Money Stuff: Soon Direct Listings Will Raise Money

BloombergOpinion Money Stuff

Matt Levine

Programming note: Money Stuff will be off tomorrow and Friday, back on Monday. Happy Thanksgiving! Direct floor listing One high-level way to think about direct listings is that they are a way for a company to go public without an initial public offering. Instead of hiring bankers to sell new shares to the public, the company announces "we're public now," and after that anyone who owns the stock can sell it on the stock exchange. One day the stock is not public and hard to trade, the next day it is public and listed on the exchange; there is just a change in status, with no big intervening transaction. A direct listing, in this view, is quiet, uneventful, boring, not a major milestone in the life of a company but an administrative change that makes trading easier for the company's investors.  Another, more market-microstructure-y way to think about direct listings is that they are a different way to pick the price at which a company's early investors first sell stock to public investors. In an IPO, the price is set, more or less, by the bankers. The underwriters strike a deal with the company and perhaps some of its employees and early investors to sell a certain amount of stock, they go out to public-market investors and market that stock, they build an order book of demand from public investors at various prices, they set the price of the stock at a level that (at least) clears the market, and then the company (and the employees and investors) sell their stock in one big block to the new investors. In a direct listing, the company just uses the stock exchange's opening auction procedures. Every morning, when stocks open for trading, a lot of people have been waiting all night to buy and sell stock. Some of them want to buy stock in the first trade, and others want to sell stock in the first trade, and the stock exchanges have long-established and fairly robust procedures to match the people who want to buy each stock with the people who want to sell it. The procedures are called the "opening auction"; people who want to sell put in orders (generally with price limits), and people who want to buy put in orders (generally with price limits), and the exchange's computers match them up with each other and keep adjusting until they get the price that allows the most shares to trade, and then the shares trade at that price.  In the market-microstructure view, the key insight of the direct listing is not "we can go public without an IPO" but rather "the stock exchanges' opening auction procedures work fine to pick an opening price for already-public stocks, and we can use those procedures instead of a traditional underwritten bookbuilt offering to pick the very first opening price for a newly public stock."  This is not a view about the eventfulness or importance of going public; it is purely a view about price. The view is usually that traditional bookbuilt IPOs tend to underprice newly public stocks, and that selling new stocks in the opening auction will tend to get a higher market price. This view matters because direct listings tend to be popular among venture capitalists and startup founders, who are sellers of stock in newly public companies and so naturally want a higher price. There are other possible objections to traditional IPOs, though; in addition to underpricing stocks on average, they also overprice some stocks, and in general have a tendency to generate a price that is rather far from the correct price one way or the other. If you like tidiness and order and predictability and efficiency, you might conclude that the opening auction is a better way to price stocks, not because it generates higher prices but because it generates more accurate ones. If your interest in direct listings is primarily this market-microstructure view, then you will have a couple of problems with the way direct listings have worked so far in the U.S. One problem is rather technical. The way you get an accurate price in the opening auction is that you have some sellers who want to sell at various price limits, and you have some buyers who want to buy at various price limits. With ordinary already-public companies there will be lots of each and there is no problem. With newly public companies, though, that is not guaranteed. What if the company only has a couple of big venture-capitalist investors and none of them want to sell in the opening auction? Then no one will show up to sell, you won't get a good opening price, and it will be a mess. To do a successful direct listing it helps to already have a lot of shareholders: If you have a lot of early investors, employees and ex-employees who all want to cash out their shares, then it should work, but if you are small and closely held it might not. The other problem is bigger and more obvious: With direct listings, so far, the company can't sell any stock itself. Existing shareholders—employees, venture capitalists, etc.