INSIGHTS: The Groundhog Day of capitalism

If the process of going public were a person, its name would be Phil Connors. For more than 30 years, it has awakened to “I Got You Babe” at 6:00 a.m. every day. The IPO process is the Groundhog Day of capitalism.Technology gave us the web in 1989, the internet browser in 1993, Netflix in 1997 and the iPhone in 2007. Today’s farm tractors contain more computing power than the first space shuttle. But somehow, the IPO process never got the memo.Nearly 4,000 U.S.-based companies ​went public between 1999 to 2019. Putting aside special purpose acquisition companies (SPACs), you can count on one hand the number of innovations applied to those IPOs:

• In 1999, UPS combined a traditional IPO and a fixed-price tender-offer
• In 2004, Google went public via a Dutch-auction tender offer
• Just two companies, Spotify and Slack, went public via direct listings

That’s it. The scarcity of innovation in IPOs stands in stark contrast with the capital markets, which have benefited from massive investments in infrastructure, software, and analytics aimed overwhelmingly at increasing the volume and velocity of trading. The total value of U.S. stocks traded in 2018 reached $33.2 trillion — that’s 14 times greater than in 1989.

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Innovation in public markets has mostly fueled trading

Source: The World Bank GroupIt’s no secret that today’s capital markets are dominated by short-term behavior. Most of the innovation on Wall Street has been aligned with short-term compensation structures and incentives.To date, there has been little incentive to rethink the process by which companies go public. The result? A disproportionate focus on innovation investment that has left IPOs behind, including the latest attempt at change, the direct listing.

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The opportunity: innovation that aligns companies and investors

Recent attempts such as direct listings and SPACs are tactical responses to a market dominated by short-term behavior. As alternatives to a traditional IPO go, they must be chosen carefully for fit.Direct listings are designed for companies expected to debut as “hot IPOs,” that is, lots of investors will want to buy the stock. Companies that are attractive candidates for direct listing tend to be well capitalized and enjoy things like big revenues, healthy growth, an established private market for their shares, and brand recognition — the stuff that fuels a hot IPO.Hot IPOs are hardly the norm. The reality of the IPO market over much of the past decade is much more sobering: Nearly one-third (27%) of companies ended their first day of trading with a price per share less than their IPO price. In contrast, the average first-day IPO gain for companies in that same period was 12%. But this story is rarely told because hot IPOs make better headlines.A major component of the traditional IPO in dire need of innovation is the allocation process. It is the most consequential part of an IPO because it sets the tone for building a strong base of long-term investors. Companies live with the consequences of IPO allocations for years after going public.In a traditional IPO, allocations take place at the end of the IPO roadshow: a six to 10 day national or global tour (lately via Zoom) where companies meet with more than 100 investors. The finale to this physically and mentally exhausting trek is allocations. That’s when companies and their underwriters evaluate overall demand for the deal. They decide which investors get shares and how many those shareholders will receive. In a hot IPO, there may be anywhere from three to 10 times more demand than there are shares to allocate.The lead underwriter presents the company with its own proposed slate of share allocations for use as a starting point. Though that seems harmless enough, companies are completely outgunned and ill-equipped to properly negotiate allocations. The investor landscape is vast and complex even for seasoned capital markets practitioners. Do not be confused. This is not a discussion with your underwriter. It is a negotiation.The way to level the playing field is to provide companies with unprecedented levels of transparency, access and control. This will tilt the process back toward companies built to last.For example, LTSE is building a coalition that allows companies to forge ties with long-term institutional investors — well ahead of a potential IPO. Software from LTSE helps companies distinguish the investors who are truly long term; knowledge that allows a company to target investors and allocate shares accordingly. The Long-Term Stock Exchange offers companies a governance platform that promotes alignment with long-term shareholders and stakeholders with a similar mindset. Taken together, these innovations are designed to afford companies breathing room to continue to build their business and advance their vision in the public markets.

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Summary comparison of direct listings and traditional IPOs

The IPO pop as the primary catalyst for the direct listing

The direct listing allows companies to bypass the traditional allocation process. As a tactical modification to the IPO process, it shows real potential for certain types of companies. The best fits are companies that do not need to raise capital in conjunction with a public listing. Some companies go public for other reasons, such as to create a public currency for potential acquisitions or to provide liquidity for employees and other shareholders.Direct listings are unique in targeting the price discovery and allocation mechanisms that are part of the traditional IPO. Its goal is to add transparency and efficiency. In that way, direct listings are primarily a response to what is commonly referred to as the “IPO pop.” The IPO pop is simply the difference between where an IPO prices and the price at which its shares close on its first day of trading. Take for instance two recent traditional IPOs, Lemonade and nCino: They generated a pop of +139% and +195%, respectively.In traditional IPOs, a 20–30% pop is considered healthy and balanced. It’s deemed to have resulted in a fair price for both the company (which didn’t leave money on the table) and for investors (who are adequately rewarded for the risk).IPO pops greater than 30% often leave the company, and its pre-IPO shareholders, feeling as if the IPO took place at their expense. They feel (and not without justification) cheated.Tech IPOs that have experienced major pops

With an average first-day gain of 12% for traditional IPOs, direct listings are best suited for IPOs that hold the potential to generate significant pops.In a direct listing, the financial advisor oversees two order books. One reflects the supply dynamics of pre-IPO shareholders, like venture capital firms, who are seeking to sell stock. The other book tracks demand from potential buyers.The advisor, in coordination with the designated market-maker and primary stock exchange, uses a reference price to begin balancing supply and demand until an acceptable opening trading price is found. By going the direct listing route, Spotify and Slack relinquished their ability to control pricing and allocations by relying on the process to effectively auto-select both.

