Takeaways:

• Shedding light on the IPO process is a welcome start to gathering more data and better aligning outcomes for companies, investors, and employees.

• Hundreds of millions of dollars are NOT being left on the table on the day of a traditional IPO. The cost of a traditional banker led IPO is approximately 2% dilution to existing shareholders, which is less than most growth tech companies issue in equity every year. 

• Direct listings make sense for a very small number of special situations that have already raised excess capital, typically at higher levels of dilution.

• Direct listings are not as democratic as they might appear, and tend to advantage a small number of elite late stage VC and public market/strategic investors.

• Management teams miss out on a lot of constructive dialog with future public investing partners if they forego a traditional IPO roadshow.

• Traditional banker-led IPOs have lots of room for improvement: all constituents should be allowed to sell on an IPO and lockups should be eliminated or managed differently; commissions could be lower; greenshoes could be eliminated; share allocations could be more transparently auctioned.

• Management teams considering an IPO should do the work to understand their options and choose either a direct listing or traditional IPO based on their unique situation. Management teams are in the driver’s seat on IPOs!

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The Great (IPO) Debate:

Let’s dig into the debate over direct-listed IPOs versus bank-led IPOs. I have been very active in the IPO market and allocation processes for over 20 years, and I have also been active in the late-stage private investing market for the last decade. While a firm like ours (NZS Capital) would benefit from more direct listings, I think for the foreseeable future, the majority of companies would be better served long term by traditional, bank-led IPOs. In my opinion, there is only a small, special class of companies that should go direct through an auction. 

Recently, legendary and extremely talented VCs Mike Moritz at Sequoia and Bill Gurley at Benchmark made several arguments against bank-led IPOs (here is Mike in the FT and Bill on a podcast), which are very much worth understanding and listening to. I completely agree with the spirit of their call for more transparency and change to the system, but I tend to think it’s more of a grey area than a black and white debate. (Side note: I am a huge fan of Bill’s – he recommended Complexity to me six years ago and it influenced the course of our investing style, leading to the creation of Complexity Investing, so everything I say here is solely in the spirit of constructive debate.) I don’t know what the ultimate truth is on IPOs, but I’m eager to put forth arguments on both sides so that we can get more data to discover the best options for each individual company.

As you’d expect, I am a huge fan of companies going public whichever way they get there. I also think that there is way too much misplaced fear in Silicon Valley about going public. Even if companies are still on the path of proving their business, they are better off being public as soon as they can – it’s almost always going to result in less dilution than a private round. For years, I have advocated for companies to go public sooner rather than later because of the huge benefits to going public and dangers of staying private for too long. Specifically, there are complications with raising too much money for too long as a private company without the constructive scrutiny and dialog a broader set of public-market investors can provide. My advice to private companies has always been: if you give us the data and the opportunity to understand your path to profitability, we can do the work to support you on that path as long-term investors. I’ve also been a successful late-stage investor with crossover investments, such as Workday, Okta, and Lyft. So, I am a fan of using private markets for late-stage companies when it makes sense. There is no religious war for me on either side of the funding fence – I want companies in all cases to do what’s right for their own business, employees, and long-term investors.

Money left on the table with bank-led IPOs:

Data suggests there is an average 18% “pop” from IPO pricing to close on the first day of trading over the last 10 years (I obtained this stat from the Bill Gurley podcast linked above). However, this is “money left on the table” only in the form of dilution to non-selling shareholders. For the vast majority of IPOs, the only shares for sale are the small fraction (~10% of existing total shares is common) of newly-created, company-owned shares. Adding in bankers' fees (~5%), that “cost” of the IPO is around 20% of that 10%, which works out to around 2% average dilution of the unsold primary shares for a typical listing. For perspective, 2% dilution is relatively modest – less than most growth companies give out in options and equity every year to employees! Here is a table showing dilution from various IPO scenarios:

