While M&A represents the majority of venture capital exits at approximately 90%, Initial Public Offerings (“IPOs”) are a relatively small but important part of how we generate liquidity for our Limited Partners, especially with respect to the most highly valued companies. In fact, more dollars have been raised year to date in 2019 by VC backed IPOs than in any other year in history, including 1999. As companies stay private longer and go public at much higher average valuations than in the past, there is a lot more at stake for all parties involved in the process: the companies and employees, VCs and other private investors, investment bankers and public market investors.
This, in turn, is attracting a great deal of attention to individual IPOs, with a particular focus on how their shares trade during the first few days after launching. While the media glamorizes big first day pops in price as a sign of a wildly successful IPO, for many it is calling into question why such enormous one-day value transfers are appropriate, and whether the entire process that results in these outcomes is outdated, if not completely broken. The banker-led IPO process has changed very little over the almost 50 years since Intel went public in a $7 million offering, despite massive changes in market structure, trading technology and the retail and institutional investment world.
Last year, when Spotify pioneered the Direct Listing (“DL”) Process, achieving a valuation of $29.5 billion (although this has since declined to around $21.2 billion, as of the writing of this post) at its open without issuing new shares or relying on Wall Street for underwriting, it garnered our attention and that of public and private market investors and regulators alike. Barry McCarthy, Spotify’s Chief Financial Officer, had long been critical of the process, as discussed by Sequoia’s Mike Moritz in this Financial Times editorial, and wrote his own eloquently phrased missive on the subject in August, giving direct insight into his rationale for pursuing the Direct Listing process, entitled IPOs Are Too Expensive and Cumbersome.
More recently, in June, direct listings gained momentum when Slack followed suit, suggesting that this innovative new way of listing could become a more pervasive – and attractive – avenue for cash-flow positive startups, particularly in the consumer space. The primary reasons these groundbreaking companies chose the direct listing process over a traditional IPO included: transparent communication with investors, fair and equal access to shares for all investors, lower fees (and cost of capital) and the ability for pre-IPO shareholders to sell shares without a lockup period. The practice seems to be gaining traction, with Airbnb making headlines for rumors it is considering a direct listing in 2020, and the Securities and Exchange Commission engaging in discussion on the subject.
While not every company is well suited as a candidate for today’s version of a direct listing, our expectation is that a combination of enhancements to the current direct listing process, as well as modifications to the traditional IPO, will lead to a greater number of companies going public in a significantly different manner than in the past. We feel that this will lead to outcomes that more fairly serve the interests of all parties to the process mentioned above, versus today’s process that disproportionately benefits the largest investment banks and their top commission-generating institutional accounts.
Recently, venture capital luminaries such as Bill Gurley of Greenspring manager Benchmark and the aforementioned Mike Moritz of Sequoia, along with several others, have become vociferous critics of the traditional IPO process on many fronts. Gurley, citing data from University of Florida professor and IPO expert Jay Ritter, asserts that over the past 38 years, $171 billion in value has been transferred from IPO companies to IPO buyers, measured by first day price increases generated by underpricing practices. That number is $15 billion for the past three years alone, and already $6 billion thus far in 2019, despite some notable deals that have traded down on the first day. Gurley feels that direct listings address the wealth transfer issue by providing “market-based pricing and allocation” and “fair and equal access to all investors.”
Pre-dating Gurley’s widely followed commentary, pushback against the traditional IPO process has existed for over 20 years. It may have begun with Pierre Omidyar after eBay’s 1998 IPO. The company’s stock soared 163% on its first day of trading and Omidyar was critical of what he felt was an undemocratic process.
The following year, technology banking entrepreneur Bill Hambrecht launched WR Hambrecht + Co. to advise companies on IPOs via its patented OpenIPO Dutch Auction process, an alternative to IPO listings designed to democratize the availability of shares while resulting in the best price for companies and their early investors. In 2004, Google chose the Dutch Auction method, which resulted in a much higher IPO price than likely would have been achieved through a banker led process. Netsuite also chose to go public through a Dutch Auction process in 2007, but as larger investment banks effectively consolidated IPO book runner market share, innovation in the IPO market completely stalled and virtually all companies from that time until Spotify in 2018 used bankers in a traditional IPO process.
The Limitations of IPOs
While the major area of concern critics have with traditional IPOs is the aforementioned underpricing—roughly 20% of tech IPOs in the past 5 years have risen over 40% on the first day of trading—there are a number of other shortcomings associated with the traditional process that are being questioned. These include underwriter fees, lack of transparency around demand and price discovery, the deal marketing process, banker bias around allocation (dual agency problem) and restricted access to shares for most investors.
Beginning with fees, the typical underwriter spread for an IPO is 5-7% of gross proceeds raised, including any shares sold as part of the 15% over-allotment option. A company doing a $1 billion IPO would pay roughly $50 million from the proceeds to the underwriting group, typically comprised of 8-12 firms. Slack, in its Direct Listing in April, paid considerably less to several investment banks for advising them through the process of listing on the NYSE (but not as underwriters), including a small amount to firms they hoped would provide research support after the launch.
In terms of demand and price transparency, a mere 50-75 accounts typically have access to a meeting with company management during an IPO roadshow, and it is often the feedback from just a subset of those accounts that determines the price and allocation recommended by the lead underwriter to the company and its board. This is in stark contrast to the modern market-driven methodology, where thousands of investors acting independently determine the price at which stocks trade and which orders are filled every day on global exchanges.
