April 17 - Leonardo Siligato
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After years of rumors, it’s finally coming: Spotify will launch on the New York Stock Exchange on April 3rd. Its music streaming service has revolutionized the music industry, killed off piracy, and made nights of downloading entire disks of music illegally a distant memory. Now, you’ll be able to invest in the Swedish company.
Its entrance to the stock market, however, will be different to usual. Rather than launching an IPO (Initial Public Offering), like Snap, Dropbox and other tech companies, Spotify will launch a ‘direct listing’, also known as DPO (Direct Public Offering). This is a much rarer way of joining the stock market, and can have a big effect on the price.
Therefore, if you’re serious about trading, it’s worth spending five minutes understanding the differences between an IPO and a direct listing. Let’s look at them together.
The fundamental difference between the two lies with money. Usually, a company launches an IPO because it wants to raise more cash.
It’s an alternative to asking a bank for more money, where they’d have to pay interest even when business sucks. But by issuing shares instead, the company draws in money from investors without having to pay interest. The investor only asks for a stake in the company and a share of profits (if there are any).
With a direct listing, Spotify will issue no new shares, so it won’t raise a penny. Instead, it just gives existing investors an opportunity to sell their shares on a regulated market, with transparent prices.
Before, they’d have to find a private buyer, do a back-room deal, and agree prices individually. With a direct listing, it will be much easier for investors to find buyers. (In financial jargon, the stock is said to be more ‘liquid’).
In short, the purpose of a direct listing is not for the company to finance itself, but to give shareholders a way out of their investment.
With an IPO launch, like Dropbox, the company issues new shares. This means the capital is diluted and each existing share is worth less.
To make sense of it, imagine Dropbox as a cake. If Dropbox has ten investors, the cake is cut into ten slices. But when it launches on the stock market, Dropbox invites new shareholders to the table. Now we have to cut those ten slices into smaller slices, so everyone gets a bit less.
Therefore, with an IPO, the value of the old shares decreases. In a direct listing, however, the price of existing shares is not affected, since no new shares are being offered.
Banks play a pretty huge role in the launch of an IPO, but not so much with a direct listing. Here’s why:
Before listing an IPO, the company execs will do a tour of the big investment companies (known as a ‘roadshow’) to find one or more banks to help them launch. These banks are called ‘underwriters.’ Basically, they help protect the IPO from being a complete failure.
How do they do this? Let’s take the Dropbox IPO as an example. Dropbox was underwritten by Goldman Sachs, JPMorgan and other banks.
First, the banks call up their friends in various investment companies and ask if they’re interested in Dropbox stock, and how much they might pay for it. That helps them figure out the initial quote price – for Dropbox it was $21 per share.
Once the price is decided, the underwriters guarantee that a certain number of shares are sold at that price. If there are not enough buyers, the banks promise to buy the shares themselves for that price.
In short, the underwriters ensure there is a liquid market for the shares from the first minute, but they charge a big fee to do this.
In a direct listing, however, there are no banks involved as underwriters. That has implications on the company and the market.
For the firm, it’s a hell of a lot less expensive than an IPO. The fat cats don’t have to do the roadshow, and the company doesn’t have to pay huge commissions to the banks. Cool.
But from the market point of view, the lack of an underwriter can create some problems.
First, no-one can determine the opening price for the stock at the time of listing. The company might indicate the price range at which stocks have sold in the past through private trades, but this range can be large.
In the case of Spotify, for example, the most recent data predicted a range between $90 and $132.50 (almost 50% more!) Nobody wants to be the idiot who sells at $90 in the first minute, only to watch the price soar immediately afterwards. So in a direct listing, there’s a risk that shareholders will decide to wait and sell, which could cause a shortage of supply.
Secondly, there could also be a lack of demand. If no-one wants to spend $90 on Spotify shares, the price may have to fall a long way before anyone buys them, much to the disappointment of existing shareholders.
This can’t happen in an IPO because the big bank agrees to support the demand at the pre-established opening price, buying shares if necessary.
Finally, the uncertainty of the opening price could create huge volatility when the stock opens, which is dangerous for investors.
When companies launch an IPO, the largest shareholders and managers usually sign a clause that prohibits them from selling their shares for 90-180 days. This clause is called a ‘lock-up agreement’ and aims to stop all the shareholders selling their shares immediately after an IPO, causing the stock price to crash.
There’s usually no such ‘lock-up’ clause with a direct listing. Only two big Spotify investors (TME and Tencent) have signed an agreement of this kind. Together, they account for 7.5% of Spotify shares. That means 92.5% of Spotify shares can be openly sold as soon as the stock launches, causing the stock to crash (it’s not going to happen, but it’s theoretically possible).
IPO and direct listing are very different. While both allow a company to join the stock market, they have different objectives, different procedures, and different costs for the company. From the market point of view instead, direct listing can make the shares less liquid and their price more volatile than an IPO.
That’s why we’ll keep our eyes glued on Spotify when it launches on April 3rd, and we suggest you do the same. On BUX, of course 😉
June 15 - Leonardo Siligato
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