There has been a lot of discussion lately in the venture community about the favorability of direct listings over the IPO process. The chief complaint of IPOs is that securities are underpriced at issue. To better understand the comparison between the two methods, we took a look at 25 of the top tech IPOs in the last two years.

Before we look at the underpricing argument, it’s helpful to look at the cost of IPOs and direct listings. At the most basic level, the cost of a direct listing and traditional IPO are relatively similar in our sample. We found that the average company paid between $29.6M and $34M in underwriting fees based on the level of exercise. It’s important to note that this doesn’t include any fees incurred by sellers. Total underwriting fees in deals where sellers sold shares as part of the IPO process ranged slightly higher, an average between $32M to $37M. The two direct listings to date, Spotify and Slack, paid financial advisory fees of $35M and $22M respectively.

An appeal of the IPO process is that it allows companies to raise additional capital, which companies aren’t currently able to do during a direct listing. In our sample, the average company raised between $794M and $913M during the IPO process. This translates to ~$26M raised for every $1M in fees. If we look at the fees that Spotify and Slack paid for a direct listing, the companies could have raised an estimated $937M and $590M respectively.

This brings us to the main point of the debate: the underpricing of IPOs. When comparing the issue price to the opening price on the first day of trading, our sample found an average underpricing of 38%. Of the 25 companies we looked at, only two, Peloton and Uber, opened below their issue price. If we add the underwriting fees and underpricing costs together, the true cost of an IPO is between $333M to $382M with only 10% of the cost from underwriting fees. The vast majority of this amount is value transferred to those who are allocated underpriced shares at issue.

If Spotify and Slack had raised capital in their listings via a traditional IPO at the levels described above and their shares were underpriced at the average 38% level, it would have represented $346M and $217M in underpricing respectively.

As we noted, there is currently no mechanism for companies using a direct listing to raise capital at the listing. One potential solution that’s been mentioned is doing a private capital raise 3-6 months ahead of the direct listing. Given the amount of private capital in the market, this should be easily achievable. Another potential option is to do a follow-on offering after the direct listing establishes a fair market price for shares. Follow-on offerings typically have a discount to the most recent public price (an average of 7.3% in 2018).

Investors in follow-on offerings demand a discount. Private investors ahead of a planned direct listing are likely to do the same. The discount is necessary because if an investor wants to take a position in a public company, or one soon to be so, there’s no incentive for them to do so as part of a structured capital raise at the market price. They can just buy shares on the open market. Companies looking for the liquidity of the public markets plus capital should be able to get it cheaper than current IPOs, but they won’t get it for free.

Top 3 Takeaways:

• At the most basic level, the cost of a direct listing and traditional IPO are relatively similar. We found that the average company paid between $29.6M and $34M in underwriting fees. The two direct listings to date, Spotify and Slack, paid financial advisory fees of $35M and $22M respectively.
• When comparing the issue price to the opening price of recent tech IPOs on the first day of trading, we found an average underpricing of 38%. Of the 25 companies we looked at, only two, Peloton and Uber, opened below their issue price.
• Companies looking for the liquidity of the public markets plus capital should be able to get it cheaper than current IPOs, but they won’t get it for free. While work is being down to raise capital during a direct listing, companies have two alternative options: they can raise private capital ahead of a direct listing or do a follow-on offering after a direct listing.

Show Notes

• [0:30] What makes a direct listing different than an IPO.
• [1:17] In an IPO, companies paid on average between $29.6M and $34M in underwriting fees. For their direct listings, Slack paid $35M and Spotify paid $22M in financial advisory fees.
• [2:14] Based on fees paid, we estimate Spotify could have raised $910M and Slack $572M if they pursued an IPO instead of a direct listing.
• [3:43] Doug poses a question – Does brand matter for direct listings in the future?
• [4:38] In the 25 IPOs we looked at, the average underpricing was 38 percent. 23 of the 25 companies were underpriced at issue.
• [6:25] While we have a small dataset, direct listings seem to show better price discovery than IPOs.
• [7:18] Four companies (CrowdStrike, Zoom, PagerDuty, and Beyond Meat) were underpriced by over 80 percent.
• [8:31] Options companies have for raising money and going public.

Disclaimer

As high-growth companies shift their narrative toward profitability, investors need to decide if they believe the new story. Also, SoftBank minces words around growth vs. profitability, Kalanick’s Cloud Kitchens receives a massive valuation, and we discuss using capital as a weapon and adding software to low-margin businesses.

Top 3 Takeaways:

• Profitability is now front and center for late-stage and growth investors. Unprofitable companies like Uber and Lyft are now changing the narrative to fast-tracking profitability, but investors may not believe it.
• Raising at a high valuation early is viewed as a success, but may create an issue for attracting investors later.
• Many inherently low-margin businesses are innovating by adding software (see Amazon, Uber, WeWork, etc.) which causes confusion among investors about the true long-term margin profile of a business.

