The traditional initial public offering has lost its luster in Silicon Valley. Startups awash in billions of venture capital are pushing off the day as long as possible. Venture capitalists lament the “broken” IPO process. The average time for US technology companies to go public has risen from four years in 1999 to more than 11 years nowadays.
But startups can’t hide forever.
Early insiders must cash out. Companies need capital to grow. Public markets are still the only game in town capable of funding all those multibillion-dollar ambitions at once. But startups wishing to access a portion of the trillions of dollars sloshing around equity markets, and avoid the traditional IPO, now have a second option: the direct listing.
On June 20, Slack will be the first Silicon Valley darling to try it, following in the footsteps of Swedish streaming giant Spotify. Slack’s direct listing (under the ticker WORK on the New York Stock Exchange) is expected to value the company at around $17 billion.
Slack is in an enviable position. It’s growing fast. Revenues are hefty and predictable. It finished the most recent quarter with $792 million in cash, so at its current burn rate of $136 million a year, Slack has six years of cash in the bank, according to its S-1. And now it’s being celebrated by startup investors looking for a way to ditch Wall Street while rewarding early shareholders.
In a direct listing, the company itself doesn’t issue shares or sell stock. Rather, founders, employees, and early shareholders sell their shares directly to public investors, avoiding Wall Street’s fees or any lock-up period which traditionally prevents insiders from trading after an IPO. It’s a rarely used but increasingly popular tactic. For a select group of well-known companies, it is the future.
The problem with IPO pricing
For most aspiring public companies, the Wall Street roadshow is a rite of passage. Investment bankers charter private jets and shepherd CEOs before potential investors in dozens of cities. “It’s grueling,” says John Mullins, an associate professor at London Business School. “You pitch three to four times per day all over the country, all over the world, explaining to stockbrokers why this is the best thing since sliced bread.” Bankers divine an opening share price for the company (“more an art than a science,” as one source told us and others confirmed). Dealmakers then parcel out offers to favored clients, usually institutional funds.
If all goes well, the CEO makes the pilgrimage to the New York Stock Exchange or the Nasdaq to ring the bell on opening day and the company raises millions if not billions of dollars. If the bank managing the IPO prices the stock wrong, shareholders are left holding the bag. Too high, and employees end up with devalued shares and worthless stock options. Too low, and early investors miss an opportunity to sell at a higher price, while the company issuing the shares has left money on the table. Either way, it’s lucrative for Wall Street. Even Uber’s disappointing $8 billion IPO reportedly earned bankers $106 million in fees.
Direct listings avoid this. They let companies retain far more control over the IPO process. Insiders can sell their shares at any time, incurring bank fees that are around 1% rather than as high as 7%. Companies can then issue stock at any time, secure in how the market views the company. Not every startup has the luxury of not raising funds for itself. But for those that can do without the capital, and have the name recognition with investors, it’s a no-brainer. “Every company would like to do a direct listing,” says Mullins. “There aren’t a lot of downsides.”
Assuming Slack’s debut is successful, IPOs once brokered in corporate boardrooms may instead become demo days where anyone with an internet connection—not just Wall Street insiders—can check out the company and make the first trade.
Arrival of the direct listing
Spotify’s successful direct listing last April valued it at $29.5 billion. For the company, the exercise was as much about marketing as liquidity. “Our focus isn’t on the initial splash,” Spotify founder Daniel Ek told potential investors in an April 2018 blog post saying he would skip the pageantry of ringing the NYSE bell. “Instead, we will be working on trying to build, plan, and imagine for the long term.”
It didn’t stop there. Spotify CFO Barry McCarthy later wrote, in a post titled “IPOs Are Too Expensive and Cumbersome,” that investment banks were ripping them off. “Bankers told us that they try to price new listings so that they rise 36 per cent once trading starts,” he wrote. That’s a huge discount for institutional investors who buy early, though banks would argue the porous ceiling is necessary to compensate investors for the risk of buying untested companies. McCarthy’s conclusion? “The economics makes sense for the investors, but the system penalises successful individual companies.”
