The bonkers IPO market has obscured an important innovation for listings

What’s old is new again.
What’s old is new again.
Image: Unity
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The IPO is fiendishly difficult to disrupt. But Unity Software’s deal in September shows that the process of going public is still being pulled into the future.

When the company listed its shares this year, it made some modifications that could shift the balance of power between Wall Street and Silicon Valley. Some experts think Unity’s offering—a hybrid of an auction and a more traditional IPO—is a sign of things to come.

A hybrid auction uses an auction process to gauge demand for the offering. Then the company itself, rather than the investment bank, uses the data to decide which investors will get shares.

“It’s a modest tweak in the process that I just think is better,” Unity CFO Kim Jabal said. Other finance executives have been calling her to ask about the company’s listing, and she said she is happily sharing her insights.

West Coast tech entrepreneurs have long chafed over the rules for IPOs that are recommended by East Coast investment bankers. This year’s bonkers IPO market, in which deals from Snowflake to Airbnb have soared into the stratosphere, obscured Unity’s success in trying something new.

In a traditional offering, investment bankers decide which investors get allocated stock; the criticism of that process is that Wall Street rewards its best clients with shares that are underpriced. And that underpricing takes money out of the wallets of investors who supported the company before it went public.

Unity wanted to try something different. Perhaps not surprisingly, Jabal said she and her team sometimes had to drag the investment banks along for the ride. The company hired Goldman Sachs, Credit Suisse, and William Blair as the lead investment banks to help manage its hybrid IPO-auction offering. “The bankers were incredibly helpful to us in positioning the story, messaging, thinking about our key metrics,” Jabal said. “But at the end of the day, doing things differently is not what bankers are known for.”

The bankers, however, may have no choice but to adapt. Food delivery service DoorDash and Airbnb, the property-sharing company, both went public in December using hybrid auctions.

“This has been under-reported by the media and is indeed a way of reducing conflicts of interest and could become the norm,” Jay Ritter, a University of Florida professor and IPO expert, said of hybrid auctions.

Why Unity chose a hybrid IPO

Jabal said there were several reasons Unity, with a software platform best known for its use by gaming developers, sought to do things a little differently. One is that Unity wanted employees to be able to participate in the IPO (employees often have to wait 180 days to sell shares), leveling the playing field with other investors. She said the 16-year-old firm also wanted the offering to be data-driven and transparent. “We felt like the traditional IPO has some parts of it that are very opaque and black boxy, particularly around pricing allocations,” Jabal said.

Stock sales by employees worked out even better than Jabal had hoped. Normally the liquidity for newly priced shares comes from hot-money hedge funds that quickly dart in and out of markets. In the Unity deal, that buying and selling was lubricated by employee shares. That allowed Unity to allocate shares to investors whom the executives wanted to target, instead of to Wall Street’s favorite clients. “It worked great,” Jabal said.

It’s not easy to make changes to a well-trod process. For investors, there may not be much upside if they participate in an innovative IPO, and they could get blasted with criticism if it goes sour. “You do have to have confidence in your business and your business model,” Jabal said. “If investors are at all nervous about the opportunity and then you’re saying to them, ‘Oh, we want you to do things differently,’ you know, the bankers alone will scare you into not doing that.”

“But we had a good business model, a good story, we felt reasonably confident,” she added. “It was a complex story—and that’s where the bankers really helped us.”

Resistant to disruption

Kim Jabal
Kim Jabal
Image: Unity

Unity isn’t the first company to try to shake up the IPO process, which has proven resistant to disruption over the years. Direct listings, in which the opening price is set on an exchange, have sometimes been hailed as a game changer. But there have only been a handful of them since Spotify’s direct listing in 2006, which suggests they’re more likely to be a niche service for well-known companies that don’t need as much support from an investment bank. (New York Stock Exchange got approval from regulators (pdf) on Dec. 22 to allow companies to raise capital using direct listings—another step in the IPO evolution.)

Per Roman, managing partner and co-founder of investment firm GP Bullhound, agrees that not every company has a big enough brand to use a direct listing, but he thinks it’s the most fair way of going to the public market, as it distributes shares more evenly to institutions and retail investors and saves money for shareholders. “It’s proven that when you talk about companies that are well know to people in general, you don’t need that very expensive investment banking process,” he said.

“Blank check” companies, another alternative to traditional IPOs, have been the rage in 2020. These special purpose acquisition companies, or SPACs, raise money through an IPO and then go out and find acquisition targets. Similar to a direct listing, a SPAC doesn’t have a roadshow.

