Heidi Sandstrom

The fact that Spotify, the leader of music-streaming services market, is going public via direct listing, has attracted an overwhelming amount of media attention. The event is going to take place on the 3rd of April. Mass media often hype news regarding major initial public offerings (IPOs), but it seems that there remains a lot of confusion regarding IPOs for non-finance practitioners. Thus, this article aims to give you comprehensive yet straightforward explanations of the IPOs market and procedure, and why it is crucial. Before that, let’s go back to the Spotify IPO first. The Swedish venture decided to pursue direct listing to list its shares, instead of going for the “traditional” IPO method because the management believes that it is better for Spotify. One of the apparent difference between direct listing and traditional IPO is that no underwriter is in the presence (i.e., the process does not involve investment bankers). But why is it so unconventional that only a very few numbers of ventures go public using direct listing? And what impacts will it have if the Spotify IPO turns out to be a success?

First thing first, what is an IPO?

IPO stands for initial public offering, and it refers to the event when a company raises its capital from the stock exchange for the very first time. The dominant way of an IPO involves the assistance of underwriting firms (i.e., the investment banks) to facilitate the startup go through the somewhat complicated process including planning, meeting compliance requirements, allocating, pricing, roadshowing, to eventually become a public traded firm. Theoretically, although the underwriting service demands a large sum of commission fees, it seems reasonable to utilize the services. The underwriters are supposed to benefit the issuer by working closely with the issuing body to determine the best initial offering price, in some case buys them from the issuer, and sells them to investors via the underwriter’s distribution network (e.g., institutional investors).

However, there are several consistent IPOs phenomenon found by many researchers illustrating that going public would mainly negatively impact the equity issuer, which is the startup. First of all, plenty research has demonstrated that the issuer “left the money on the table,” which refers to the situation that the closing price of the first trading day of the IPO share has increased substantially compared to its issue price. This is the infamous phenomenon called IPOs underpricing. Secondly, since market timing is proven to be significantly influential on the success of an IPO, the valuation of IPOs stocks tend to be biased (usually inflated). This results in another well-known phenomenon called IPOs underperformance (in the long run). That is, only a very few IPOs firm remain its share price level at its IPOs listing prices, say, three years after the IPO takes place. With the direct listing, although for the issuer it poses higher risks and volatility compared to traditional IPO, directing listing allows Spotify to shows that it is transparent. And, it will let the market decides how much it’s worth—without the distortion of share price caused by stabilization and allocation of shares in traditional IPOs.

Main reasons Spotify choose the direct listing

On top of the transparency of the IPO process and market-driven pricing of the shares, there are three other main reasons why Spotify makes this major decision. The first one is that direct listing is cheaper compared to IPOs. For example, Snap Inc. spent roughly $100m on the underwriting services for its IPOs. Spotify, on the other hand, does not need to spend this substantial amount of fee, and it hires three investment banks as its financial advisors for $35m. However, as mentioned before, in order to save this money, Spotify also runs higher risks of the instability of its share price after going public. The second reason explains why Spotify is confident about its decision: it has faith in its brand and power in the industry. Not every venture is suitable to go public using direct listing. In fact, Spotify is the very few startups that have ever done this, and it has the highest capitalization and business size among the others that choose to go public via the direct listing (in February 2018 it is valued at $19.7bn according to the Financial Times). Since direct listing does not involve the phase of roadshowing as in the traditional IPOs, Spotify’s share is more vulnerable to volatility comparing to the deals that are proceeded by underwriters potentially due to the lack of publicity. The third reason, as the CEO of Spotify mentioned in the investor day 2018 earlier in March, Spotify currently does not need any additional cash; “We are well capitalized, with €1.5bn in cash and zero debt. There is no reason to dilute our existing shareholders to raise the money we don’t need.”.

What does it mean if Spotify direct listing is successful?

The success of this event will potentially invite more ventures to opt for direct listing, especially for the companies that have similar characteristics with Spotify—such as with globally renowned brands and a sustainable and scalable business model. Direct listing has multiple benefits for certain types of business, as mentioned above. In short, direct listing is much cheaper in terms of the expense as well as the time. On top of that, a direct listing will not involve issuing new shares. Therefore, it will not cause share delusion (i.e., the control and ownership over the company will not be diluted). Furthermore, its process is much more transparent comparing to the traditional IPOs; As the usual IPOs route consisted of a series of closed-door meetings, roadshows for a privileged group of investors, mostly the institutional investors, in which the process itself is far from transparent. If the positive effects of direct listing outweigh the drawbacks—why wasting money hiring underwriters?

If you want to read more about the dynamic of IPOs

Earlier in 2018, I finalized my bachelor’s thesis on the topic of IPOs and venture capitalists in the technology industry. In the thesis, I explored plenty models of the role of venture capitalists during the process of going public of startups as well as the impacts of market timing on the long run performances of IPOs stocks. Check it out (click HERE) if you are as passionate about the research on IPOs as I do!