Early Investing

Be Ready for Direct Listings

Be Ready for Direct Listings
By Vin Narayanan
Date December 9, 2020

I’m starting to think IPOs — initial public offerings — are overrated. That’s a really weird thing for an early investor to say. Because for early investors, the IPO is the holy grail. It’s why you invest in startups. An IPO is one of the few moments in time when you can turn paper gains of 10X, 50X or 100X into cold, hard cash. 

IPOs also come with a lot of pomp and grandeur. Founders are invited to ring the bell to open trading on the NASDAQ or New York Stock Exchange. Jim Cramer spends five minutes talking about how great the company is on CNBC. The Wall Street Journal writes a series of stories about the startup’s journey and what the opening price might be. So does Bloomberg and the rest of the business press.

It’s a heady time for any startup investor. After years of waiting, they’re finally being rewarded for being smart, bold and visionary. It’s time to cash out.

Or at least it used to be that way. Now, holding on to those shares should be the (almost) automatic play in one specific case.

The Changing IPO Landscape

Twenty five years ago, companies went public while they were still small — worth $500 million or less and still growing. And they were mostly profitable. That was good for everyday investors like you and me. We had a chance at 10X returns (or even 5X) if we invested in the stock markets wisely.

But now, companies going public are routinely valued in the billions before they go public. Most of the startups that go public now have exited their growth phase. And many are still figuring out how to become profitable. High valuations, slowed growth and lack of profitability make it hard for the everyday investor to make gains in today’s stock market. So the only way for investors to make at least 10X is to invest early, while companies are still private startups.

Startup investors have a choice when one of the companies in their portfolio goes public. They can sell their shares and lock in their profits. Or they can continue to hold their shares in the hopes that share prices continue to rise and chase even bigger gains.

Andy Gordon did a good job exploring this choice a few weeks ago. So I won’t spend any time on reviewing the risk/reward scenarios. Instead, I’m focusing on why startup investors should almost always hold onto their shares in startups that choose direct listings

Understanding the Direct Listing

Most startups try to raise capital when they IPO. They need the cash to continue to grow. And they want to reward their first employees (who often accept a reduced salary in exchange for stock options), early investors and founders by allowing them to sell all of the stock they’ve accumulated. So they hire a bunch of bankers to sell the stock, build some buzz around the IPO and support the stock price as it goes public.  

It’s an expensive process that rewards bankers and late-stage early investors more than anyone else. But most startups go through it because they need the money — and because that’s how it’s always been done.

But for companies that don’t need the capital to grow, there’s a better way. It’s called a direct listing. In direct listings, startups basically take existing private shares and list them on public exchanges so they can be traded — and early employees and investors can cash out. 

By listing directly, startups can bypass the bankers — who are essentially middlemen — and save a lot of time, money and aggravation. They don’t raise any capital. But they don’t need it. And they can hold onto all the value they worked so hard to build.

More importantly for investors, these startups are in the best position to succeed as public companies. They already know how to be profitable — something Lyft hasn’t done yet and Uber struggles with. They have the cash on hand to grow, which means they’re likely much further along (financially) than startups going the traditional IPO route. And they’re likely well run. There’s a reason they’re in position to do this in the first place.

Direct listings are fairly rare. But the most prominent direct listings in the past few years are doing extremely well.

  • In 2018, Spotify opened at $165.90. That opening was significantly higher than the $132 reference price set by the New York Stock Exchange (NYSE). And it’s currently trading at $332. These prices are a huge win for early investors, who were able to get their shares nice and cheap.
  • In 2019, Slack opened trading at $38.50. That was almost 50 percent higher than the NYSE’s $26 reference price. And it’s market cap when it went public was $19.5 billion. Last week, Salseforce bought Slack for $27.7 billion. Early-stage investors who hung on to Slack stock have done really well for themselves.  
  • In September, Palantir opened trading at $10 — a nice jump from the $7.25 reference point set by the NYSE. It’s currently trading around $28. Once again, another big win for early investors. 
  • Asana went public on the same day as Palantir. It’s NYSE reference price was $21. It opened trading at $27. And it’s currently trading at $29.02. The results aren’t as good as Slack, Spotify and Palantir yet. But Asana’s early investors that held onto their stock are still doing quite well.

Like I said earlier, we shouldn’t be too surprised these companies are doing well. Startups that go the direct listing route are set up for success. But as investors, we need to be ready to recognize this reality — and react accordingly.

If you’re lucky enough to be an early investor in a startup that goes the direct listing route, the decision should be almost automatic at this point. Hold onto those shares — because the fun is just starting.

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