Direct Listings? Better Than IPOs, But Not Good Enough
(Bloomberg Opinion) -- I suppose if my venture capital firm had been the second-largest outside investor in the We Co. after having been the leading financial backer of Uber Technologies Inc. — yeah, I’d be looking for a new way to take companies public, too.
That’s probably a little unfair to Bill Gurley, the high-profile partner at Benchmark Capital, the firm in question. To give him his due, he’s long complained about the flaws in the initial public offering process. But please forgive me. On Monday, when I read that he and Michael Moritz of Sequoia Capital had organized a big meeting of technology company executives and venture capitalists to promote a new way to go public — called a “direct listing” — I couldn’t help thinking that what finally moved Gurley to act were those twin disasters.
The meeting took place on Tuesday, and the two VCs are hoping that in its aftermath, “going public” will never be the same. That may or may not be a good thing.
In 2017, you’ll recall, Gurley orchestrated the coup that led to the resignation of Uber’s founder and chief executive, Travis Kalanick. The ouster was surely necessary, but it brought to light Uber’s many problems, starting with its toxic bro culture. This past May, when Uber finally went public — using the traditional method of hiring investment bankers to organize a road show and set the IPO price — it was a disaster for just about everyone except Gurley himself, who pulled down a reported $600 million, according to Bloomberg.
Priced by the underwriters at $45 a share, Uber opened at $42. Four months later, it is hovering just below $30, down 35 percent since its IPO. After announcing a $5 billion loss in its first quarter as a public company, it is hard to see the stock gaining ground anytime soon.
As for We — the parent company of WeWork — well, you know what happened there. The company had hoped to raise $4 billion in an IPO, money it badly needed to continue expanding. But when potential investors read We’s prospectus and realized that the company’s economics were highly problematic, and that its chief executive, Adam Neumann, had been enriching himself all along, they revolted. Although Neumann stepped down, We withdrew its public offering on Monday.
On the one hand, you can make a pretty good case that the IPO process actually worked with both Uber and We. Private investors, caught up in the hype, had wildly overvalued both companies, while the tougher scrutiny that came with an IPO valued them realistically. On the other hand, Uber’s public investors are losing fistfuls of money, while We’s venture capitalists and other insiders haven’t been able to cash out. That’s hardly how Silicon Valley defines success.
The essential case against a traditional IPO — the case Gurley has been making for years — is that it’s a rigged game, with Wall Street doing the rigging. The investment bankers allocate the shares, which they give mostly to big mutual and hedge funds that are their best customers (and who typically kick back some of their profit in the form of commissions). The bankers often purposely misprice the IPO so that the stock will “pop” when it starts trading publicly, thus guaranteeing those who get IPO shares an instant profit. To state the obvious: The free money those Wall Street clients get from the pop is also money that companies are not getting, even though the point of the exercise is meant to raise capital.
Despite its self-image as a “disruptor,” Silicon Valley has been loath to mess with the IPO process. Tech startups like the prestige of having a Goldman Sachs or a Morgan Stanley as their lead underwriter. Executives like ringing the bell at the stock exchange when their company goes public. In many cases, they even like the pop, seeing it as great free publicity. What they don’t like are the steep investment banking fees — traditionally 7% of the offering — and the fact that they have to wait 180 days before they can sell stock after the IPO.
For Gurley and Moritz — and presumably others — the lightbulb went on in the spring of 2018, when Spotify Technology SA used direct listing to go public.
In a direct listing, a privately held company becomes a publicly held company when the private shareholders — venture capitalists, company executives and employees, and others who were able to acquire shares while the company was still private — sell stock directly into the public market. Simple as that.
For venture capitalists, a direct listing is “manna from heaven,” says Lise Buyer, a former Google executive who advises tech companies planning to go public. With a direct listing, the VCs and company executives don’t have to wait 180 days to get a return on their investment — it’s their shares that serve as the IPO stock. The company has to release financial information, but there is no need for an extravagant road show. While bankers aren’t cut out entirely, there are fewer of them and they get smaller fees.
No wonder venture capitalists like direct listings! Yet a direct listing has a serious flaw: The companies themselves get none of the money that’s raised. It all goes to private shareholders. The proponents of direct listing say that that’s not a big issue because companies today can raise so much capital from private investors, prior to going public, that the need to raise capital in an IPO is less pressing than it once was.
That certainly may be the case for an Uber or an Airbnb (which is said to be considering a direct listing), but I imagine most companies will still want to use a public offering to raise capital. That will limit the utility of the direct listing model.
It also has a second flaw. If the exact right number of shares aren’t offered during the direct listing, the initial price will not reliably reflect how the market is going to ultimately value the stock. With both Spotify and, more recently, Slack Technologies Inc., the aftermarket has not been kind to the stocks. Which is to say, the direct listing mispriced the stocks — it was just a different kind of mispricing from a traditional IPO.
There is a third model for going public, one that is superior to both the traditional IPO and the direct listing model. It’s called a Dutch auction. In a Dutch auction, potential investors list how many shares they are willing to buy and at what price. When a certain price attracts the number of shares the company wants to sell, all the investors who have bid at that price or higher get those shares.
A Dutch auction does not require high-priced investment bankers. There is no pop, so it maximizes the amount of money the company raises. It arrives at a true market price. And there is no particular need for a 180-day lockup; private investors can sell shares alongside the company.
The one big IPO that used the Dutch auction method was Google’s. It was a roaring success and proved that a Dutch auction was the fairest method yet devised for taking companies public.
In 1998, Bill Hambrecht started a new company, WR Hambrecht & Co., determined to convince Silicon Valley of the beauty of Dutch auctions. The firm did a few small deals, but the idea never got much traction after Google. I called him the other day to ask him about it.
“It was frustrating,” he told me. “After Google we had some real momentum.” The firm did a few other Dutch auctions, but then worked on a handful of deals with several of the major investment banks. “They marginalized us,” he said. The big firms’ sales forces hated his method, and undercut it. When the financial crisis arrived, Hambrecht threw in the towel. Companies simply felt more comfortable using big-name bankers, even though the IPO process wasn’t necessarily in their best interest.
Venture capitalists like Gurley are right to want to disrupt the IPO process, which has long put Wall Street ahead of companies. But the model they prefer helps them a lot more than it helps companies.
The Dutch auction is the one model that puts companies and the stock-buying public first and foremost. But it doesn’t do a thing for investment bankers or venture capitalists. No wonder nobody wants to use it.
Back in 2013, I got my hands on internal Goldman Sachs documents relating to the 1999 IPO of eToys. Goldman set the IPO price at $20, but the stock immediately shot up to $78 — meaning that thanks to its underwriter, the company left some $450 million on the table, far more than it actually raised. This was no accident. The documents I saw included an email from the lead banker betting her colleagues that the stock would hit $80 at the opening. You can read my old story here.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Joe Nocera is a Bloomberg Opinion columnist covering business. He has written business columns for Esquire, GQ and the New York Times, and is the former editorial director of Fortune. His latest project is the Bloomberg-Wondery podcast "The Shrink Next Door."
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