Rage against the machine

Legendary investor Bill Gurley wants to blow up IPOs and replace them with direct listings.

Bill Gurley, the legendary Benchmark general partner who was an early investor in Uber, Zillow and StitchFix, among others, has helped to transform many industries.

But now he is on a public mission to transform the very process that turned his investments in these companies into actual cash returns: the IPO.

The traditional IPO, argues Gurley, is inefficient, outdated, and most importantly rigged in favor of the buyside that becomes the beneficiary of the first-day stock pop.

Attempts to create an alternative to the IPO have been around since the late 1990s, but one such method, a Dutch auction, never caught on. “This is an old Silicon Valley movement that has more momentum behind it now,” Gurley told Venture Capital Journal.

Gurley said that he has had issues with traditional IPOs for a while, but he became the leading voice against them only after two large tech companies, Spotify and Slack, had smooth public debuts via a novel approach called a direct listing. (Gurley took Venture Capital Journal through a slide deck detailing the advantages of a direct listing.)

“Until the door was opened by Slack and Spotify, there were no other good alternatives,” Gurley said.

No longer an obscure topic

Unlike in a traditional IPO, where underwriting banks price the company’s new issue at a discount to the expected trading range so that a stock can pop on the first day on a public market, no additional capital is raised in direct listing and the stock simply starts trading on an exchange. (For a detailed explanation of how a direct listing differs from an IPO please see the separate story, “IPOs vs direct listing: the good, the bad and the elegant”)

Over the last few months, Gurley succeeded in turning the idea of direct listings from a relatively obscure topic into one of the most discussed in Silicon Valley. His crusade has rallied up the business community, from founders to GPs, from bankers to lawyers, and even the U.S. Securities and Exchange Commission to consider the benefits of a direct listing instead of an IPO.

A who’s who of Silicon Valley

In early October, Gurley helped to organize a full-day symposium in San Francisco called, “Direct Listings: A Simpler and Superior Alternative to the IPO.” The event was attended by CEOs and CFOs of more than 100 late-stage venture-backed companies, as well as more than 25 venture firms and fund managers.

“It looked like a who’s who of Silicon Valley,” said Previn Waas, Deloitte’s national IPO service leader who attended the event. “Following that direct listing discussion, a lot more CFOs and VPs of finances are engaging us to see if a direct listing is something they should consider.”

Previn Waas
Waas

Gurley argues that the biggest advantage of a direct listing is that all the proceeds from the stock’s sale to the public go to founders, employees and investors, rather than partially pocketed by the buyside in what he calls a “big one-day wealth transfer.”

Since investment bankers underprice new shares so they can rise once trading begins, institutional investors who buy stock at the IPO price the night before it opens on an exchange get to keep the entire value of the first-day pop.

Gurley dug deep into the data compiled by Jay Ritter, a University of Florida professor, and discovered that since 1980, Silicon Valley companies have given away more than $170 billion as a result of IPO underpricing.

“The underpricing by the banks is getting worse,” Gurley said. “The data shows that over the past three years, the average pop has been increasing.” In 2019 alone, despite several underperforming IPOs, including Uber, Lyft and Peloton, newly public companies left a net of $6 billion on the table, according to Ritter’s research.

What’s behind the IPO pop?

Gurley took to Twitter to illustrate how Datadog, a company that had its public debut on Sept. 19, gave up $293 million to new investors after the price jumped 39 percent on its first day of trading. The venture capitalist wrote that since the “deal was 35x oversubscribed,” the large pop is a result of investment bankers ignoring 97 percent of demand for the stock.

The traditional IPO process may seem like a big gift to the buyside, but a portfolio manager from a major asset management firm who asked to remain anonymous told Venture Capital Journal that the IPO discount does not make a difference to the performance of the portfolio. Due to a severely limited supply, the IPO allocation is a tiny portion of the position the asset manager wants to take in the newly public company. Given a choice between an IPO and a direct listing “it may be a wash,” this source said.

“What I like about the traditional process is that the bankers are providing me with research and helping me understand the business in-depth,” the portfolio manager said. (In a direct listing a company releases forward guidance to everyone.) “But the benefit of a direct listing is that I don’t have to do much posturing with the company and the banks to show them that I will be a good long-term investor. I can also build a sizable position faster.”

But it is not only the limited IPO supply, which is kept low because of the six-month lockup, that also explains the massive first-day pops, according to Gurley.

The venture capitalist insists that the underpricing can be explained with an economic concept called a multiple agency dilemma. In an IPO, a single agent, an investment bank, is representing two customers: the buyside and the company. But since institutional investors are banks’ ongoing customers across various asset classes, underwriters are more aligned with the buyside firms than the soon-to-be public-company, Gurley said.

Investors who are getting allocations to the hottest IPOs are not those willing to pay the highest price for the issue, but the ones who are the banks’ most important customers, according to Gurley. Underwriters don’t deny that they may not always allocate IPOs to the highest willing buyers, but they do this because they want to place stock in the hands of long-term investors rather than hedge funds who can flip it the next day.