—can put in orders to sell shares in the opening auction, but the company can't. This means that the company can't solve the previous problem—not enough shares for sale—by just selling some shares itself, the way it would in an ordinary IPO. It also means that the company can't raise any money when it goes public via direct listing. On the "becoming public without any drama" interpretation of a direct listing, this is fine; really it's the point. You're not looking to sell stock; you just want to slouch onto the public markets. But on the market-microstructure interpretation it is very frustrating. The point of this interpretation is that the direct listing is a way to do an IPO with a higher and more accurate IPO price. If you want to sell stock to fund your company's operations, surely you want to sell that stock at a higher and more accurate price. Also, on this view, there is no particular reason to think that a direct listing will be a non-event, and in fact Spotify's and Slack's direct listings were big events that focused a lot of attention on those companies.[1] If you want to raise money, you should do it when a lot of attention is focused on you and a lot of investors are interested in your story. It seems a shame to waste that opportunity. Yesterday the New York Stock Exchange filed a proposed rule change that would let companies raise money in direct listings. Here is the rule filing, which calls the new idea a "Primary Direct Floor Listing." Here are stories about it from Bloomberg News, the Financial Times and TechCrunch, and a client memo from Davis Polk & Wardwell LLP. Here's Davis Polk: Under the proposed rule change, an issuer would be able to sell newly issued primary shares on its own behalf directly into the opening trade, without a traditional underwritten public offering and with the IPO price determined by the opening trade auction. This change could make the direct listing route more attractive to issuers that need to raise capital, although it is an open question whether issuers will be able to achieve the desired pricing and distribution of shares in a way comparable to that done in a traditional underwritten IPO. In addition, traditional IPOs allow stable, long-term holders to buy a significant stake in a company, which may not be possible in a direct listing. We note that while there would be no underwritten IPO or underwriters, existing SEC rules do require that investment banks participate as financial advisors and accept underwriter liability, so that the basic registration and due diligence process will remain largely as it is for underwritten offerings. Nasdaq is working on a similar rule. They still need to be approved by the Securities and Exchange Commission, and stock exchange rules are not the only legal impediment to doing a capital-raising direct listing, but the trend is clear and the appeal is obvious. If you like direct listings, and people do, then you should like this, and people will. Someone will do this pretty soon. It is definitely an experiment that will be tried. Will it become the norm? Will companies stop doing traditional IPOs and start doing Primary Direct Floor Listings instead? I don't know.[2] On the one hand, I have written before that the general tendency to underprice IPOs is actually a good thing for the IPO system, and for repeat players in that system like venture capital firms. If investors expect to make money on most IPOs, then they will devote attention to smallish unknown companies, and it will be relatively easy for those companies to raise money and for their investors to sell shares. If the expectation is that every IPO will come at a market-clearing price and then have a 50/50 chance of going up or down, there is less incentive to invest the time and effort to figure out what IPOs to buy and what the right price is. Also, separately, if you just want a higher price for your IPO, you can just price your IPO higher; you don't actually need to do a direct listing.[3] At the same time I would feel like an idiot saying "no, you can never use computer algorithms to balance supply and demand to price a stock, that can only be done by highly-paid humans with long experience and good gut instincts." I don't believe that about anything else in the capital markets, and when hedge-fund managers or stock-exchange floor traders say it I make fun of them. I happen to be a former capital markets banker, so it is tempting to believe that my long experience and gut instincts are irreplaceable, but you know what, fine, just do an auction for the new stock, why shouldn't that work? The march of progress, the continuing trend to efficiency, and the disintermediation of humans in financial services might be coming for the IPO too. Mini-tender In the world, sometimes you can buy things at the wrong price. If you haunt estate sales there is always a chance you'll be able to buy a Caravaggio for like $50. In the U.S. stock market this doesn't really happen. Oh sure sometimes a stock will be trading at $100 and you'll be confident that it's worth $200 and you'll buy it for $100 and be right, and you'll tell people "I bought it at the wrong price and made a profit," but that doesn't really count. You bought it at the right price, the price reflecting market consensus; you just happened to disagree with the consensus about what the price would be in the future. What doesn't happen is: The market price is $100, the consensus is that it's worth $100, the stock is trading at $100, you agree it's worth $100, and you go to a garage sale, see a share of the stock, offer $50 for it, and the owner sells it to you not knowing any better. This doesn't happen because people do not sell stock at garage sales. They sell it through brokers. The brokers generally have an obligation to seek "best execution," and stock sales generally have to happen at or inside the "national best bid and offer," and so basically if the market price is $100 everyone ends up buying and selling stock at prices between, like, $99.98 and $100.02. And there are fierce