Adam Augusiak-Boro, an analyst at EquityZen, says the Spotify model will spread. Rather than the 7% or so fee investment banks may charge for flying planeloads of investment bankers around the world, companies like Slack can simply hold a webinar.
At its live-streamed “Investor Day” on May 13, Slack executives presented on the company, addressed questions, and posted materials for investors to review. “Management is not distracted for a whole week and you’re not hauling bankers across the country and expensing hotels,” says Augusiak-Boro, a former New York investment banker.
It helps that products like Slack or Spotify are easy to understand and already installed on many potential investors’ laptops and smartphones. Their global reach means the tech world’s brightest stars are already household names by the time they want to sell shares.
Direct listings aren’t for everyone
Jai Das, president of Palo Alto-based Sapphire Ventures, says direct listings still don’t make sense for most companies. “I think it’s a way to go out in public markets if you don’t need to raise any capital,” he said. For most money-burning startups, he argues, not raising capital during an IPO is not an option. Overall, says Das, “we’ll probably see 1 to 2 [direct listings] every year but it’s going to be the exception, not the rule.”
Alex Castelli, a managing partner at tax firm CohnReznick, agrees that “there is very little threat of direct listings replacing IPOs.” Only for a certain slice of “well-known companies that don’t need capital and who can tell their story to potential investors” will direct listings make sense.
But are other companies really better served by the traditional IPO process? Bill Gurley, a venture investor at Silicon Valley firm Benchmark, cites recent IPOs such as Crowdstrike and Zoom as cautionary tales. Both tech firms saw their stock prices spike by as much as 80% after their shares began trading, suggesting they left more than $1 billion of potential capital on the table. A price “pop” isn’t always a bad thing. Employees, for example, can cash out rather than be stuck with underwater stock options. But that’s meager compensation to Gurley.
“CrowdStrike (and other way underpriced deals) are the true definition of a ‘broken’ IPO,” he tweeted on June 12. “Imagine if a CFO/CEO gave away a half a billion dollars? Or simply squandered it. How would that be viewed? This is similar, but it’s institutionalized, and therefore everyone is numb to it.”
Gurley predicted Slack’s direct listing would spark a new era for startup financing. “There is no reason whatsoever equities cannot be priced in a blind auction,” Gurley wrote, referring to how investors in a direct listing set the price by buying stock rather than relying on banks to set the price for them. “This is how 100% of IPOs should be done. And hopefully will one day.”
Whoever is right, change is coming to the exchanges. Conditions are shifting in ways that favor direct listings.
For starters, exchanges that provide secondary markets for shares of private companies are getting more liquid. These exchanges, which allow accredited investors to buy and sell shares before they are publicly listed, and give public investors a clearer view into the value and workings of the company, are exploding in volume. EquityZen says it has placed 7,500 transactions in the last five years.
Meanwhile, for a company with enough buzz to consider going public, there’s a good chance that large investors such as institutional funds have already poured hundreds of millions of dollars into transactions of the company’s privately held shares, as they did with Slack. This price transparency means the company can have far more confidence in how to price its shares on the public exchanges.
Spotify, for example, chose to sell shares through a direct listing at $132, very close to its then-recent secondary share pricing. The stock rose about 26% during the first day of trading (it’s now down about 8% since its April 2018 listing) and the company saved millions on underwriting fees.
Rather than a rite of passage, the IPO may soon become just another fundraising round. Six months after its own direct listing, Spotify is promoting its path as the future for all companies, even those that need growth capital. “Raising money from an IPO is an entirely tactical decision and should be weighed against all the other funding alternatives for private and public companies,” its CFO wrote last October. “Companies have more flexibility than they may realise when it comes to raising capital. And the same is true when it comes to going public.”