The End of the IPO as We Know It

One could argue that this particular crop of companies is simply uniquely lacking for some reason, like a fumbly year in the AFC East or a dull season on Broadway. To be sure, more than a few IPO candidates in 2019 boasted — and were burdened by — extremely high, late-stage valuations despite lacking profitability. Uber, for example, was valued at $84 billion at its peak, while WeWork hit $47 billion at its imagined high point; neither firm has turned a profit, though Uber says that its core rides business would be profitable on its own.

Some observers argue that the market worked as intended, correcting for unrealistic optimism on the part of venture capitalists and private equity investors who poured millions into these businesses without fully interrogating whether the business models worked. But it’s difficult to prove that hypothesis, and, anyway, it might not matter. That’s because a growing chorus of entrepreneurs and venture capitalists are deciding that if the IPO market isn’t hospitable to their companies, there must be something wrong with the IPO market. More so than ever before there’s a move afoot to knock the chess board on the floor, scatter the pieces, and start fresh. “Sometimes we need a big shakeup in the system,” says Aswath Damodaran, a professor of finance at New York University’s Stern School of Business.

Led by Benchmark Capital’s Bill Gurley, these IPO skeptics are now looking to popularize the direct listing, an alternative avenue for a company to go public, selling existing shares rather than issuing new shares. They argue the process is streamlined and less regulated, and more democratic and entrepreneurial. They cut out Wall Street, provide greater flexibility to key stakeholders including equity-holding employees, and prevent the unnecessary dilution of private shareholders. After Spotify went public using a direct listing in April 2018, Slack used a direct listing to go public on the New York Stock Exchange in June, and Airbnb is said to be considering one as well.

Critics argue that direct listings are less rigorous than IPOs (in terms of due diligence and public disclosures) and therefore are ripe for abuse, creating more risk for Main Street investors and thereby possibly diminishing the integrity of the public markets. Now, a lawsuit in California involving Slack is placing the debate center stage — with Slack’s lawyers arguing that companies that go public through a direct listing should face fewer regulatory obligations. The outcome of the case could have huge implications for technology companies, Silicon Valley, Wall Street, investing in the stock market — and the very future of the IPO.

Last October, Benchmark’s Gurley invited a group of iconoclastic Silicon Valley personalities to meet at the Palace Hotel in San Francisco — best known as the site of ardent capitalist Warren G. Harding’s death in 1923 — to discuss the state of the IPO market. A hundred entrepreneurs reportedly attended the invitation-only event, as well as representatives from 25 venture capital firms, and more than 200 CFOs and other financial executives from technology companies. After spending a morning cataloging their gripes — from high fees to unnecessary dilution — the participants’ attitudes about the IPO process, and about Wall Street underwriters in particular, were as stone-cold as the 29th president.

“We’re not out to start a fistfight, we’re not out to vilify a particular bank,” Gurley told CNBC after the event. “There’s that old saying, ‘Don’t hate the player, hate the game.’ It may be that the game has changed in a way that all of these players are self-optimizing.”

Or, put another way, self-dealing. IPO critics have long resented the high fees charged by the investment banks such as Goldman Sachs and Morgan Stanley to underwrite an IPO. And given the recent travails of post-IPO companies, entrepreneurs and VCs are wondering what exactly those steep fees are getting them.

Gurley, for example, argues that the traditional IPO roadshow, during which Wall Street underwriters act as a high-class chaperone, bringing CEOs and CFOs from city to city to make their PowerPoint pitch to conference-rooms-full of large, institutional investors, emphasizes “anxiety and pageantry.” The actual market-building activity implied by underwriting adds precious little value, as banks rely on the same handful of clients to participate in each IPO they do. “Even in 2019 with a traditional IPO someone basically just got a list of accounts and how much they’re willing to give,” Gurley told author and well-known asset manager Patrick O’Shaughnessy on his podcast.

Many insiders have seen other investors reap big gains only to have their stock languish closer to the end of the lockup period.

And in exchange for this service, banks charge a fortune in fees. The typical underwriting fee in the U.S. is about 7%. “That’s a lot to take off the top,” says Robert Pozen, a senior lecturer at the MIT Sloan School of Management and the former executive chairman of MFS Investment Management. “Plus, there are lots of other expenses and if you don’t really need the money why should you do it?”

The capital markets have changed dramatically even as the IPO process has not. Historically, an IPO was the only way to raise a truly significant war chest for your company. But access to capital for private businesses has become much more abundant over the past 20 years. The cost of capital for a large Series D, E, F, or G round is often much lower than on a comparable amount drawn through an IPO.

One problem, of course, is liquidity. Absent access to public markets, it can be difficult for investors, founders, and early-stage employees to cash in their shares; there are some fledgling secondary markets for pre-IPO shares, such as SharesPost, EquityZen, Forge, and Cooley Go — but the volume on these exchanges is dwarfed by the public markets.

Once a company goes public, it can seem as if founders, employees, and early investors are needlessly constrained by arcane rules. That’s because company insiders are obliged to hold their shares for 180 days after an IPO is completed, a period known as the “lockup.” But given gyrations among recent IPO stocks, many insiders have seen other investors reap big gains only to have their stock languish closer to the end of the lockup period, in effect limiting their ability to profit from their contribution even as fair-weather latecomers make out handsomely. And then when the lockup does finally expire, insiders scramble to sell shares, making a weak stock even weaker. At Uber, for example, the day the employee lockup expired, the share price tumbled by 7%.

