March 2018

Spotify’s IPO & Direct Listing on the NYSE, will Uber and Airbnb be next?

Written by Toh Zhen Zhou
IPO & Placements Specialist, Smartkarma

Read more of Zhen Zhou’s work by clicking here!

The announcement of Spotify’s direct listing on NYSE on the 3rd of January 2018 has sent Wall Street into a flurry of mixed emotions around the possible success of such a trend setting move. In a world where decentralisation is being embraced, cryptocurrencies are being discussed in high schools and the continued advancements of technologies driving digitally disruptive companies, will this be the start of a long and drawn out headache for investment banks and brokers, as unlisted companies choose to list directly on the world’s stock exchanges?

It’s clear that small and mid-cap companies have no chance of entertaining such a daring move, however, this could shape the way IPOs are held in the future, especially for successful, popular and well-known private companies that are not cash hungry, but interested in broadening their scope of opportunities. What affects this will have on all IPOs is yet to be known, but it’s clear that 2018 is set to be the year that IPOs took a turn, better or for worse, we will soon find out.

The biggest question of all, will Uber and Airbnb follow? With their rumoured IPOs expected in 2018 or 2019, they may well hold to see how Spotify as the first mover plays out.

How it has always been done

Listing on the stock exchange via an IPO has been a long and drawn out process that has many moving parts, from financial reporting to legal documentation to industry outlook reports. Investment banks have typically played a critical and controlled part in the chain, including planning and more importantly, selling the shares to investors. Although, it’s common knowledge that this process has a number of drawbacks for the unlisted company and is not the most efficient.

Essentially, the direct listing by Spotify cuts out the underwriter and leaves the price discovery solely in the hands of the market, rather than relying on institutional investors and brokers. Spotify’s decision to circumvent these standard processes has opened a new IPO method that is transparent and efficient.

Process of an IPO and the problems associated with them:

• Planning phase: The company engages an investment bank and prepares the Form S-1 registration statement, then it takes another two months to receive SEC comments and negotiate changes with the SEC.
• Underwriting: This part of the IPO process can be commoditised, even outsourced. In many cases, the “underwriting” has been shared across institutional investors anyway!
• Roadshow: The investment banks in charge of the IPO take the company on a “roadshow” to various possible investors (often large long-only or preferred clients of the investment bank) to determine the appropriate price for the IPO. In return, these investors often receive the initial allotments of IPO shares and benefit from the price appreciation imbued in the increase between the offer price and the open price when it starts trading.
• Collecting orders and distribution: Sales traders still send out the details of term sheets through emails. Orders from institutional investors are still collected the same way. Blotters are bloated and ineffective. There hasn’t been much innovation here.

Additionally, there is the constant struggle between the three parties: the company, the investment bank, and institutional investors. The trilemma can be split into sell-side pushing for the highest valuation to earn more commission, the institutional investors trying to buy shares at the cheapest possible price, while the company trying to dilute its shares as little as possible.

The bottom line, this process is expensive, convoluted, and does not always see a direct alignment of the interests of the company, sell-side, and institutional investors. If the company carries most of this burden is debatable, but what if there was a better way. 

The traditional IPO process is by no means obsolete. However, like most industries in the age of disruption, there are many processes in an IPO that can and should be improved.

Shortening the lead time (pre and post-IPO)

• The obvious advantage of a direct listing is that the company will not need to have a price discovery process.
• By cutting out this process, which involves the back and forth bidding of underwriters and institutional investors, the company will be able to reduce the IPO lead time.
• There is also no need to hold a roadshow and there will not be a lock-up period that underwriters typically demand in an IPO. This means that shareholders of the companies can start selling much earlier.

