Monday, April 2, 2018
This timely post comes to us from Jeremy R. McClane, Associate Professor of Law and Cornelius J. Scanlon Research Scholar at the University of Connecticut School of Law. Jeremy can be reached at firstname.lastname@example.org.
Spotify, the Swedish music streaming company known for disrupting the music market might do the same thing this week to the equity capital markets. On April 3, Spotify plans to go public but in an unusual way. Instead of issuing new stock and enlisting an underwriter to build a book of orders and provide liquidity, Spotify plans to cut out the middleman and list stock held by existing shareholders directly on the New York Stock Exchange.
This will be an interesting experiment that will test some prevailing assumptions that about how firms must raise capital from the public.
The Importance of Bookbuilding. First, we will see just how important bookbuilding is to ensuring a successful IPO. When most companies go public, they hire an underwriter to market the shares in what is known as a “firm commitment” underwriting. The investment banks commit to finding buyers for all of the shares, or purchasing any unsold shares themselves if they cannot find buyers (an occurrence which never happens in practice). The process involves visiting institutional investors and building a book of orders, which are then used to gauge demand and set a price at which to float the stock. The benefit of this process is risk management – the issuing company and its underwriters try to ensure that the offering will be a success (and the price won’t plummet or experience volatile ups and downs) by setting a price at a level that they know market demand will bear, and ensuring that there are orders for all of the shares even before they are sold into the market.
Without underwriters or bookbuilding, Spotify is taking a risk that its share price will be set at the wrong level and become unstable. In Spotify’s case, however there is already relatively active trading of shares in private transactions, which gives the company some indication of what the right price should be. Nonetheless, that indication of price is volatile, in part because the securities laws limit the market for its shares by restricting the number of pre-IPO shareholders to 2,000, at least in the US. In 2017 for example, the price of Spotify’s shares traded in private transactions ranging from $37.50 to $125.00, according to the company’s Form F-1 registration statement.
The Necessity of Gatekeeping/Reputational Intermediaries. Relatedly, the direct listing will test how necessary reputational intermediaries are to a successful IPO. Usually, there is little public information about a company about to IPO, and one of the underwriter’s functions (in theory at least) is to serve as a gatekeeper, by selecting good prospects to take public. Underwriters have reputational incentives to do this well; after all, nobody would invest in, say, Goldman Sachs led IPOs if they were mostly flops. Underwriters also perform an in-depth due diligence investigation into companies they are taking public, for both reputational and liability reasons. Thus, an underwriter’s reputation provides a signal about the quality of the relatively unknown companies going public, and the level of vetting that has occurred. Spotify won’t have the benefit of such a mark of quality, at least not in the traditional sense. Spotify has hired Morgan Stanley, Goldman Sachs and Allen & Co. as financial advisors to provide guidance on the mechanics and pricing of the deal, but these banks do not have any skin the game because they are not guaranteeing the sale of any shares, performing any due diligence or helping to find initial investors for the shares. The banks’ involvement in the deal does not necessarily signal anything in particular.
Spotify does have several things going for it in this regard however. It has top-notch law firm Latham & Watkins advising it on legal matters, as well as Ernst & Young serving as its auditor, and these firms may provide enough reputational capital to the deal to assure investors. Moreover, Spotify is better known than many companies that IPO, so the information asymmetry problem may be less important to investors than it would be for other companies. We will have to wait and find out. Nonetheless, Spotify has yet to post a profit, a fact that could scare some investors off in the absence of the usual due diligence and gatekeeping that usually accompany underwriting by well-known investment banks.
The Role of Lockups. Unlike most IPOs, Spotify’s offering will not require insiders to hold stock for any period of time before selling it. Most IPO’s explicitly forbid company insiders and early investors like venture capitalists from selling their stock until at least six months after the offering has occurred. On benefit of such lockups is that they provide a credible signal to the market that the insiders have a vested interest in the company’s long-term success and aren’t just looking to cash out quickly. Lockups also prevent insiders from dumping stock, and thus driving the price down, before it has a chance to stabilize in the market. Spotify has no such lockup restrictions, and in fact it would make no sense to, because the shares being listed in the offering are primarily shares currently held by insiders, employees and early investors. If these shareholders couldn’t sell, there wouldn’t be much of an offering. It remains to be seen how investors will react to the lack of any assurance that insiders have long-term skin in the game, however.