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By the numbers: Spotify

• Initiated IPO price discovery in its direct listing by publishing a $132/share reference price. This reference price closely tracked Spotify’s valuation in the private secondary market prior to going public.
• The reference price served as a starting point to balance supply and demand for Spotify common stock.
• Equilibrium between buyers and sellers translated into a $165.90/share opening trade, 25.7% above the reference price.
• Public investors paid and pre-IPO selling shareholders received $165.90/share.
• Spotify closed down 10.2% on the first day of trading.

By the numbers: Slack

• Initiated IPO price discovery in its direct listing by publishing a $26/share reference price. This reference price closely tracked Slack’s valuation in the private secondary market prior to going public.
• The reference price served as a starting point to balance supply and demand for Slack common stock.
• Equilibrium between buyers and sellers translated into a $38.50/share opening trade, 48% above the reference price.
• Public Investors paid and pre-IPO selling shareholders received $38.50/share.
• Slack closed up 0.3% on the first day of trading.

Price discovery nuances between traditional IPOs and direct listings

The Spotify and Slack precedents did not really eliminate the IPO pop. Instead, the direct listings transferred the pop to pre-IPO shareholders from public investors. In addition, while Spotify and Slack experienced 25.7% and 48% increases to their respective reference prices, supply and demand dynamics could have dampened the possibility of a greater pop that hot IPOs typically experience.In a traditional IPO, companies typically sell anywhere from 10%-20% of their outstanding shares to public investors — commonly referred to as public float. This is the percentage of total outstanding shares that can trade in the public markets without restriction. Public float remains very low until sometime after the IPO lockup expires (typically six months after pricing).There is significant scarcity value between pricing and the expiration of the lockup. That creates a challenging supply and demand dynamic for companies and their advisors as they try to calibrate the value of shares for an IPO: Valuing an entire company based on demand competing for just 10%-20% of its shares is tricky. Trading activity fueling hot IPO pops may reflect lots of demand chasing very little supply.Direct listings do not contain lockups. As a result, pre-IPO shareholders have no restrictions on the sale or distribution of their shares once the company is public. This is a major benefit for those shareholders but may be a mixed bag for companies.For example, since its listing in June 2019, shares of Slack were regularly introduced into public float by pre-IPO shareholders. About one year later, roughly 95% of Slack’s total outstanding public common stock is now in public float. The absence of a lockup allowed venture capital firms, employees and other pre-IPO shareholders of Slack to aggressively exit their shares in the public markets.This aggressive exit can be both a blessing and a curse. It’s a blessing in that companies no longer have to worry about the downward pressure pre-IPO shares can place on its stock price (commonly known as “overhang”). A curse because the sale to the public of shares held by pre-IPO shareholders may reduce demand for shares that companies may need to sell into for future capital raises.Five other technology companies went public through traditional IPOs within two months of Slack’s direct listing. The average public float for those companies as a percentage of outstanding shares now stands at roughly 63%.

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Innovative IPOs require companies to plan

The transition between private and public life can find companies at their most vulnerable. The transition creates friction because companies must navigate out of a well-known and comfortable private support system toward a new, public support system.Preparing to go public, whether via direct listing or traditional IPO, takes most companies anywhere from 12 to 18 months. In fact, companies that want to preserve the option to pursue a direct listing must add an additional three months of preparation because in a direct listing, the company itself is responsible for investor outreach and education.Waiting too long to begin is the most common mistake that companies make. Ironically, the friction and vulnerability companies experience during their private-to-public transition actually cause them to make it. Worse, as companies rush along on compressed timelines, they are prone to cede control over critical aspects of preparation and execution to transactionally motivated stakeholders.At LTSE, we advise companies to start preparing for an IPO early, with a focus on building a long-term support system and taking control. Companies are best served when they:

1. Begin preparation 18 to 24 months ahead of a potential public listing.
2. Create a roadmap that places the best interests of the company and its long-term stakeholders above all else.
3. Proactively institute practices that can help navigate the conflicts and friction that can arise during the course of going public.
4. Tactfully optimize transactional support in order to maintain control and transparency during IPO preparation and execution.
5. Join a community and ecosystem that stays with and supports them well beyond the first day as a public company.

Companies can avail themselves of the innovations that we’re pioneering here at LTSE whether they’re pursuing a direct listing or a traditional IPO. However you choose to go public, we will work side-by-side with you to make the transition to the public markets one that sets your company up for long-term success.