No one is being robbed blind on that one-day IPO pop unless they sold pre-existing shares at the beginning of IPO trading – which, again, is typically not the case due to the lockup period – thus all remaining shareholders, on average, are facing a relatively low percentage dilution. This dilution is the only “cost” of a bank-led IPO. Companies need to determine if it’s worth it or not. If a stock falls 10% below its IPO price a few months later, then that money raised was actually anti-dilutive. Under the current system, most employees and VCs would be selling shares six months later (after lockups expire), often at higher prices than the IPO. I think in many cases a traditional IPO is worth this dilution for reasons I will go into below, but I also think there is room to get that bank commission down even lower, and a lot of room for improvement in the IPO process overall.

Excess demand and gaming the system in IPO allocation:

Another common claim against banker-led IPOs is that most deals are 10-20x “oversubscribed.” This is true but misleading: institutional investors know they will get filled, on average, a small fraction of what they put in for, and thus there is a game of putting in larger orders than desired. The actual demand for shares is ultimately very close to the actual supply at the given price determined by a bank – there is no high excess demand that is being ignored by banks. Again, this is NOT actual money left on the table.

Long-term investors that don’t flip IPO shares on the first day (or buy more shares after an issue starts trading) are typically rewarded with higher allocations in future IPOs (banks that lead IPOs typically have visibility into the first few days of trading so they can keep score on this). This positive feedback – enabled by banks – is good for companies as they build relationships with their long-term investor base, and good for companies who list in the future, as the data can enable optimal balancing of long-term investors and liquidity by banks. 

There are obviously bad actors and flippers trying to gain from the IPO market. Often these are hedge funds that trade a lot in other stocks and derivatives that generate a lot of commission dollars for banks, creating a conflict of interest whereby a bank can allocate shares to a flipper knowing those shares will get flipped and that the bank will make more money on future commissions for other trades. However, it’s also important that stocks have adequate liquidity, and if 100% of shares are allocated to long-term holders, the lack of liquidity can create unnecessary volatility. A more transparent allocation process could curtail this type of behavior. Additionally, allowing more employee and VC shares to be available on day one of an IPO, like you have in a direct listing, would likely help the liquidity issue (I cover this in more detail below). 

Another problem with bank led-IPOs are greenshoes. Greenshoes allow banks to buy an incremental 15% of shares from the company at the IPO price. The details are a bit tedious, but greenshoes were essentially introduced as a mechanism to theoretically stabilize stocks following the start of trading. However, they seem to have become an unnecessary way for banks to make money on a transaction without providing a ton of value to companies or investors; as such, I don’t see much downside in eliminating them from the IPO process.

When does direct listing make sense?

A main reason for going public is to raise capital for the company itself (in the form of creating new primary shares, that ~10% discussed above). Direct listings currently don’t allow companies to create new shares (instead allowing sale of 100% of existing shares), but this situation could change with future legislation. So, currently, if companies want to raise money and do a direct listing, they would need to raise money ahead of the IPO – possibly using a banker and likely at a lower price per share than what they would garner in a future IPO. This is illogical to me because it would cause more dilution to all shareholders. Slack raised about $500M in a Series H round at about $14/share in 2018, which enabled them to do a direct listing in June of this year. That private round caused about 2.5x more dilution compared the $38.50 their direct listing traded at. Spotify raised about $500M at $55/share in their series G and $1.1B at $125 in their series H private fundraising to enable a direct listing IPO that started trading at $165/share. Were these dilutive pre-IPO rounds smart capital allocation decisions? I could argue that the direct listings of Slack and Spotify advantaged a very small number of VCs and strategic investors in the late-stage private rounds and disadvantaged the average investor buying in for the first time on the IPO. There are of course a small number of tech companies that generate cash and do not need to raise a big dilutive private round, which could consider direct listings.