Show Notes

• [0:28] SoftBank’s conflicting message around profitability and long-term growth.
• [2:58] Did the size of the Vision Fund leave SoftBank outside of their core competency?
• [4:30] Valuing free cash flow for venture investments and why WeWork’s peak valuation was too high.
• [8:00] Now that profitability is a priority for investors, every high growth company has a plan to fast track profitability, but will investors believe the narrative?
• [14:50] Travis Kalanick’s Cloud Kitchens raises $400M at a $5B valuation.
• [17:19] What type of businesses can use capital as a weapon and when is raising too much money a negative?
• [20:00] Building a software layer on an inherently low-margin business does not create software-like margins.

Disclaimer

Is marking up your private investments by leading consecutive rounds a mistake or a brilliant move? Doug and Gene discuss SoftBank’s tactics, Lyft, Lime, Faire, and SPACs vs. direct listings.

Top 3 Takeaways:

• While SPACs may be useful in some circumstances today, direct listings still offer a better alternative to the traditional IPO process.
• Illiquidity in the private markets and the lack of frequent price discovery hides the fact that private market investors still worry about valuations all the time.
• Lime currently has structural problems related to unit economics, but one of several innovations, especially around the durability and payback period of scooters, could make it a great business.

Show Notes

• [0:27] Virgin Galactic goes public via a SPAC.
• [2:31] SPACs vs. direct listing, and why direct listings will evolve to include a capital raise.
• [4:03] Lyft earnings and what it means for the tech IPO climate.
• [8:22] Illiquidity in the private markets and the lack of frequent price discovery hides the fact that private market investors still worry about valuations all the time.
• [9:35] Smoking your own supply – a mistake or a brilliant move?
• [11:33] Should Lyft have been more upfront about a real path to profitability when they were marketing?
• [13:41] Does Lime have a structural challenge with their business model?
• [17:20] Will we ever get to a scooter model that lasts long enough to payback the cost and generate revenue?
• [18:19] Marketplaces, fintech, and subscription software continues to be well received by the market. How will Faire fair?

Disclaimer

The SoftBank and WeWork debacle has huge implications on the late-stage funding landscape and may cause SoftBank to adjust their strategy. Doug and Gene discuss WeWork, the pros and cons of public vs. private, how to value autonomy, and the possibility of air taxis.

Top 3 Takeaways:

• Eventually, we may strike a balance between the discipline and hygiene required to be a public company and the benefits of thinking long-term and building based on a vision that are associated with being private.
• There is a disconnect between public and private market valuations of the potential for autonomous driving, exemplified by the valuation of Tesla and a handful of private self-driving startups.
• Both Doug and Gene agree that we will reach widespread fully autonomous driving before urban air mobility like air taxis are popular.

Show Notes

• [0:44] More on WeWork, the first venture bailout.
• [4:08] SoftBank rethinking the way they approach investments from the Vision Fund – growth vs. profitability.
• [5:52] Swinging for the fences is an important part of portfolio construction.
• [6:27] The narrative that public market investors are shortsighted is wrong.
• [7:36] Zoox announces a $200M raise.
• [8:03] How does Gene think about valuing autonomy for a company like Tesla?
• [12:30] The paradoxical nature of valuing autonomy for Tesla vs. self-driving startups
• [14:30] VTOL vehicles, air-taxis, flying cars, and Lilium’s fundraise.
• [16:49] Will we reach widespread level 5 autonomy on the ground or air taxis first?

Disclaimer

Liquidity explores all things related to venture exit activity including IPOs, direct listings, SPACs, and late-stage financings. As early-stage venture capitalists and former public stock analysts, our experiences meet in the middle, and we share those insights on the podcast through discussions between Loup partners and industry guests. We see investors continuing to commit more capital to the private markets, and our discussions on Liquidity will be focused on figuring out where the puck is going.

Top 3 Takeaways:

• As more money flows into the private markets and companies continue to stay private longer, the natural path still remains going public. However, we believe we will see more intermediary price discovery so private valuations don’t get too disconnected from the public markets as we saw with WeWork.
• The concept of quality of growth should be top of mind for venture investors.
• A successful transition from the private to the public market requires more than solid numbers, including proper management of expectations and messaging.

Show Notes

• [0:35] Why we started the Liquidity podcast & skating where the puck is going.
• [2:36] WeWork and the disconnect between technology and real estate investors.
• [4:57] Tesla and WeWork similarities?
• [7:29] The concept of quality of growth in venture investing.
• [9:55] Is the IPO window shut or still open?
• [11:20] Canva’s recent capital raise.
• [17:06] Airbnb’s lock-in and their track toward profitability.
• [20:15] What should late-stage private companies be doing before they go public.
• [25:05] Will Airbnb go public via a direct listing?

Disclaimer