controversies, whole books are written, about whether it is a grave injustice that people are selling for like $99.985 instead of $99.99, but basically everything happens within a couple of pennies of the consensus price. The strange exception is the "mini-tender," in which a stock is trading at like $100, and someone comes along and launches a tender offer to buy a small amount of the stock at like $80. (We have talked about mini-tenders here once or twice.) This really should not work, but somehow it does; it slips through a lot of cracks. For one thing, the Securities and Exchange Commission has lots of strict rules regulating the fairness and disclosure of tender offers, but most of those rules apply only to tenders for at least 5% of a company's stock; mini-tenders are for smaller amounts (thus the name), and so avoid a lot of regulation. (The SEC hates this, and tries to warn investors about mini-tenders.) For another thing, many brokers forward mini-tender-offer materials directly to customers; the customers end up getting an official-looking document, sent to them by their broker, explaining how they can sell their stock. (The SEC encourages brokers to attach dire warnings to the forwarded documents.) And then when the customers get those documents, they might think a big official-looking document saying "here's where to send your stock" means that they have to follow those instructions, they might think that a "tender offer" is always a good trade—that it always comes at a premium—and so sell their stock without actually checking the price, or they might just think, you know, stocks always trade at the right price, so that if they sell their stock in the tender offer then they'll be getting the right price. Nope! Anyway last Friday International Business Machines Corp. put out a Form 8-K telling shareholders not to fall for a mini-tender: On November 14, 2019, IBM received notification of an unsolicited "mini-tender" offer by Novus First Inc. ("NFI"), dated November 11, 2019, to purchase up to 40,000 shares of IBM's common stock, which is approximately 0.0045% of the 885,637,454 shares outstanding as of September 30, 2019, at a price of $111.00 per share in cash. NFI's offer price is approximately 19.34% less than the $137.61 closing price of IBM's common stock on the New York Stock Exchange on November 8, 2019, the last trading day before the mini-tender offer commenced. IBM does not endorse NFI's mini-tender offer and recommends that IBM stockholders do not tender their shares in response to the offer because the offer is at a price below the current market price for IBM's shares. I don't know! In general I am all for, like, letting tricky people do tricky things to keep the market on its toes. Technically there is no fraud here; NFI is telling people what price it will pay, the market price is readily available, and if they are willing to sell for below the market price then that's their problem. Still it seems clear that something close to 100% of people who tender in below-market mini-tenders were, in some important sense, tricked, and not even in a fun way that makes markets more efficient or even teaches them not to fall for it again. It doesn't feel like this adds much value. Podcasting Here's a very strange story about a guy named Nathan Latka who runs a business that collects and aggregates financial data about software startups and sells it to venture capitalists, and a podcast. The way it works is that he invites the founders and chief executive officers of the startups onto the podcast, asks them about their companies' finances, writes down the answers in a spreadsheet and sells the spreadsheet to customers of his data business. Much, much later, the podcast episode airs. "Latka, who has bragged that he is the 'most sued podcaster,' has also been known to hold back the publication of podcast episodes by more than a year unless a guest introduces him to three other entrepreneurs that he can pitch on the show, according to emails." Some entrepreneurs feel deceived and scammed by this process. In his defense Latka points out that he's reasonably open about it; like, if you're a regular listener to the podcast, you can tell what he's up to. In the entrepreneurs' defense, I don't know man, it is asking a lot of them to expect them to listen to his podcast before appearing on it. There are a lot of podcasts. His is called "The Top Entrepreneurs." If someone cold-emails you to be like "hey you are a top entrepreneur, want to come on my podcast 'The Top Entrepreneurs' and talk about what a top entrepreneur you are," it can be hard to say no. Talking about what a top entrepreneur you are is probably one of your favorite activities! Similarly: They could have also declined to provide the financial info Latka asks for, though some of the entrepreneurs told Recode they were caught off guard and feared the interview would go off the rails if they did not answer in some way. Others said they provided him inaccurate information because they did not want to reveal sensitive data. The way to get entrepreneurs to reveal sensitive financial data is to ask them for it.  