With respect to the marketing of an IPO, most meetings with major institutional accounts consist of 45 minutes of a scripted presentation and Q&A with 2-3 members of the company’s management team. This process allows little time to get to know the company well or provide meaningful feedback. Many companies would prefer a different format, such as a multi-hour education session led by a broader group of senior managers from various parts of the company that could then be uploaded to a site for the benefit of all investors, particularly those who represent buy-and-hold, long term shareholders.
Another potential shortcoming of the current process is the dual agency problem, where the underwriters can be said to serve two sets of clients: the issuing company that will only do one IPO in its lifetime and the institutional clients who pay commissions to the trading desk of the underwriter every day. When the time comes to price and allocate shares of an oversubscribed IPO, the natural bias of the banker is to price at an attractive level for the institutional client and to allocate shares based on the relative level of business each client does with the underwriter. Many investors who place orders with no price limit get zero allocation, which never happens in a market driven process. This can lead to larger first day price increases and the temptation for “over allocated” accounts to flip their stock for a quick profit. At the same time, the “under allocated,” potentially longer-term holders of the stock, are forced to buy most of their shares in the aftermarket, which can be challenging due to the limited “float,” or shares available to trade.
That brings us to the next concern: the traditional 180-day lockup the underwriters impose upon pre-IPO shareholders, such as venture capitalists, agreeing not to sell any shares for six months. The traditional argument is that buyers of the IPO would not be willing to pay as much for the newly issued shares given the large overhang of additional shares owned by the VCs. While this sounds like a plausible argument, there are two observations that suggest otherwise. First, Slack’s stock traded in a 10% band for its first two weeks of trading, despite the potentially significant selling or distributions of shares by VCs. Second, a recent panel of institutional investors expressed their frustration about the difficulty of building a meaningful ownership position in newly public companies due to the artificially limited supply of shares in the aftermarket.
From our perspective, innovations that help establish a more stable public shareholder base, are potentially less dilutive to the company and provide firms like Greenspring more flexibility around returning capital to our LPs warrant serious consideration.
How Direct Listings Work
Given the many shortcomings of the traditional IPO process and the success of the Slack and Spotify listings, let’s discuss how Direct Listings work.
The preparation phase for a Direct Listing often begins with the cultivation of relationships with major public institutional investors, often as much as a year or more in advance of a listing. Additionally, the company should begin to allow for secondary trades in its shares several quarters in advance in order to develop some price discovery and broaden the cap table. As with an IPO, regulatory filings must be drafted that are very similar to those required for an IPO.
Often, the company will engage several investment banks as advisors to assist with drafting and developing a marketing plan. Once the requisite filings are publicly available for several weeks, an investor education process begins that is likely to include an investor day—both in person and online—with hundreds of participants engaging with a broad group of company executives. This can be supplemented with follow up investor meetings. The company can then ask the SEC to make the regulatory filings effective, which allows them to provide guidance to analysts and investors, and even do an earnings release—all prior to the stock trading.
The day before trading begins a non-binding reference price will be set, based on feedback, comparable public companies and private market trades, and the Designated Market Maker (“DMM”) will then open the stock using the exact same process they use to open every stock every day. The only difference is that it can take several hours for the DMM to balance the buy and sell orders since there is no prior trading history. The idea is to open the stock on as much volume as possible so that the first trade price is representative of where the stock is likely to settle in the near term. The beauty of this system is that everyone from the largest institution to a retail investor with an online account has equal access in the process—as if buying or selling any other stock during market hours.
Should Every VC-Backed Company Consider this Approach?
For the time being, there are certain aspects of a Direct Listing process that suggest that larger, consumer-oriented (rather than enterprise), better-known and well-capitalized companies should comprise the next wave of direct listings. While we support this new avenue for shareholder liquidity, in practice it may not be suited to the majority of venture-backed companies today.
First, primary capital cannot be issued through a direct listing under current regulations. While the SEC, major exchanges and attorneys are hard at work to make that possible, it could take time. Companies could choose to do a large private round prior to listing given the abundance of available capital at that stage, however, companies below a billion in value may not have the same access to that capital as their more highly valued peers.
Second, both Spotify and Slack would emphasize the importance of having established broad relationships with public institutional investors in order to ensure that there is plenty of interest in the stock when the listing takes place. That cultivation can take time, and certain management teams may prefer to focus more exclusively on growing their businesses than meeting with new investors. In those cases, having bankers do most of the lifting around connecting companies to investors closer to the time of an IPO might make sense.
Third, a healthy secondary market in a company’s private shares can be a beneficial part of pre-listing price discovery. It is not clear how many private companies would favor allowing secondary trading, or even if they did, how much interest there would be in the shares of smaller companies. Despite the above, there are many highly valued, very broadly known companies—in both the consumer and enterprise segments—that seem ideally suited to pursue direct listings. Those that require primary capital, for the time being, can access the late-stage private market prior to listing and others can follow the lead of Slack and Spotify.
We applaud those two pioneers for blazing a trail that will become well-trodden and believe that more participants in the process of becoming a public company will be more fairly and better served, including our Limited Partners. Ultimately, we are in favor of all forms of exit options that can create better liquidity for shareholders and our Limited Partners.
Update: As of November, 2019 the NYSE filed a proposed rule change with the SEC to remove a key obstacle to many companies considering a direct listing - not being able to raise primary capital.
 M&A/IPO as a Percent of Total VC Exits. Source: Venture Economics. Data as of 12/31/2018.
The content here is for informational purposes only and should NOT be taken as legal, business, tax, or investment advice. It does NOT constitute an offer or solicitation to purchase any investment or a recommendation to buy or sell a security. In fact, the content is not directed to any investor or potential investor and may not be used to evaluate or make any investment.
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