Spotify investors, observers mull benefits of direct listing versus the risks

Spotify’s unconventional direct listing on the New York Stock Exchange (SPOT) means that private investors can cash out without their shares being diluted, and with less of the offering proceeds going to underwriter fees.

But it’s unclear whether benefits like those will outweigh the risk of price volatility and low trading volume when the company’s shares begin to trade publicly on April 3.

“If I were an investor, I’d be a little worried,” said Rick Kline, a partner at the law firm Goodwin Procter and co-chair of the firm’s capital markets practice. Kline is not connected to Spotify or working on its listing.

“If you are a long-term investor, the company is going to be valued where it should be valued. But I think it is likely to be more volatile than most [IPOs],” he said.

Spotify, a Stockholm provider of streaming services for digital music, podcasts and video, filed to go public in February, 12 years after it was founded.

Instead of pursuing an IPO, in which the company issues new shares and underwriters help determine the offering price, the company is pursuing a direct listing. In such a process, existing shares enter the public market as holders put them up for sale.

Direct listings are more common among small companies, but Spotify is believed to be the first large tech company to pursue this type of offering. A spokesperson for the company declined VCJ‘s request for comment, citing SEC regulations.

With the direct listing, current holders’ shares won’t be diluted. And because underwriters aren’t involved, fees associated with the listing will be lower than those typically charged by investment banks, which can be as high as 7 percent of the offering.

Other advantages for shareholders include knowing exactly what their investments are worth at any given time, and greater liquidity for those who want to sell, according to Jason Paltrowitz, executive vice president of corporate services at OTC Markets, which provides price and liquidity information for over-the-counter securities.

“But with Spotify, the risk is that their shareholders don’t want to sell,” Paltrowitz said. “If they don’t want to sell, you’re not going to see a lot of volume crossing the tape.”

In early 2018, the Spotify’s ordinary shares traded on the private markets for as high as $132.50, valuing the company above $23.4 billion. Other calculations have valued the company at about $19 billion.

For 2017, the company reported a loss of €1.2 billion ($1.48 billion), compared with a loss of €539 million ($669 million) a year earlier. Revenue reached €4.1 billion ($5.09 billion) last year, up from €3 billion ($3.7 billion).

The company said much of its recent losses stemmed from convertible debt it raised in 2016 and converted into equity in December 2017.

Although the company is not raising capital in its direct listing, that does not preclude it from raising money in later offerings, Paltrowitz and Kline said.

In its filing, the company warned shareholders and potential investors that the early days of public trading could see substantial volatility, without underwriters guiding the stock price.

And because the company has strong brand awareness among consumers, individual investors could influence the opening public price, the filing noted. “This could result in a public price of our ordinary shares that is higher than other investors (such as institutional investors) are willing to pay,” it said.

Given the potential for volatility in the early days of trading, firms that are current shareholders may wait to ride out some of the uncertainty before distributing their shares, or selling them and distributing the cash, to their LPs, Kline said.

“Most funds will have discretion” about when to sell their shares, Kline said. “When a lockup comes off, usually VCs don’t dump all their shares. They will wait until the next open window to sell some portion,” he said.

To avoid disrupting the market, venture firms will often distribute shares to their investors, rather than cash, Kline said. That is because investors’ internal rates of return are calculated when the shares are distributed, and selling a large chunk of shares could cause the price to fall.

Firms that currently hold Spotify in their portfolios include D.E. Shaw Group, Goldman Sachs, Northzone Ventures, Norwest Venture Partners, Technology Crossover Ventures, P. Schoenfeld Asset Management, GSV Capital and Blisce, according to Thomson Reuters.

Investors who have sold their shares include Accel Partners, Creandum AB, Mail.Ru Group, Fidelity Ventures, Horizons Ventures, Kleiner Perkins Caufield & Byers, Northzone Ventures and Wellington Partners, according to Thomson Reuters.

Despite the chatter created by Spotify’s direct listing, Kline and Paltrowitz do not expect to see many other large tech companies follow Spotify’s course and filing a direct listing.

Few companies meet the criteria that allow Spotify to pursue a direct listing, Kline said.

Spotify doesn’t “need to raise cash, and they already have a high enough profile that the marketing bang of an IPO isn’t that important,” he added.

While companies like Airbnb and Uber could potentially have enough cash and publicity to try a similar offering, “there are not that many companies that fit into those buckets,” Kline said.

“Not wanting to raise capital but having a public market for its equities is relatively unique,” Paltrowitz said. “I don’t think you’re going to see a rush of these things.”

Photo of the logo of online music streaming service Spotify reflected in an audio music CD. Reuters/Vincent Kessler.