Sure they don't want to tell you, sure they know that keeping it secret is important for the success of their company, but at the same time, if they don't tell you, then the conversation will become awkward. What is the threat of financial ruin compared to the possibility of an awkward conversation? This is a lesson that goes well beyond podcasting, or even startups. I assume that a lot of "corporate access" in the public markets, in which investors meet with corporate executives to chat about their companies, consists of the investors saying "so are you going to beat earnings this quarter ha ha ha just kidding I know you can't answer that" and the executives saying "ha ha ha good one, of course I can't answer that, but seriously I think you'll be pleased." Sure Regulation FD says that they can't give material nonpublic information to some investors privately without giving it to all investors publicly, but what are they going to do, make the investors feel awkward? Contrarianism The whole business of investing consists of disagreeing with what everybody else thinks. I mean, that's not my approach to investing, or Vanguard's.[4] Index funds let you invest by agreeing with the aggregate of how everybody else thinks, and that's mostly how I invest, and it works well. But if you are an active investor, if you are trying to beat the market, then that necessarily means that you are taking some views that are out of consensus. You are betting that some company that everyone thinks is bad is actually good, or vice versa, or whatever.[5] Every active investor, to the extent that they are active—to the extent that they are taking a position that some stock is over- or undervalued—is a contrarian. So the entire investing industry is made up of contrarians. The mainstream of the industry is contrarian, and all of the upstarts and rebels and countercultures in the industry are also contrarian. (Except, again, the indexers.) Also the aggregate of all of those contrarian views—the price set by the market—is the consensus that they are all being contrarian against. If you sum up the contrariness of all the contrarians you get conformity. It's a little weird. It's also semantically awkward. Everyone says "I'm a contrarian," and it sounds ridiculous, like that scene in "Life of Brian," but it's also basically true. They all are contrarians. Good for them. But because contrarianism is desirable—if you are paying for active management, you want it to be active, etc.—and because everyone (accurately) claims to be a contrarian, investors have to take extreme measures to stand out from the contrarian crowd. And so you get things like Peter Thiel's "Pyrrhonian skepticism," which consists essentially of saying that everything that is right is actually wrong.  Or here's a funny New York Times story about how venture capitalists love the term "narrative violation," which is a way of saying that the conventional wisdom is wrong, but being confrontational and annoying about it. Here are some quotes about the usage of "narrative violation": Rob Go, a founder of NextView Ventures, defined it as "kind of like 'contrarian,' but more contrarian and complex." Hunter Horsley, a founder of Bitwise Asset Management, a cryptocurrency start-up, called it "a contrarian way to say contrarian." Here is a selection of recent facts that have violated the narrative: A ride-hailing start-up being profitable; crime falling in San Francisco; boomers driving the urban apartment surge. There's a joke about starting a VC firm called "Narrative Violation Capital." In a world where everyone is contrarian, "kind of like 'contrarian,' but more contrarian" is the way to stand out. Things happen Citigroup Hit With Record U.K. Fine for Incorrect Reporting. Why Your Good Governance Fund Is Full of Saudi Bonds. MSCI pressures Chinese regulators over market access reforms. MiMedx Ex-Senior Executives Indicted on Fraud Charges. Goldman Sachs wants employees to disclose their emotions in real time. Pope Francis Criticizes Vatican Banking Regulator. Man City stake sale breaks valuation record for a sports group. Investment product of the year: Credit Agricole. Dog-Walking App Backed by SoftBank Loses CEO Amid Sale Talks. Papa John's Founder Decries Pizza After Eating 40 in 30 Days. "Long story short, I got four haircuts from four separate barbers." If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] Another recent notable U.S. direct listing, for Watford Holdings Ltd., … wasn't? It didn't really get much attention. But it happened. [2] One point I should make is that the rule change is about new listings, not about existing public companies. In theory you could imagine existing public companies that wanted to raise more stock doing so by just selling that stock into the opening auction. In practice follow-on offerings by public companies tend to be either (1) sold as a block to investment banks or (2) sold via regular bookbuilt public offerings. If the opening auction was the best way to sell large blocks of stock, you might expect more public companies to use it that way. [3] Similarly, sometimes people argue that an advantage of the direct listing is that, unlike an IPO, a direct listing does not require existing investors to sign lockup agreements preventing them from selling stock for six months after the IPO. But an IPO doesn't require that either! I mean, virtually all U.S. IPOs *do* require that, but it's a point of negotiation, and the company could just say no—and the success of direct listings proves that an IPO without a lockup would be fine. [4] Except in the meta sense that Vanguard launched index funds when people thought they were a crazy idea.  [5] This is not 100% accurate, and you could have a view like "we are getting paid for assuming risks that other people dislike," that is, loosely, a "smart beta" view rather than an "alpha" view.

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