Bill Gurley – Direct Listing vs. IPO - [Invest Like the Best, EP.144]

The traditional IPO process, which has remained largely unchanged for decades, results in significant underpricing of companies, particularly those in Silicon Valley, amounting to a staggering $171 billion. This underpricing occurs due to a frequency mismatch and the outdated nature of the process. Bill Gurley, a general partner at Benchmark Capital, uses the analogy of a sports team owner or a homeowner finding out their asset was sold for much higher after the fact, feeling like they've been taken advantage of. An alternative, called a direct listing or direct public offering, might be more attractive to founders and employees of early-stage companies as it bypasses the underwriting process and the associated underpricing. This conversation with Bill Gurley sheds light on the issue and the potential benefits of direct listings.

The IPO process in Silicon Valley is heavily skewed towards a small number of successful entrepreneurs and companies, while other parties involved, such as investment banks and mutual fund investors, engage in multiple IPOs each year. This frequency differential leads to anxiety and a reliance on tradition, perpetuating an outdated process that may be questioned in the future. When a new company goes public, they face a lengthy and complex process filled with advisors and handlers, SEC reviews, and roadshows where they present to potential investors. Despite the challenges, it's essential for investors, founders, and employees to understand this process and its implications. The IPO market is a unique and intricate system, and being informed can lead to better decision-making and more successful outcomes.

The traditional IPO process is heavily influenced by human decision-making, leading to unpredictable pricing and allocation of shares. The process involves investment banks gathering indications of interest from potential buyers, often keeping this information private from the company. The goal is to be oversubscribed, sometimes by as much as 10 to 20 times, which often results in ignoring a large percentage of demand. Decisions on pricing and share allocation are made by humans, often favoring certain accounts, even if they have lower bids. This can lead to disappointment for some investors and a potential pop or underpricing of the stock. It's important for companies to understand this dynamic and work closely with their banks to optimize the IPO process.

The IPO process, particularly in the tech industry, can result in significant wealth transfer from the founders, investors, and employees to the buy side due to the agency problem and handpicked pricing by investment banks. This issue has been escalating in recent years, with an estimated $171 billion in wealth transfer over the past four decades and $12 billion in the last 18 months. For instance, in the cases of Elastic and Zoom, the one-day giveaways amounted to $338 million and $623 million, respectively. These numbers represent the difference between the hand-allocated prices and the first-day closing prices. Had these companies opted for a direct listing, none of this wealth transfer would have occurred. The employees, who often own significant stakes in these companies, also miss out on this value. This issue is particularly concerning as it disproportionately affects founders, investors, and employees, who may not have the same level of market knowledge or resources as investment banks.

The Initial Public Offering (IPO) process, particularly the role of investment banks in setting the offering price, can lead to significant underpricing, with an average of 18% over a 10-year period for VC-backed IPOs. This underpricing, combined with the fees charged by investment banks, can result in a high cost of capital for companies going public. The variability in underpricing between different lead banks was surprising, with Credit Suisse underpricing the least (3.3%) and Goldman Sachs and Morgan Stanley having significantly higher underpricing (33.5% and 29%, respectively). This inefficiency in the IPO market can be attributed to the psychological comfort provided by the reputation of these top-tier banks and the anxiety surrounding the IPO process. Direct listings, which bypass the traditional IPO process and its associated underpricing, may offer a simpler and more intuitive alternative. Understanding these details and their implications is crucial for companies considering going public and for investors evaluating potential investments.

The hype and excitement surrounding a successful initial public offering (IPO) can be misleading for founders and CEOs. The short-term focus on the pop in stock price can distract from the long-term responsibilities of the leadership team to shareholders. The press, which often criticizes short-term thinking on Wall Street, reinforces this short-term mentality by viewing a pop as a positive marketing event. However, the reality is that the pop is fleeting, and the long-term performance of the company is what truly matters. Additionally, the IPO process is a transaction that provides no ongoing involvement or commitment from the investment bank, unlike a venture capitalist firm. Another difference is the use of the green shoe option, which allows for the sale of 15% more shares than initially planned if the stock price pops, leading to a larger raise than intended. Overall, while an IPO can bring significant financial gains, it's essential for founders and CEOs to keep their focus on the long-term success of the company and their fiduciary duty to shareholders.

The underwriting process in IPOs, specifically the use of the green shoe option and lockups, can lead to profit maximization for banks and instability for companies. The green shoe option allows banks to buy additional shares at the IPO price, which they can keep as profit, and the lockups restrict insiders from selling their shares for six months, creating a secondary selling opportunity for banks to make more fees. These practices can result in volatile stock prices and anxiety for companies. Direct listings, on the other hand, simplify the process and eliminate these issues. Additionally, the reluctance of VCs to sell in these inefficient processes contributes to float issues and volatility.

The direct listing process for public offerings, as opposed to traditional IPOs, leverages existing technology and market mechanisms to provide a more fair and accessible market for all investors. Unlike IPOs, where buy-side firms often face restrictions and high volatility, direct listings use the same technology that opens stocks every day on the NYSE. This technology, called price-time priority, matches supply and demand anonymously, filling orders at the price and in the order they are received. This system ensures that no demand is intentionally ignored, providing a level playing field for all investors, regardless of their size or reputation. This not only leads to lower volatility but also faster access for buy-side firms to acquire meaningful positions in the company. Overall, the direct listing process represents a more efficient, fair, and accessible method for companies to go public.

The direct listing process, as used by companies like Spotify, offers greater fairness and access to potential investors compared to the traditional IPO process. This is because the direct listing allows for wider dissemination of information about the company through digital means, reducing the need for expensive roadshows and one-on-one meetings with investors. Additionally, many companies no longer need to raise capital through an IPO as there is ample funding available in today's market. However, the SEC currently does not allow for primary offerings in direct listings, but this may change in the future. Overall, the direct listing process represents a shift towards more transparency and inclusivity in the public markets.

The current IPO process is unfairly favoring a select few large buy side firms, leading to a significant wealth transfer and privileged access. This issue stems from the regulatory framework and the traditional IPO process, which requires firms to pay high fees to investment banks to secure a place in the allocation. The SEC, which values fairness and access, may favor a change to this system. However, buy side firms, particularly those who have benefited from this wealth transfer, are likely to resist. For smaller firms and long-term buy and hold investors, a direct listing process would offer a more equitable opportunity to build significant ownership positions. Ultimately, change may come through persuasion and representation from prominent firms, rather than regulatory action.

The success of a company in opting for a direct listing over a traditional IPO depends on both intelligence and courage from the founders. Mike Moritz of Sequoia emphasized this point in his Financial Times piece. The intelligence aspect is important, but the courage required to make the move is often more challenging. Moritz highlighted that founders who are excited about this new path are already emerging. Patrick O'Shaughnessy, the podcast host, shared his personal reasons for becoming passionate about this topic. As a successful investor, he wants to ensure that the investor community is not taken advantage of, and he sees the direct listing as a potential solution. He also finds the current system intellectually offensive and wants to contribute to a better, more coherent investment landscape. The conversation concluded with a reminder to listeners to leave a review for the podcast and sign up for the book club at investorfieldguide.com.