“I don’t think the SPAC boom is going to persist,” Ritter said. He argues there are too many blank checks chasing too few good companies. “They can play them off each other and push up the bid price, and that’s going to make it difficult for SPACs to get good returns,” he said. “There’s a danger they’re going to overpay.”

Unity’s finance chief thinks part of the reason the company was willing to experiment with its listing is because its team was made up of women. In contrast to the mostly male worlds of tech and finance, the women who worked on Unity’s offering included Ruth Ann Keene, Unity’s general counsel, controller Elaine McChesney, and Lise Buyer of Class V Group, an IPO consulting firm. “It was a very female-driven IPO,” she said. “We wanted to try something different. We were the ones pushing this whole structure in the beginning,” she said.

In theory, an auction should provide the highest possible price for a deal while giving a wider range of investors (rather than just well-connected institutions) a chance to participate.

Google used an auction for its IPO in 2004, but the process failed to catch on. Ritter has suggested there were several reasons Google’s offering wasn’t seen as a success. Part of it was bad luck, as tech shares were cooling at the time of the listing. And management declined to answer some questions from investors, perhaps making them less confident about the offering.

Ritter also says the investment bankers—from Credit Suisse and Morgan Stanley—effectively “sabotaged” the deal, by telling investors that could probably get shares even if they low-balled their bids. Underwriters “feel threatened by auctions,” he wrote in Forbes in 2014. “With an auction, the underwriters no longer have the power to allocate underpriced shares to their favorite customers.”

Unity’s Jabal is well acquainted with Google’s offering, as she was at the tech company during its IPO, and Class V’s Buyer was also at Google at the time. The auction idea at Google was driven by the company’s engineers, Jabal said, and she thinks the company didn’t appreciate the human element of running an IPO.

“They missed the mark a little bit because they weren’t as focused on those relationships with investors,” she said.

Jabal said Unity spent a lot of time with investors over the years and had researched which ones were likely to be long-term holders of the company’s public stock. They found giants like BlackRock and Fidelity aren’t necessarily the most loyal, and that some midsize money managers were more likely to stick with the investment. When it came time for the IPO, the company was able to combine that information with the demand spreadsheet to decide who got shares. Jabal says data since the offering has shown their hunch was correct.

“It’s those middle-conviction, smaller funds where we gave them a meaningful allocation, which they had probably never gotten before, and they are still holding every single share,” she said. Jabal credits William Blair, the Chicago-based investment bank, for helping the company to find that sweet spot in the market, and Goldman Sachs for its willingness to help with the software used for the listing.

IPO first-day pops

One of the hallmarks of 2020 is the track record of extraordinary first-day pops of newly minted tech shares. IPOs have jumped about 36%, on average, during their first day of trading, according to data compiled by Ritter. That’s the highest average of any year since the dot-com bubble.

The jump has been especially jaw-dropping for some recent deals, like Airbnb, whose shares soared more than 100%, and DoorDash, whose stock jumped some 80%. Both companies used hybrid auctions for their IPOs like the one used by Unity, whose shares rose about 30% during the first week of trading.

There’s a lot of speculation about why certain IPOs have been so wacky. Some blame the surge in retail trading, and exuberance of uninformed newby traders who have flocked to apps like Robinhood and TD Ameritrade.

In an age where interest rates on government bonds are hovering around 1% or less, the demand for growing companies has been astronomical. “This has been the most phenomenal year in the history of the tech IPO, definitely since 1999,” GP Bullhound’s Roman said. “Part of this is of course is because the venture growth and private equity industry are holdings companies private much longer.”

The surge in DoorDash and Airbnb stocks shows that hybrid auctions aren’t immune to massive jumps on the first day of trading, which indicates the process still needs ironing out.

Jabal suspects Unity’s stock jumped so much during the first week of trading, in part, because so many shares went to long-term investors. That could have reduced the supply available for trading during those busy early days, potentially pushing the shares even higher during heightened demand.

“We really did skew toward investors that we felt like they know our story,” she said. “It’s possible that it contributed.”

The debatable value of IPO bankers

There is, however, at least one thing Jabal says she would do differently. IPOs can have a number of investment banks that are part of the syndicate for the offering, with two or three lead managers and a few other banks playing a smaller role, all of whom get paid by the company. She thinks the lead bankers are helpful because they help write the regulatory filings, explain the company’s story to investors, and decide which kind of offering is the best fit.

But she’s not so sure about the other banks in the crew. “The rest of the bankers in the syndicate—I honestly don’t know if they add any value as part of the actual process” Jabal said.