Companies that go public in 2019 still follow the same process that tech stalwarts like Intel, Microsoft, and Apple used when they became publicly traded companies decades ago.

"It's moronic," says Barry McCarthy, Spotify's chief financial officer.

The Swedish music streaming company went public on the New York Stock Exchange in April 2018. Instead of an initial public offering, Spotify opted for a direct listing, meaning rather than issue new shares, the company started trading by letting existing shareholders sell their shares directly on the public market. It also meant Spotify didn't raise a cent--all the proceeds went directly to the selling shareholders, such as early investors and employees. 

Now Slack is following suit. On Thursday, the company started trading on the New York Stock Exchange under the ticker symbol "WORK." It is the first tech unicorn startup based in the U.S. to do a direct public offering (DPO) instead of an IPO. Its performance--whether a home run or a flop--could fundamentally change the way entrepreneurs think about going public and how they go about it.

It's about time, too, according to McCarthy. Fundraising conditions for private businesses have changed dramatically in the past decade, he says, but initial public offerings have not. And while direct listings are not exactly new, he clarifies, they give more control over the process to the company and its founders.

Below, McCarthy, who spearheaded Spotify's direct public offering, gives his take on the critical things you need to know about DPOs.

1. They're cheaper.

The main difference between a traditional IPO and a direct listing is the lack of underwriters. In a traditional offering, investment banks like Goldman Sachs and Morgan Stanley agree to buy your shares at a discount and then pocket the difference when they sell them to their client base at your IPO price.

In a direct listing, you hire these banks as financial advisers to help you navigate the process. While neither option is cheap, DPO fees tend to be less expensive. Uber paid $106 million to its underwriters, while Spotify gave €29 million (about $32 million) to its financial advisers. Another benefit of having no underwriters? Because you're not issuing a percentage of shares to the banks, existing shareholders won't experience dilution when you start trading. 

2. You don't raise money--but that's not necessarily a bad thing.

Of course, since you are not issuing new shares, you don't get any money when you go public. Instead, all the proceeds go to existing shareholders who decide to sell.

In Spotify's case, McCarthy says, this wasn't a downside. You can raise a bunch of money before going public--something both Slack and Spotify did--or do it six months after your direct listing, under better deal terms if your business performs well, he says. "It's just a matter of timing." 

3. You need to be ready to disclose a full year's worth of financial projections. 

If you're doing a direct listing, you have to be prepared to offer guidance about your financial performance for the full year, McCarthy says. "You can't do it otherwise," he notes, adding that companies doing a traditional IPO can usually "get away" without it because the underwriters' analysts tell investors what to expect.

Which is another drawback to direct listings: Since there are no underwriters, there's no guarantee their analysts will cover your stock. Investors use analysts' research to help them assess a company's performance. If they don't know enough about you, they're probably not going to buy.

In Spotify's case, the company defined success as having at least 15 research analysts covering its stock, McCarthy says. "We had 15 analysts before we even traded," he adds. "We had a scaled business people couldn't afford to ignore."

4. There's no lockup period for employees.

In a traditional IPO, insiders are barred from selling their shares during the first six months of a company's public life. It's a mechanism required by underwriters to make sure there won't be a barrage of people dumping their shares and sinking the stock price to the ground. Sometimes, it also means your stock could be trading below its IPO price by the time your employees and other shareholders are able to sell their stakes. Lyft and Uber, for example, are currently trading below their IPO prices. Their lockup periods expire in the fall. 

While there's a risk that they could bring down the stock price by flooding the market with shares, employees can cash out on the first day of trading.

5. "Pop" gains for everyone. 

Banks underwriting an IPO price the stock with the goal of achieving the so-called "pop," McCarthy says, which is market lingo for when shares trade above their IPO price on opening day. "It's basically the fee that investors extract from investment bankers for their continuous participation in the deal flow," he adds.

The result is that, as McCarthy wrote in an op-ed last August, "the system penalizes successful individual companies." For example, online pet supply store Chewy went public last week at a $22 IPO price. The stock opened at $36 per share, however--a 64 percent uptick for IPO investors--but meaningless to the company's overall raise. In other words, McCarthy says that when the IPO process works exactly as designed, companies end up leaving a lot of money on the table.

In a direct public offering, market forces dictate opening price, McCarthy notes. If a listing is successful right off the bat, selling shareholders--and not just a limited group of investors--enjoy big gains.

6. You're going to have to grapple with a lot of uncertainty.

"The big unknown is how the stock is going to trade and whether there will be enough shares," McCarthy says, referring to the pool of people willing to sell. "And whether there will be enough demand for those shares."

You have to have done enough work to make sure there's a liquid market, he adds, and hope that people will care enough to want to buy into a different process. Spotify, as a popular consumer product, was able to leverage its brand recognition and a solid business performance to drum up investor demand. In short, "people couldn't afford to tune out," McCarthy adds.

Slack might be a different story--while it's well known among certain circles, its use case is limited to workplace environments. The company started trading at $38.50 per share, above the $26 reference price set by the NYSE on Wednesday evening. If the listing goes without a hitch, there's a good chance other companies will be willing to adopt this process. "If it falls on its face," McCarthy warns, "we won't be talking about direct listings anytime soon."

Published on: Jun 20, 2019