Brokering owner-investor relationships – an advantage of bank-led IPOs:

When a company goes public via a direct listing – providing informational videos and a prospectus to potential investors instead of having one-on-one interactions – I think it’s a massive missed opportunity for open dialog. A bank-led roadshow allows management teams to meet a large number of diverse investors, and while they aren’t perfect, I know far more CEOs and CFOs that greatly valued an exhaustive set of meetings than management members who disliked the experience. Meeting as many investors as possible is also a critical way to establish beneficial, long-term relationships. To some extent, companies can “choose” their shareholders by educating them, being consistent, and under promising while over delivering on expectations over time. Investors that understand a business will provide ballast for the stock when companies inevitably hit a rough patch (and 100% of companies experience these!) and thus dampen volatility (which is, quite frankly, good for employee morale if nothing else). It’s not clear to me that a typical retail investor can watch a video, read a prospectus, and make an informed decision on their own about a soon-to-be-listed company, to the potential detriment of both owner and investor. As such, while direct listings may seem more democratic with respect to the ability for any investor to buy shares, they actually favor large funds who have the resources to meet with companies for years leading up to IPOs. I still see the potential benefits of opening up IPOs more to retail investors and advisors, and I think this is a clear change that needs to happen. IPOs are risky investments though, maybe not as risky as Bitcoin, but a lot of effort needs to be put in by retail investors to understand the risks and valuation of the businesses they are investing in.

The tricky business of valuation:

In addition to opening up participation, allowing for both more sellers and more buyers in an IPO transaction makes good sense with respect to valuation. I like the idea of VCs and employees being allowed to sell on IPOs, which is a big positive for a direct listing. Much of the price volatility following bank-led IPO results from the tiny float (recall that often only 10% of shares outstanding are available to trade) until a lockup expires. Lockups usually last six months and create a lot of problems for the stock, employees, VCs, and investors. Having 100% of shares available to trade day one is likely a better way of matching supply and demand and determining a fair starting price (assuming you have a good population of informed investors!). It’s important to note that more supply could actually mean a lower IPO price in some cases, especially if there are fewer investors who were able to meet with companies and understand the business better. Determining a price for an asset on a specific day – whether through an open auction or with an auctioneer like a bank – involves a lot of guesswork; how many IPOs trade exactly at that price 12 months later? 

Valuations, especially on young growth companies, are really a matter of opinion as they involve a lot of predictions of the future that may or may not ever come true. By definition, newer growth tech companies that are going public have a very wide range of potential outcomes. Valuing their future cash flows is a far cry from the practice of valuing a mature business or a bond. For several years, there has been a clash between public and private market valuations and expectations. Private market valuations are less efficient because they are set by one seller (the company) and a handful of buyers (VCs), whereas public valuations are set by a big population of diverse, global buyers and sellers. That said, all investors, whether they be VCs or public fund managers, can and do (all too often!) get it wrong over the short term. Valuations set too high in private markets hurt employees of those firms more than anyone else and can set up years of digestion that creates recruiting and morale problems. As legendary value investor Benjamin Graham said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” In other words, whether you conduct an auction with no auctioneer (direct listing) or an auction with an auctioneer (banker-led), the price at which a company starts trading on any given day is frankly a guess.

To pick on one example just to show how hard it is to value a company on a single day with a wide range of future outcomes, let’s again look at Slack and their direct IPO listing in June. Slack is a great company with a great product that is early in its adoption curve and facing a range of competitors. While it’s easy to be optimistic about the future of Slack, there is a wide variety of opinions on what the value of Slack’s future cash flows should be priced at today. The stock is down around 40% from its IPO compared to the S&P 500, which is flat, and the Invesco Dynamic Software ETF, which is down 5% over the same time period. There was a tech momentum market sell off in the month of September; if I attempt to normalize for that movement, Slack is down around 20% relative to the market. It’s hard to argue that retail investors benefited from this particular direct listing, yet it’s also impossible to know if a traditional IPO would have opened at a different price and how it would have traded in the subsequent couple of months. Valuing a stock with a wide range of outcomes on a single day is anyone’s best guess.

