors will never truly have the same information institutional investors do. Not because they can’t have it, but because they can’t do it — they don’t have the resources.
An initial offering also has a significant piece of pricing information missing: The stocks have no price history. For many investors, this alone represents additional risk because they can’t see how the stocks have behaved during varying market conditions.
Spotify’s direct listing, like Google’s Dutch auction, does not herald a democratization of the IPO process. For many investors, it may be very difficult to get shares in a highly sought IPO. But that may also mean that they didn’t get shares in Snap last year, either.