Originally posted at Financial Times.
Like all things in capitalism, the age-old practice of initial public offering is malleable. It’s no surprise then that, in the past few years, we’ve been seeing companies experimenting with the process of offering shares to the great and good of the investing public.
In 2019 IPOs came under fire by vocal proponents of the direct listing — the practice, as done by Slack and Spotify, of listing shares on the market without selling equity. Of late, another popular route to market has been via a reverse merger with a listed cash shell, or Spac, which has the advantage of skipping some of the costlier elements of the traditional IPO.
The record of companies listing via a Spac, in our view, speaks for itself. But what of direct listings.
In our view, they’re not all they’re cracked up to be either for a company. Let us explain.
The arguments for a direct listing are, on the face of it, persuasive. Proponents, such as storied venture capitalist Bill Gurley, argue that companies are “leaving too much money on the table” by passing along large profits to investors via the expected Day 1 “pop” in the share price.
For example, NCino recently raised $250m through its IPO priced at $31. However, the stock opened at $71. If the company had raised cash at the share price after the pop, it could have either got more bang for its buck, or sold fewer shares. We suspect the latter argument plays a part in the venture communities’ criticism of the IPO pop, as less shares sold equals their stakes in a company being less diluted, boosting returns.
What direct listings do better than any other vehicle is efficiently convert a company’s private shareholder base to an entirely public one. From day one, all of the shares can be traded as there are no lock-ups. While allowing insiders to cash out, it does also remove the overhang of lock-up expirations, which can weigh on a stock for months after it has begun trading.
However, that’s the only major advantage for the company and it’s not even much of an advantage any more. Take Snowflake, a hot cloud software business, which is due to IPO this week. In a modification to the usual process, one of its investors is selling a $320m block of shares to Berkshire Hathaway at the price Snowflake immediately lists at. Although unusual, this deal shows there is a mechanism to realise gains if an early investor — for whatever reason — wants to sell immediately. Snowflake has also sought to eliminate the lock-up overhang by expediting the lock up period. If at 90 days post-IPO, the share price is 33 per cent higher than the IPO price, 25 per cent of mid-level employee, former employee and non-employee stock becomes free to trade. This mechanism will act as a natural hand break if the share price gets out of hand early on.
While a direct listing means a company, in theory, gets the most cash for the fewest shares, businesses should be aware that not all investors are created equal. IPOs, unlike direct listings, allow a company to find the right type of public investors at the right price through pre-listing allocations.
Snowflake is a case in point. Berkshire Hathaway, alongside the $320m secondary block, has agreed to buy $250m of the listing. Salesforce has also signed up for the same amount. Berkshire’s $570m stake will provide both the benefits of a stable anchor investor, and give the company institutional credence when it comes to raising money — in the IPO and further down the line. A direct listing on the other hand, means a company has no influence on whether it ends up in bed with a Carl Icahn or a Warren Buffett.
It’s also important to note that by selling stock to Berkshire and Salesforce at what will presumably be a discount to where the stock will trade on day 1 post-pop, the company is de facto engineering a profit for these quality shareholders. By rewarding shareholders, it will help to retain them longer term.
In a way, one of the issues with the debate over direct listings is that it’s hard to measure success. Asana, another cloud software business, is due to enter the market via a direct listing soon. OK, the business will list, not leave any money on the table or pass quick profits to new investors — but by those standards it can’t fail really fail.
However in the long term will Asana’s listing be as successful as it might have if they did an IPO and allocated stock to the investors it wanted? It’s an impossible question to answer factually, given that the counterfactual can never be proven. But it’s one that a company should ask ahead of time.
Indeed it is the critical question when a company is considering how to go public. A successful stock means the company has a currency that’s more valuable, whether to potential acquisitors or in terms of employee compensation. That, in turn, should improve shareholder returns.
Companies can only IPO once. The decisions made through the process can have a long-term impact well past the day 1 pop which, in hindsight, can look like a rounding error if a company succeeds. Any changes made to the IPO process should be made to empower companies, and not for another party’s benefit.
The primary function of an IPO is to attract the right kind of public shareholders, whether it be new or existing ones, so that a company has the right partners in the volatile world of the listed markets. That is how success should be measured and what will lead to these customised IPOs, not direct listings, becoming the new standard.
