I will be dating myself with this reference, but… much like the old Fleetwood Mac album, “Rumours” are swirling around Spotify potentially seeking a “direct listing” versus a traditional IPO. Whether or not it happens remains to be seen, but I wanted to take this opportunity to share my perspective on the potential benefits and drawbacks associated with such a move.
A direct listing is different from a traditional initial public offering (IPO) in that there’s no fundraising as part of the process. Instead, a company like Spotify would simply list its once-private shares for trade on a public exchange so shareholders could trade them. After some period of trading, a market price is established, at which point the company could consider selling stock to raise more capital.
There could be many reasons Spotify is considering this idea. One, the company likely desires to get liquidity for shareholders yet could be sitting on plenty of cash so doesn’t have a pressing need for capital. Two, it’s possible that a direct listing would help avoid the possibly dilutive impacts from the handling of the convertible bond Spotify issued previously in 2016 and/or from anti-dilution provisions from prior rounds of preferred stock that won’t trigger. Three, the company could be seeking to avoid the costs associated with the underwriters spread (fees they take on an IPO), and the discount at which shares are usually sold in an IPO.
If Spotify goes through with a direct listing, I doubt others will copy it. There are considerable risks to this kind of approach:
- The Friendly Klieg Lights. Underwriters dispatch research analysts to cover stocks. While sell-side research is often viewed as less valuable than proprietary buy-side research, it still helps educate the market and keeps companies in the public eye. The IPO roadshow also serves as an opportunity to further strengthen a company’s brand. The press covers it. The PR machine whips up to the point where everyone is talking about it, and that can have a lasting effect. (Despite the shrinkage of publicly listed companies over the past decade, there are still more than 5,000 companies that trade publicly in the U.S., so it’s easy to get lost in the noise).
- New Money, New Friends. Despite all the flipping associated with IPOs, many companies harvest new relationships with large institutions who buy into IPOs to establish (or continue building) long-term positions – this is helpful as companies transition their shareholder base from VCs to public investors.
- Lock Ups. IPOs include lock up agreements for existing shareholders. Lock ups enable a more orderly transfer of ownership from founders and VCs to public shareholders. In a direct listing, without lock up restrictions, the market could get flooded with sell orders, creating huge pricing pressure from which recovery is difficult.
- Funky Structures. There are also some structural challenges with this type of deal. For instance, since VCs usually buy preferred stock, conversion from preferred to common stock usually occurs upon a “qualifying IPO,” as defined in each financing. A direct listing typically won’t force conversion of preferred to common, so companies who do direct listings could end up with lots of preferred stock outstanding in addition to common shares. There is limited history with this type of capital structure in the public market and it will likely deter many from buying common stock in a company which does a direct listing.
Despite these potential risks, we should not forget there are very smart observers who applaud Spotify trying this approach (if the rumors are true). Fred Wilson recently opined that the idea of direct listings is super interesting given the availability of capital for private companies nowadays. Additionally, Spotify’s CFO — Barry McCarthy (previously CFO of Netflix) — is widely regarded as one of the smartest minds on Wall Street. Spotify is also a truly global brand, recognizable worldwide. That may be enough to relieve them of going through the pomp and circumstance of a traditional IPO process, despite the challenging capital structure issues it still has. I wouldn’t bet against McCarthy and his team, though I also wouldn’t expect many other companies to try a direct listing anytime soon. Like a new album hitting Spotify from a favorite artist, this will be fun to watch (and listen to).