No opening ramble today. Straight to the newsletter:
Topic of the Week: Spotify’s IPO(ish)
Spotify formally announced its plans to go public. You can find the From F-1 here.
While $4B of revenue, 40% revenue growth and 40% market share are all compelling data points, the focal point of this deal is “how” Spotify plans to go public.
Instead of a traditional IPO, Spotify is directly listing its shares on the NYSE.
This is a unique and unprecedented situation. The NYSE had to get approval from the SEC to allow this transaction to take place. It will be the first direct listing of a privately held company on the NYSE.
The tech world, financial community, and media are all watching this transaction closely. If Spotify’s direct listing is successful, it could offer a blueprint for other high-profile, well-capitalized Unicorns to go public.
While novel, “the how” is not very interesting to me. What I find interesting and worth discussing is “Why Spotify chose a direct listing vs. a traditional IPO.”
Before we dive into that, let’s quickly level set on what a traditional IPO process looks like and the differences between a traditional IPO and a direct listing.
An Oversimplified Summary of a Traditional IPO Process:
1) Company decides it wants to raise cash to fund growth and allow existing investors to get liquidity. To do this, Company plans to go public by offering new shares in an IPO.
2) Company hires a team of investment bankers in Gucci loafers to underwrite the deal, manage the IPO process, and ensure adherence to SEC requirements in exchange for a big fee.
3) Bankers take the Company’s senior management on a roadshow where they pitch to institutional investors and convince them to buy large blocks of stock at a predetermined IPO price.
4) IPO price is determined by bankers in coordination with institutional investors.
5) Institutional investors buy new shares at the IPO price.
6) Shares begin trading on exchanges and are made available to the broader public.
7) Bankers help generate buzz and demand for shares immediately following IPO, thereby stabilizing price.
8) Management, employees, and existing shareholders must wait 90-180 days, known as “the lockup period,” before they are allowed to sell shares to the public and get liquidity.
9) Everyone hopefully makes a lot of money and the bankers buy new Gucci loafers.
Here’s How Direct Listings Are Different:
First, the Company doesn’t issue new shares. Instead, existing investors must sell shares in order for new investors to buy shares on an exchange.
Second, the Company doesn’t hire investment bankers to underwrite the deal. In theory, this means no roadshow, no institutional investors lined up to buy big chunks of stock, no set IPO price, no price stabilization out the gate, and less Gucci loafers for investment bankers. Because of this, direct listings risk more price volatility out of the gate than traditional IPOs.
Lastly, there is no formal lock-up period for existing investors. They can sell whenever they want.
Why did Spotify Choose a Direct Listing?
While I am not privy to the board discussions at Spotify, here are a few of the more broadly circulated hypotheses for the direct listing:
1) Spotify has ~$500M of cash on the balance sheet and no immediate need to issue new shares to raise cash to fund operations or growth.
2) Spotify is already well-known to investors, having raised nearly $3B over its ~10 year life. They aren’t worried about drumming up interest from institutional investors and the public.
3) Spotify will save a lot of money on fees to investment bankers. (They are still paying advisory fees to JP Morgan, Goldman Sachs, and Allen & Company.)
All of these reasons help craft a nice narrative going into the direct listing. Spotify is a high-profile, VC-backed technology company that doesn’t need to play by the rules of outdated and inefficient financial markets.
Cutting through that narrative, a direct listing allows Spotify to get to market faster, with less poking and prodding by institutional investors, and secure immediate liquidity for existing shareholders.
Without a formal underwriting process, there is more uncertanity around price volatility; however, if I was Spotify’s existing shareholders, I would be willing to accept this risk.
I’d probably be concerned the music streaming business is already low margin and getting more expensive by the day. We only have a 20% gross margin after paying for all those licensing fees, who knows what this business will look like a year from now.
I’d also be worried about the $1.6B outstanding lawsuit that was filed in January by Wixen Music Publishing, who is claiming we illegally streamed content without paying licensing fees.
I’d also prefer to avoid a roadshow where I have to rationalize why my company is worth a 10x valuation premium to the directly comparable public company, Pandora. Pandora trades at only .58x Revenue, which if I applied that to Spotify, it would represent a $2.8B valuation vs. our last private round valuations of $18-$28B.
Finally, if I were the executive team, I would certainly be motivated to get a deal done before July 2, 2018, to avoid massive dilution from the convertible notes I raised in 2016. See pg 88 of the F1. These notes originally had a 20% discount to the IPO price and a 2.5% increase in that discount every six months Spotify didn’t go public after April 1, 2017. While these were converted to equity last year, the noteholders can reverse this transaction if an IPO isn’t consummated by July 2, 2018.
It will be fascinating to watch this one play out. I’m particularly interested to see how much the larger existing investors sell early on.
Have a great weekend everyone.