The Value of Ancillary Investment Banking Services. There are a few other ways in which Spotify’s IPO will test the necessity of services that usually accompany underwriting, including price stabilization and the provision of analyst coverage. Underwriters have the option of stabilizing the price of stock shortly after it floats to limit the possibility that the price crashes early in trading, and thwart would-be short sellers. They usually do that by buying shares (or transacting in ways that have the same effect as buying shares) if the price goes below the offering price, to create demand and prop the price back up. This activity is permitted by the SEC under Regulation M, but it may only be undertaken by underwriters. Without an underwriter to provide this service, Spotify will not be able to halt a slide in its stock price if plummets. This might create an opening for short sellers who could exploit the problem and drive the price down even more.
In addition, underwriters often provide coverage by their securities analysts to help provide investors with information about a company, although the analysts operate independently of the sales and trading side of the bank. Since Spotify is well known and the deal is attracting a lot of interest, it should not be a problem for Spotify to get analysts to cover it, but they may not get as much coverage as they would have with an underwriting syndicate helping out.
Why Forgo Underwriters? Given the risks of direct listing, it is natural to wonder what Spotify stands to gain by going public this way. There are several possible advantages. Bookbuilding is a time-consuming and arduous process for a company’s management, and for a company like Spotify, the tradeoffs may not be worthwhile. Unlike most IPO companies, Spotify does not need the public markets to raise capital or attract attention. Spotify is already highly visible, and has proven capable of raising money in the private capital markets, and so it doesn’t really need an IPO to raise money for its business. Rather, the purpose of its IPO is to create a liquid market for its securities which allow its employees and early investors to cash out and create a readily used currency for corporate acquisitions. Thus it can afford to take risks that less prominent companies may not be able to take.
At the same time, the possible downsides of bookbuilding are large. Among other things, it is time consuming. The process requires a company’s management to spend time and effort on a “road show” during which they travel to investors and pitch their stock. Spotify avoided this hassle, and instead held an “investor day” during which its management made virtual presentations.
Another big advantage of avoiding bookbuilding is that Spotify will save on underwriting fees. Underwriters typically take a commission on the total proceeds of an IPO. The average commission is around 7%, although marquee companies like Spotify can often negotiate lower rates (for example, Facebook famously negotiated a fee of 1.1%, unheard of at the time). If, as some have speculated, Spotify’s stock is worth $20 billion, a 7% commission would mean $1.3 billion to the underwriters. Even a 1.1% fee would means that Spotify would be giving up $209 million to underwriters. That seems quite high compared to the $30 million that the company is paying Morgan Stanley and its other financial advisors.
But the commission isn’t the only cost that comes with bookbuilding. Underpricing is also a well-documented cost in underwritten IPOs. If an IPO is underpriced, it means that the price of the stock is set below the level that the market will bear. The result of this is that the price shoots up on the first day of trading. This “pop” on the first day of trading is usually regarded as a good thing because it generates interest in the stock, draws publicity to the company and signals to the world that the deal is a success. In fact, investment banks intentionally try to underprice an IPO stock by around 15% for these reasons. However it is not uncommon for IPOs to be underpriced by 50% or even 100% or more, far exceeding what is needed for a successful deal. In those cases, the issuing company is leaving a lot of money on the table unnecessarily. Investment banks lose a modest amount in terms of their commission as well, but the upside for them is far greater. This is because their institutional clients who invest in an IPO at a low, underpriced level are guaranteed a good return if the stock pops. A good return makes those institutional clients happy, and happy clients make for happy bankers who are more likely to get more future business. In a typical deal company insiders don’t have a huge incentive to care about this problem because they aren’t selling their own shares in the deal (because they are locked up) and so they aren’t losing money personally, even if the company is. But Spotify’s offering consists entirely of the shares of insiders and early investors, and they presumably want to maximize their gains from any sales.
So, despite the risks, there are good reasons for Spotify to prefer direct listing, and there is a good chance its offering will be a success. It is an open question whether this will serve as a template for other companies going forward however. Spotify is likely able to get away with things that other companies never could, because of its notoriety and its market niche. But whatever happens, Spotify’s IPO will be an interesting one to watch. If its stock rises and stabilizes, it will vindicate its risky strategy of forgoing underwriters and listing directly, and possibly create a paradigm shift in equity capital markets. If the stock is volatile or drops sharply, it will support many of the longstanding assumptions about what companies need to go public.