Reducing significant cost

• The company will not need an investment bank to underwrite their shares or take them on a roadshow to meet investors since there is no public offering as such.This significantly reduces the cost of an IPO.
• Based on research by PWC, a typical underwriter’s fees would dominate all other costs as they charge 5 – 7% of the gross proceeds raised. A company with raising an IPO gross proceeds of above US$100 million, the underwriter cost will be on an average 5.5 – 6.6%.  
• As a company raises more money, the average cost naturally rises in tandem but the percentages decline only marginally.
• For companies with US$1bn revenue and above, the underwriter’s charge still dominates 78% of the total IPO cost followed by legal cost.
• Furthermore, based on Spotify’s implied valuation of between US$15 – 22bn, if it actually was to go through an IPO, its gross proceeds could easily surpass US$1b which would imply a US$55mn cost (assuming US$1bn proceeds and 5.5% underwriter charge).
• This compares to Spotify’s listing cost of approximately US$29m mentioned in its prospectus much lower than the estimated implied cost of US$55m.

No dilution while stock can be its currency

• Direct listing allows the company to come onto the market without diluting their existing shareholders. This usually applies to cash-rich unicorns which have raised a significant amount of capital in private placements and hence, raising more money is not the primary reason for listing.
• As the company gets listed, it has now created a liquid market for its stock which will allow the company to use its stock as a currency for executing M&A transactions.
• It will also allow employees and other prior shareholders to liquidate and monetize their shareholdings.

Implications on future IPOs and research going forward

The NYSE recently made an announcement that it has changed certain regulations with respect to a direct listing.

Attracting more well-known, cash-rich private companies to list

• Previously, without an IPO, spin-off or transfer from another exchange, a company could only list on the NYSE at the exchange’s discretion and if the market value of its publicly held shares was at least $100 million, based on an independent third-party valuation and recent trading of a sufficient volume in the unlisted market.
• Under its revised listing standards, NYSE will allow a company to list directly in the absence of an IPO and without any unlisted trading, if it can demonstrate that its publicly held shares have a market value of at least $250 million, based on an independent third-party valuation.
• Of course, this will pose no obstacle for Spotify. Rather, this US$250m hurdle is likely to prevent smaller companies from sneaking onto the NYSE based on shady valuations.
• The NYSE’s latest amendment will also tighten the independence standard for the financial advisers, and preclude the use of any financial adviser that has recently served as an underwriter, consultant, or other adviser for the company.
• Although smaller companies (with US$250m valuation) will not be able to take advantage of the lower listing costs, the ramifications will be far-reaching because underwriters will now try to lower their fees and improve the traditional IPO process.
• This could lay grounds for the listing of other well-known private companies that don’t need the cash but still wish to create a liquid market for existing investors to partially or fully exit.
• This can include companies like Airbnb and Uber which have raised US$4.4bn and US$22.2bn respectively and more likely to have investors who want to exit their investments but the companies themselves are not exactly in need of cash.

More independent research and demand for corporate access

• A direct listing can translate to more demand for independent IPO research in the market because in a traditional IPO, institutional investors rely on roadshows to get a better understanding of the company’s business since there is no syndicated research for IPOs in the US.
• Without roadshows, institutional investors will not be able to get access to management to ask questions and this will create demand for services that connect investors to corporates.
• It also levels the playing field for independent researchers if Spotify opens up their corporate access sessions to independent analysts as well and for connected analysts.
• This is exactly what is happening for Spotify’s IPO right now. The company is living streaming its investors pitch to everyone which “democratizes information”.
• This is something that Smartkarma sees as a rising trend in Asia, where investors want to be able to speak to companies’ management while investor relation departments wants to easily disseminate and clarify information to their investors.
• Hence, at Smartkarma, we are currently developing a range of products which will help facilitate this shift in demand and disintermediation of investment banks going forward.  This will be called C-Suite.

Conclusion

Spotify’s IPO will likely have a strong and positive impact on the US IPO landscape going forward. It will pave the way for future well-known private companies which are not cash hungry to list through this process and this will change the way investors and research is being conducted on IPOs. The democratization of information through a live stream of investor pitch is the kind of change that improves transparency for analysts and investors. It levels the playing field for independent researchers specifically.

Spotify’s IPO & Direct Listing on the NYSE, will Uber and Airbnb be next?

Written by Toh Zhen Zhou
IPO & Placements Specialist, Smartkarma

Read more of Zhen Zhou’s work by clicking here!