But Gurley doesn’t buy into this narrative. “Fidelity can always dump the stock. They don’t have a contract,” he said.

Gurley went as far as analyzing IPO data by an underwriter in which he discovered that the two most reputable investment banks, Goldman Sachs and Morgan Stanley, underprice IPOs more than other underwriters. “Turns out that if you go with the best investment bank, you get the worst execution,” Gurley said.

Over the last decade, Goldman Sachs underpriced IPOs by an average of 33 percent, according to Ritter’s data. In other words, shares underwritten by the bank, jump on average more than a third during the first day of trading. This means that hiring the premier bank is good for the headlines, but bad for the company’s balance sheet.

Direct Listings: an elegant solution

Gurley said that he started focusing all his energies on promoting direct listings because he finds the IPO process “intellectually offensive,” and to give back to the Silicon Valley community. In fact, he loves to point out that Barry McCarthy, Spotify’s former CFO and the architect of the direct listings model, called IPOs “moronic.”

“The door that Barry McCarthy unlocked is elegant,” Gurley said. The opening stock price will settle where demand meets supply, meaning that anyone who wants to buy the stock will have their orders filled as long as the bid is equal to or exceeds the equilibrium price. This means the sellers of the shares get to keep 100 percent of share price and the “single-day wealth transfer problem” is eliminated.

Despite standing to possibly lose some of the lucrative underwriting fees, investment bankers are very much a part of the direct listings’ conversation. Goldman Sachs organized a session on direct listings at a Las Vegas conference in September, while in October, Morgan Stanley held a private event on the topic in San Francisco.

“The cat is out of the bag on direct listings. I am hard-pressed to see any firm that is not leaning into this,” said Jeff Rosichan, a senior capital markets banker at Evercore.

Gurley says that it is “tautological” that the market will set a fairer opening share price than underwriters do through their book-building efforts. Bankers are not denying this. “We are supportive of democratizing the process, but there are also advantages and disadvantages to direct listings. VCs are not getting diluted and there is no lock-up. But is also a lot more work for companies and there is no way to raise primary capital,” Rosichan said.

One misconception is that companies can save substantially on banking fees if they do a direct listing. “Savings are not that great, to be honest, that’s certainly not the motivator,” Stewart Butterfield CEO of Slack told CNBC on the day the company had its direct listing.

Despite the movement’s growing popularity, it is unlikely that many companies are ready to choose this method for going public.

First, only companies that don’t need to raise capital could consider a direct listing. “There are a couple of short-term solutions to this problem,” Gurley said. Companies in need of cash can raise a private round just prior to a direct listing or conduct a secondary offering shortly after going public.

The SEC has also started the conversation about the possibility of adding a capital raising component to direct listings. “Very little has come out of that first meeting,” said Alan Bickerstaff, a partner with a law firm Shearman & Stearling, “The SEC probably has a positive view of the Spotify and Slack listings and is trying to be flexible in modernizing the security law for alternative ways of raising capital.” (Shortly after this story went to press, New York Stock Exchange filed a proposal with the SEC for allowing new capital to be raised in conjunction with a direct listing.)

Alan Bickerstaff
Bickerstaf

Yet, in the current environment, many companies are flush with private capital. “The list of companies who can do a direct listing without needing additional capital is longer than one might think,” Rosichan said.

Second, conventional thinking is that only well-known brands can attract the attention of institutional investors without the help of investment bankers. This may be true for now, but Gurley said that buyside firms are doing a lot of crossover investing and are closely tracking many late-stage companies.

So far, the only company that is expected to go public via a direct listing is AirBnB, a brand with a very known business model.

Other companies are thinking about a direct listing route. Gurley estimated that five to seven companies are considering this, while another source said that four “big and notable” companies are expected to hold a direct listing in 2020.

But the real test for direct listings will be when a less-well-known company tries to go out this way, Rosichan said.

At the end of Gurley’s presentation is an image with logos of some of the most successful tech companies, including Facebook, Amazon, Netflix and Salesforce. “This is my favorite slide in the entire deck,” he said. “Question, which of these companies traded below their initial IPO price?” Gurley’s punchline answer is of course, “all of them.”

His point is that a company doesn’t need an IPO pop and all the ensuing attention to grow into a tech giant.

Spreading the word

The venture capitalist is continuing to spread the word about this method far and wide within the late-stage VC ecosystem. “Twenty-five VC firms are talking to their portfolio companies about the possibility of doing a direct listing,” Gurley said. “We set up a group of 150 private companies.  We will keep talking to them and sharing service providers.”

Gurley’s immediate goal is clear: recruit entrepreneurs willing to follow in Spotify’s and Slack’s footsteps. But one thing he says it is not is a reaction to any of the less-than-successful 2019 IPOs or a WeWork fiasco.

“Companies should do this regardless if there is a hot market or a cold market,” Gurley said. “And we will be cheerleading them all the way.”