Brokers in the age of transparency: 

A broader point here – one that is near and dear to SITALWeek – is the role of brokers in the Information Age. The traditional broker in many industries is built on information obfuscation – holding dear the details that people need to pay you for. In this new age of transparency, that’s not going to work anymore, and that’s why there is now significant room for improvement to the bank-led IPO process. But that doesn’t mean there is no role for the bank either. 

We have seen a bifurcation and/or broadening range of broker value in other industries as well. For example, I’ve written extensively on Zillow and iBuying: in the real estate market, the traditional 5-6% commission is changing to a range of 1 to 10%; in some cases a broker adds 1% value, while in others liquidity provided in a transaction could be worth 10% or more. Or consider travel: we can go online and instantly book flights for no fees, but if we want to book a three-week tour of Europe, it’s great to have a human with experience help you out and earn a modest fee for doing so. 

I’d suggest the same is true of the role of banks in the IPO process: some companies don’t need them, but many could benefit from their involvement, especially if that involvement evolves into a higher win-win outcome for everyone. I’m not here to defend banks: although there are some banks that I think genuinely want to provide clear win-win outcomes, some are simply trying to maximize their own cash flow. The reality is that banks provide an efficient medium for new companies to meet a wide variety of investors, and that role has some value. Without banks, their conferences, analysts, and introductions, these encounters would be possible, but much more difficult and higher friction. Just like you wouldn’t necessarily want to list your house and leave the door unlocked, or make people rely only on photos and videos before they buy, it can be helpful to have broker remove some of the friction and qualify buyers. 

IPOs in an ideal world: 

I believe there is significant room for improvement in the current IPO process. I would favor a hybrid approach that involved banks and traditional roadshows combined with more informational videos and a more transparent, auction-based system that allowed more sellers upfront by eliminating the lockup periods. This system would set a price that is closer to market clearing even though it’s possible that price would be actually lower than a liquidity-constrained, traditional banker-led IPO. The reality is we need a lot more data on direct listings and we need more experimentation on bank-led IPOs. So, this dialog is welcome and needed for companies, VCs, investors, regulators, and bankers.

Advice to Management: 

Take an active role in your IPO process whichever path you take. If you choose to do a traditional bank-led IPO, then be aware that you are in charge. It’s your company’s shares that are being sold. You can actively allocate shares to investors you want to partner with for the long term, and you can have full and transparent access to the order book, client information, and the real demand level those clients have, not just their inflated share count they’ve asked for.

In a passionate editorial in the FT, legendary VC Mike Moritz penned the following taunt aimed at managements of private companies considering going public: 

“During the next couple of years, companies already well advanced with plans to go public will probably use the conventional approach. But, for all others, the choice of a direct listing or a traditional IPO has become a test of two attributes: courage and intelligence.”

Instead of telling management teams they are both chicken and dumb for not choosing a direct listing, I would instead suggest the courageous and intelligent thing to do is gather information and make an informed decision that's the best choice for your company, employees, and investors.

-Brad

Disclaimers:

The content of this newsletter is my personal opinion as of the date published and are subject to change without notice and may not reflect the opinion of NZS Capital, LLC (“NZS”).  This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress, especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I often I try to make jokes, and they aren’t very funny – sorry. 

I may include links to third-party websites as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by NZS Capital, LLC (“NZS”). If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which NZS Capital has no control. In no event will NZS be responsible for any information or content within the linked sites or your use of the linked sites.

Nothing in this newsletter should be construed as investment advice. The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. There is no guarantee that the information supplied is accurate, complete, or timely. Past performance is not a guarantee of future results. 

Investing involves risk, including the possible loss of principal and fluctuation of value. Nothing contained in this newsletter is an offer to sell or solicit any investment services or securities. Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.