IPOs are not Broken, a response to Spotify’s CFO

Last week, Spotify’s CFO, Barry McCarthy, published an Op-Ed in The Financial Times, in which he claimed that the “US initial public offering market is broken.” Here at Digits to Dollars, we try to be  diplomatic in our postings, but we think he is wrong, and disagree with almost the entire piece.

We counter that while the US IPO process needs some reform, it is not broken in the way that McCarthy lays out. In fact, many of the bugs he points outs in the current system are features that make for a much smoother process. He argues that other companies should follow the Direct Listing approach that Spotify undertook. Far from being a model that others should emulate, we think Spotify’s situation is unique to that company. It does not demonstrate a path to going public that will work for most other companies, and it is actually a pretty bad idea to even try.

Some background. Spotify is a great company. We are big fans of their service, and see their traction in the marketplace everywhere. We have no argument with the company itself. However, McCarthy lists three benefits to a direct listing that we see as serious drawbacks, these are:

  1. Quiet periods ahead of IPOs
  2. Employee lock-ups
  3. Discounts to IPO investors and first day stock pops

Let’s walk through those.

The thing to remember about SEC regulations on IPOs and other US securities laws, is that they were written in response to past bad actions. The heart of these laws were introduced in the 1930’s, coming out of the 1920’s stock market bubble and ensuing 1929 crash. Subsequent additions to the law followed other similar periods of loose practices. (‘Loose’ being an euphemism for some pretty shady behavior.) Admittedly, many regulations are a bit long in the tooth, in need of some modernizing. That being said, the guiding principals still hold validity, especially in this day of weaponzied, micro-targeted ads.

The Quiet Period is a case in point. The idea is that companies should not be engaged in overly promoting their stock to a mass audience in the month before an IPO. Companies should not cloud the info-sphere with noise ahead of the listing, allowing a period for investors to quietly consider the company’s financials as reflected in security filings. Spotify is an upright company, but many other actors would take advantage of any loosening of quiet period laws to hype a stock and create an atmosphere of Fear of Missing Out (FOMO) ahead of the IPO. Of course there is a lot of subjectivity in all of this, but the point of the quiet period rules is that they err on the side of caution to prevent bad actors from taking advantage of the system.

The second point makes this even clearer. McCarthy argues that employees should not be subject to “lock-up” periods after an IPO, the lock-up being a 90-day period after the IPO in which employees cannot sell their stock in the company. McCarthy’s argument is so far off-base here, that we really question his wisdom in making this claim. The root of the problem is to ask why should employees be in such a hurry to sell their shares? If the company is so promising to outside investors, what harm is there in asking employees to wait 90 days? A hurry to sell insider shares should justifiably be a major warning sign to outside investors. Those selling shares know a lot more than those being asked to buy them. The purpose of the lock-up is to balance that information asymmetry a bit.

We understand the desire for employees to be able to sell their shares. Long-suffering private company employees have to work for years with reduced cash salaries. We sympathize with their desire to reduce mortgages, pay schools fees and buy new sports cars. But that is only part of the story. The biggest holders of the stock, the ones most subject to the lock-up, are the founders, senior management and venture investors. Isn’t it reasonable that outside investors, coming in at the IPO, ask that those large holders be willing to share some of the IPO risk?

We would take this a step further. A perennial problem for start-ups is post-IPO talent drain. All too often the best, longest-serving employees of a private company cash out at the IPO and then lose all motivation to work. As an employee, we understand that drive. However, we think it is a big mistake for a CFO to be in a hurry to cash out those employees. The immediate aftermath of an IPO can be a chaotic time inside a company. Officers of the company should be much more concerned with re-establishing stability. Eliminating lock-ups would focus employees on big paydays and volatile share prices at precisely the time they should be most focused on getting the company back to ‘normal’ operations.

McCarthy’s third concern is the discount offered to IPO investors and the resulting bump in share price on the day of the listing. Admittedly, this is ‘lost money’, a gift given to participants in the IPO at the expense of the company’s coffers. Certainly, the massive jumps that were part of the 1990’s Internet Bubble IPOs were offensive in their scale and magnitude. That being said, we would argue that today’s discounts and first-day pops are much smaller. As we argue in our book on IPOs, “A Practical Guide to IPOs”, there is a case to be made that giving IPO investors a small discount is perfectly reasonable. These investors come in with no protection, little information, and no relationship with the management team. Giving them a small cushion gives them time to get comfortable with management. This is especially true when compared to the incredibly preferential terms given to late-stage, pre-IPO investors. Those investors are now commanding even larger discounts and often valuation guarantees (at the expense of employees). And they often get those terms for fairly short holding periods.  It is common sense that the the earlier someone invests in a company, the bigger the discount they can expect. Investors should be compensated for risk. A small discount off the IPO price is just the last step in that process.

Also, recall that investors coming in at the IPO are often long-term holders, mutual funds, who ideally want to hold the stock for many years. Many of the things that McCarthy is asking for takes value away from those holders and gives it to people who are exiting the stock. This is not the way to build long-term shareholder value in a company.

The thing to remember here is that Spotify is a very well-known company with a strong consumer following and brand. This, more than the direct listing, made it possible for the company to have a successful stock listing. Few other companies could hope to achieve this. At best McCarthy is overlooking those advantages. While the US IPO process has its flaws, it also has been a reliable provider of liquidity for companies for decades. When looking to fix its problems, would-be reformers need to be honest about their aims and to not confuse features for bugs.

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