“The lockup is there to protect the retail investor,” says David A. Frankl, the managing partner at Founder Collective, an early-stage venture capital firm, with offices in Cambridge, Mass., and San Francisco. But critics argue that banks use the looming deadline of a lockup expiring to upsell companies on additional transactions.

“I think a lot of [Gurley’s] rallying is that as much as the lockup serves as a stabilizer, it’s another way of enabling more fees,” Frankl says. “You can do secondary sales to institutions in that period, for example, but there are lots more fees along the way.”

And then there are long-standing complaints about pricing in general. While the business media and many market watchers often celebrate a big, first-day-of-trading spike in share prices (see Zoom as a prime example), venture capitalists, entrepreneurs, and late-stage investors take a dimmer view. This phenomenon is known as underpricing, and it occurs when a Wall Street underwriter prices shares too cheaply, essentially failing to determine the latent demand for the stock and thereby undervaluing the company.

“The pop is the bone of contention,” Frankl says. “For an entrepreneur or late-stage investor, imagine if a company was priced at $20 and on Day One it closes at $40. The press has made it like the bigger the pop the better it is, but the entrepreneur is left thinking ‘I should have doubled the price per share.’ If everybody is feeling so good about themselves, they haven’t done the math.”

Besides not capturing cash that would have gone right to the IPO company’s balance sheet, VCs and other private shareholders in this scenario see their ownership stakes diluted much more than they had to be.

Underpricing is so common that Jay Ritter, a professor of finance at the University of Florida, has found that over the past 10 years, $171 billion in value eluded newly public companies and accrued to hedge funds and other Wall Street insiders in the first 24 hours following an IPO.

The phenomenon may be due to a misapprehension of the share price on the underwriter’s behalf, or it may be something less honorable — an instinct to manufacture a windfall for their own institutional clients. Distrusting Wall Street bankers is, of course, something of a national pastime. “The investment banks have been tarred, rightly or wrongly, by the financial crisis,” says Damodaran. “In the past, people thought the banks might not be the best, but at least they are good at pricing. That was the perception. But lately, the pricing has been so bad that it wiped away the last vestige of what people thought the banks were good for.”

“They are viewed as people who didn’t know what they were doing, which is bad,” Damodaran continues, “or they knew what they were doing and did it anyway, and that’s worse.”

With an IPO, large investors buy shares at an offering price, akin to a friends-and-family price for Wall Street clients that can sometimes be much less than the opening price — that is, the price at which shares begin trading on the public market. A direct listing collapses the gap between offer and opening price, which is in theory better for the issuing company but represents a lost opportunity for the banks.

And what if a stock falls on its first day? Yet another point of contention occurs with the so-called “greenshoe” option, which allows an underwriter to create an incremental number of shares (equal to 15%) on top of those a company plans to issue, which the underwriter can repurchase in the event the stock struggles at open. In theory, the banks can move in and stabilize a faltering stock by buying up shares, but in practice, Gurley asserts, they often treat this as an opportunity to maximize gains. In the case of Uber, Gurley says, the underwriter made an incremental $100 million on the greenshoe option. And in the Aramco deal, the greenshoe option likely netted well into the billions.

Enter the direct listing, in which a company sells existing shares — drawn from investors, founders, and employees — made available to the public for the first time. There’s no need for a traditional underwriter or a roadshow. There’s no lockup hamstringing employees, founders, or investors. The fees paid by the company are simplified and greatly reduced, with much less regulatory red tape.

In theory, the drawback is an inability to raise new funds. But with the rise of large, late-stage deals, a company can choose to raise money privately and then use a direct listing primarily to achieve public liquidity. “It is good to have an alternative way to go public for companies that have that kind of investor interest don’t have a need to raise a lot of cash,” MIT’s Pozen says.

For every hyped unicorn, there are plenty of unsexy companies that are as interested in raising money as they are in gaining liquidity.

Best of all, Gurley argues, the pricing dynamics of a direct listing are much more straightforward — essentially algorithmic, like the bond market or, for that matter, StubHub — in terms of matching sellers with buyers. “You could hire a programmer in Python, probably a first year out of a top 100 comp-sci program, and they could do it in a weekend,” Gurley said on Patrick O’Shaughnessy’s podcast. “It’s not hard technically and it’s not hard intellectually.”

Gurley asserts that long-term institutional investors are also able to build up a meaningful position in a company much more smoothly and efficiently once the underwriters are out of the picture, which would typically result in less volatility and more stability for the stock.

This is the rosy picture, of course. Skeptics say that the direct listing model, while attractive in its overall simplicity, isn’t a feasible replacement for an IPO. They argue that it only really works for high-profile companies that have raised a lot of money privately, and are already well known to institutional investors. For every hyped unicorn, there are plenty of unsexy companies that are as interested in raising money as they are in gaining liquidity. And for businesses that are not already staples of CNBC and the business press, the chance to tell their story through an organized roadshow does provide a meaningful opportunity to raise their profile in the investor community. “One reason you need banks is people don’t know who you are,” Damodaran says.

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