[Sunidhi is a student at Rajiv Gandhi National University of Law.]
Initial public offer (IPO), as a traditional market exit strategy, compels private companies to undergo a strenuous process to become public -- it is time-consuming, challenging, and overly expensive. Recently, there have been various instances of big companies having unsuccessful IPOs, and yet it remains a company’s next-big-strategy to raise capital. This could be because, for a company, becoming public means joining the “big leagues” and instilling greater shareholders’ trust, leading to enhanced future value. However, the costs involved may sometimes outweigh the benefits accrued from a public company.
Due to the burdens associated with IPOs, Spotify has paved the way for becoming a public company without an IPO through "direct listing". Direct listing, as an alternative to an IPO, allows a company to list its shares on the national stock exchange directly without an underwriter. It does not allot new shares but instead allows early investors or existing shareholders to sell their shares upon listing.
In this article, the author highlights the differences between traditional IPO and direct listing while building a case for recognizing direct listing as an alternative exit strategy in India. Throughout the blog, the author discusses direct listing in the context of unicorn companies and explains how it is an effective strategy against the recent trend of "staying private" and delayed IPOs.
The Failure of Unicorn IPOs: Inflated Valuations
Unicorn, as the name suggests, was first used to describe rare and elite companies with a valuation of over $1 billion. Although these privately held companies are now not as uncommon, their public debuts have created a lot of buzz around them. When companies like Uber, Lyft, and Wework decided to make their debuts in the public market, surprisingly enough, none of these companies had a successful IPO.
For instance, Uber’s issue price was set at $45, but after the first day itself, the price went southward and was settled at $28, marking a decrease of over 37%. Similarly, Deliveroo marked a decline of 29% below the issue price. The reason for these famous unicorn IPO flops is because of the inflated valuations, creating a price bubble. A private company’s value is based on expectations and predictions, which may or may not happen. The numbers do not reflect historical data but instead are based on potential future profits, thereby exceeding the fundamental value of stocks by a large margin.
Such examples highlight the difference in approach observed in the public and private markets. Private equity (PE) and venture capital (VC) organisations, with their high-risk appetite, readily write off even 100% of their investments by basing their valuations on the potential profitability of the company. This is where the public market differs; public investors keep aside potential future earnings and instead rely on the substance of their financial statements. Despite the grand valuations, nearly half the companies that went public in 2019 were trading much below their offer prices.
Spotify’s Case of Direct Listing
Amidst the unsuccessful IPOs, Spotify chose an unconventional or a rebellious route of going public; it made its debut in the public market without an IPO. Spotify opted for "direct listing" which enabled the existing shareholders to resell their shares on the New York Stock Exchange (NYSE) directly, without the help of an underwriter. It did not offer any new shares; it only permitted the reselling of its existing shares. Although Spotify had to work really closely with the US Securities and Exchange Commission (SEC) to make its direct listing possible, it was nevertheless a great success. Rule 144 (an SEC regulation) prescribes a holding period before a share can be sold or re-sold. Depending on the type of company, the period ranges from 6 months to a year during which a shareholder may not resell his shares. The shares held for more than a year were therefore exempted from this rule, and the few who did not fulfil the conditions under Rule 144 were registered with the SEC under Form F1. Notably, the existing shareholders are getting the benefit of selling their own stock immediately instead of adhering to the mandatory lock-up period as seen in traditional IPOs. More importantly, to get out of the rut of failed unicorn IPOs due to inflated valuations, in direct listing, shares are not sold at any set price; instead, the prospective buyer is the one to choose a suitable price. A direct listing is essentially where the company does not hire underwriters or banks to fix an IPO price. The investors are at liberty to establish prices through private market transactions, creating powerful market-driven dynamics for trading.
Since Spotify’s path was unconventional, there were unknowable risks associated with direct listing. However, the company conducted this process with the utmost transparency and took all the necessary safeguards to prevent causing an undue disadvantage to investors. For instance, in their prospectus, Spotify cautioned prospective investors about the volatility of the share prices without an underwritten IPO. Moreover, Spotify organized a special "investor day" to educate all prospective investors. With such transparency, Spotify hoped that its share prices would reach a natural equilibrium, which they did.
A Solution for Bad Corporate Governance in India?
In India, there has been a recent trend of companies wanting to stay private for longer. The reason is either the heavy costs associated with registration or the increased scrutiny and regular reporting requirements under SEBI regulations. As a result, companies are delaying their public debuts by getting cheap credit from PE and VC organisations. However, as SEBI’s radar is somewhat limited to public companies, these privately held companies are often characterized by poor corporate governance, eventually hurting the shareholders’ interests.
BYJU’s, a famous Indian ed-tech company valued at $22 billion last year, is now in troubled waters, which has brought down its valuation to $5 billion. The company has been making waves due to its poor business model, management conflicts, and recent employee exits. The company is also entangled in a lawsuit by one of its investors for defaulting on a $1.2 billion loan repayment. The downfall of BYJU’s is attributed to its reckless and impetuous financial and management decisions. Moreover, the company failed to disclose its financial accounts and withheld crucial information about finances, which subsequently also hurt the interests of the investors.
The unfortunate fate of the company and its investors would have been avoidable if BYJU’s had chosen to go public at the right time. The reckless management and financial decisions would not have gone unchecked, and the management could have gotten warnings well in time for course correction. Moreover, it would have saved its investors from making misguided and ill-informed decisions.
Companies like BYJU’s make the ideal candidate for direct listings; immediate requirement of cash and a strong brand. Through direct listing, the company could have gone public without going through the traditional tedious and expensive process of an IPO and could get instant liquidity due to the absence of lock-up period. However, it is pertinent to note that in direct listing, as opposed to an IPO, the ultimate benefactors are the existing shareholders who can avail themselves of an efficacious exit strategy.
Direct listing, if not an alternative to IPOs, can serve as a stop-gap mechanism for struggling unicorns with widespread consequences. Big private companies, or unicorns, are largely founder- or CEO-centric and shareholders have limited control over board decisions. Bad corporate governance in such companies cannot be excused when large investments and people are involved. BYJU’s, for example, in order to cut corners, ended up firing employees across departments.
Conclusion
Spotify’s innovative method of direct listing seemed like the correct thing to do amidst popular unicorn IPO flops because of inflated share prices. By choosing direct listing, Spotify enabled the discovery of prices through transparent, market-driven forces. Due to the absence of underwriting, there was no scope for self-inflating or manipulating the share prices. And moreover, the biggest advantage of direct listing is that there is no underwriting fee, which makes it a much cheaper alternative than an IPO.
While direct listing can be an effective exit strategy for companies wanting to go public, it can also serve as a corporate governance enforcement strategy. Specifically in the Indian context, where privately held companies with dysfunctional corporate structures and hazardous business models are escaping scrutiny from market regulators, direct listing can be a timely remedy for investors to get immediate liquidity. Moreover, it can bring more transparency to disclosures and strengthen corporate governance through shareholder empowerment.