The Middle Man Lives: Wall Street Equity Underwriting after Spotify’s Direct Public Offering

In 2004, a technology startup looking to raise capital through an Initial Public Offering (IPO) decided to forgo the traditional route, instead using a novel method colloquially known as the “Dutch auction”. Here, investors bid for the stock to dictate the price of the initial offering. The company priced at $85 per share, well shy of the $135 share price the tech giant desired—raising a mere $1.67 billion with a $23 billion valuation.

Today, that company—Google—is worth well over $700 billion.

Startup founders look toward the widely-regarded failure of Google’s unconventional IPO route as affirmation to not challenge the system. A “conventional” IPO takes place when companies wish to raise money from the market. A “lock up”’ period of 90 to 180 days prevents principle shareholders from selling stock into the market initially. Underwriters from investment banks set the price and support it in case the stock begins to crash. This traditional method reduces volatility in the price and allows for a company to raise capital for future investments and expansion.

However, Spotify, which went public in April 2018, made waves as the largest company to ever pursue a Direct Public Offering (DPO). A more decentralized process, this kind of listing allows existing investors or employees to directly sell shares to the public. The company being listed also does not issue any new shares. The most widely reported difference between the DPO and IPO was the elimination of the middle man, the underwriter. Headlines across the country surmised the doom of the investment banks as more technology companies would pursue direct listing to save on underwriting fees. In reality, Spotify’s choice to pursue a DPO was nuanced and done with advice from some of the world’s best financial advisors.

The ensuing concerns about what this would mean for the investment banking industry is understandable–IPOs are incredibly important to the entire industry. Equity underwriting is one of the most lucrative fields on Wall Street. This is especially apparent during the underwriting of an IPO, when banks receive roughly seven percent of capital raised. In 2017, the United States’ five largest investment banks made over $20 billion in equity underwriting. Large companies vying for the largest pool of expertise and research often employ five to seven different underwriters. For this reason, the elimination of IPO underwriting could easily have drastic effects on the industry as a whole.

Had Spotify pursued a traditional IPO, each of their Wall Street underwriters would have earned tens of millions of dollars in fees. In reality, the banks were not entirely removed from the equation. In the company prospectus, Spotify disclosed that advisory fees of $35 million would be shared between Allen & Co, Goldman Sachs, and Morgan Stanley. This price did not include the underwriting fees that total 13 to 15 percent of bank revenue.

Many concerns over Spotify’s use of direct listing came from beliefs that the technology sector would follow suit. Over the next two years, a new wave of some of the decade’s most notable startups will go public, raising billions of dollars for their businesses. According to Dealogic, 2018 tech public offerings have already raised more than all of 2016 and 2017, combined.

Investor consensus is on pace to make a sharp turn in 2018 with both Spotify and Dropbox holding their prices after going public, while Snap and Blue Apron’s 2017 IPOs saw price collapses. This bullish attitude towards the market is urging big names to go public. Uber’s CEO has made clear plans to go public in 2019. Lyft began posturing for a public offering after speaking with investment banks. In what is likely preparation for a future IPO, Airbnb executives began adding independent directors to their board.

Technology IPOs are critical for the innovation landscape. Money raised upon floating shares to the public can be returned to employees who start new companies. Some capital is returned to venture capitalists, who use it to invest in the companies formed by ex-employees. Public offerings in the technology sector are so critical for this very reason.

Given the critical nature of tech IPOs, companies within the sector spend a significant amount of time preparing for their listings. Spotify’s choice to pursue a direct listing was a calculated move tailored to the company’s strengths. Most companies listing shares publicly do so in an effort to raise interest-free capital for future investments and acquisitions. Spotify, on the other hand, did not issue shares and raise new funds in an effort to keep existing stakes at their value. The company, instead, allowed existing shares to be traded. This situation is impossible under an IPO, where companies float new shares on the market. Raising capital is the principal reason for the vast majority of companies going public, a barrier to the direct listing process.

While Spotify’s DPO circumvented underwriters and reduced cost, it also removed many of the tasks that are key for soon-to-be-public companies. During an IPO, bankers and executives travel around the country visiting institutional investors and advertising the company they represent. Underwriters also speak with their firms’ largest trading partners, agreeing to buy and sell the shares at a price that earns these partners profits. These services don’t occur for a DPO. Spotify was able to eliminate this process due to publicity. Spotify is unique in its incredible brand recognition across the world. The company had no need to gather the support and guarantee of institutional investors to pick up the stock price due to its prominence throughout households. Other companies potentially going public in 2019—including Slack and WeWork—simply lack the appeal and prominence of Spotify, giving value to the underwriters in their public listings. Spotify’s ability to eliminate underwriters was unique given its incredible brand recognition.

Spotify’s unconventional motivation was another factor that distinguishes it from other technology companies. As previously mentioned, the company did not intend to raise capital from this round. Instead, Spotify wished to increase liquidity and reduce volatility for its investors.  As a result, the DPO investors and employees alike had the opportunity to immediately sell their shares. On the first day of trading, there were few sellers and buyers. Over time, groups became more comfortable with the listing, and the initial volatility of the stock price fell dramatically as more investors and employees sold. In the scope of a traditional IPO, this would appear to be a failure: large blocks of shares were not moved to institutional investors, and the price was volatile in early hours of trading. Yet, in Spotify’s scope, this IPO was ideal. The company’s share price increased from $48.93 to $132.50 privately to between $136.51 and $169 publicly. In just two days of public trading, over 600 percent more Spotify shares traded hands than after ten weeks of private trading.  Spotify increased investor and employee liquidity through this move, which was in line with the company’s motivation for the public offering.

Since the birth of the IPO, companies have been characterized as successful based on whether they ticked a series of checkboxes—none of which Spotify touted during its public listing. Within the technology and banking sectors, IPOs play a critical role. The introduction and success of Spotify’s DPO resulted in some reactions that the tech industry would shift to this new model, cutting out the underwriters. The reality is that the number of private companies with name recognition, no need to raise money, and a desire to give investors liquidity can be counted on one hand. Spotify’s path to public trading was a unique event tailor-made for its situation. Those worried about the downfall of Wall Street equity underwriting should not fear–Dropbox’s pursuit of a traditional IPO in March of 2018 resulted in shares trading up 40 percent. Evidence of a resurgence of tech public offerings is abound, and–thankfully for the banking industry–the DPO is no substitute for an IPO.