What Correction? An End of the World, Again?
In late 2018, the technology sector fell more than 20% (the broad US tech sector index, NASDAQ, lost 23% from early October to the end of December 2018). A decline of such magnitude is officially referred to as a «correction»; prior to its start, the market has gone unnaturally high, it was clear, however, that prices cant advance forever. And soon, the times for private IT companies changed putting an end to their lavish lifestyle.
The so-called «unicorns» (private companies valued north of $1 billion) were happily postponing their public offerings the entire last year: while the sector was in the bullish mode, finding cheap investment capital wasnt a problem getting $100 million in funding was a mundane task, and startups could easily afford waiting to be acquired by, say, Google for lots and lots of money. But market correction in December has changed everything: investors grew cold towards technology companies and potential buyers now prefer to wait anticipating lower prices. In turn, venture capitalists suddenly decided to take their profits while they could, and unicorns were forced to urgently consider going public to ensure liquidity.
In fact, thats exactly what economists predict for 2019 a year of unicorns: a large number of exciting IPOs by technology companies.
However, an IPO is not the only option on their table.
What Is a Direct Listing?
Spotify decided to take an alternate route to the public market last year. The company went public through a direct listing procedure where its OTC shares (held by management, employees, and venture investors) were listed on an exchange and became available for trading no underwriters, no pre-sale at discount pricing, and no lock-up periods. Slack and Airbnb are reportedly considering following in Spotifys footsteps this year. And chances are they may not be alone in this endeavor.
There are two key advantages versus an IPO:
- No need to leave money on the table to underwriters and their clients (usually banks get in fees around 7% of the amount raised, while their clients buy shares pre-IPO at an average discount of 18%).
- No lock-up period of six months for holders of «aged» shares, which is a standard period in case of an IPO; in a direct listing, venture investors and companys employees are eligible to sell their stakes immediately after the listing, if they desire.
But the direct listing coin has two sides, of course, and namely:
- Underwriting banks exist for a reason: they audit, analyze and assess the companys business, find and persuade large investors as well as protect their clients with their reputation. In addition, they provide «maintenance» services after the fact regularly publishing research and analysis of the companys performance. Investors feel safe and secure when underwriters are around.
- No new funding. Well, its technically possible, but doing so would make a direct listing to some extent pointless (ensuring a liquid market for existing shares).
- In view of no lock-up period, a situation is not unlikely where all existing shareholders decide to dump their shares as soon as possible while theres insufficient buying power in the market. Oh, my!
What Drives a Successful Direct Listing?
The above advantages and disadvantages in particular, show that direct listing is a viable option for companies that are very well-known to the general public and have no additional funding needs. In the technology industry, these companies represent large B2C businesses and/or those that have a massive user base. And its no surprise why Slack and Airbnb are mentioned in this regard: they are very well-known and are likely to find a large enough market for their shares among retail investors. Sparking interest among institutional investors should also be relatively easy for them even without support from banks.
The problem is that most unicorns expected to go public this year are active in the B2B markets exclusively, and often in highly specific niches like cyber security and big data. Their names are much less known even in the broader IT community.
Have you ever heard names like Crowdstrike, Druva, or Medallia? These unicorns, however, are among the top twenty most anticipated IPOs.
Even Palantir, rather a decacorn, can hardly be found in news headlines, while generating $1 billion in annual revenues and valued at $41 billion.
Such companies may have a hard time attracting institutional interest without underwriters support, and even more so in the current «chilly» environment. Choosing the IPO path looks more reasonable for them. Nevertheless, should their venture investors anticipate less favorable conditions in the near future, they may opt for a direct listing in order to ensure a liquid market for their equity stakes right here and right now, rather than after the lock-up period.
Other IPO Alternatives?
In 1999, Ravenswood Winery went public in a Dutch auction where anyone could place a bid for any number of shares they wanted to buy and, given enough demand from investors, the company was able to price its shares at the high end of the range. This case was the first application of the OpenIPO platform invented by investment banker William Hambrecht. When Google attempted to do something similar in 2004, many predicted that «classic IPOs will go extinct» and called «to stop feeding investment banks and their greedy clients». But eventually it went nowhere.
First, if Google can afford arranging an auction simply owing to its worldwide popularity, smaller companies risk facing low demand from investors (see disadvantages above).
Second, the auction Google arranged for its IPO wasnt really an auction the company engaged underwriters (Morgan Stanley and Credit Suisse) who secured share price discounts for their clients. Which means someone yet managed to get better terms, and the experiments integrity was violated.
These days, IPOs in form of auctions are rare and represent an amusing case rather than a trend.
A new public offering mechanism Security Token Offering, or STO is expected to go full steam ahead this year. At its core, STO looks very much like an IPO exhibiting all its key intrinsic attributes (with applicable regulation by supervisory authorities, e.g. the Securities and Exchange Commission, as the major one), where blockchain-based tokens and smart contracts represent the voting shares. In contrast to an ICO with its battered image, tokens that get listed in an STO have attributes of a security unlike some speculative «coins» with unclear intended use. STO tokens give rights to vote on important issues regarding issuers development as a business and also provide for dividend payments. And most importantly, they are approved by a traditional securities market regulator.
Thus far, there have been only a few successful STO cases. For the lack of clear regulations, such companies registered their token offerings with SEC as raising investment capital. Pavel Durovs TON Network has pioneered the procedure raising $1.7 billion in two rounds. The projects progress is yet unknown but the listing of Gram tokens either by an exchange, such as Nasdaq, by way of conversion into ordinary shares in a direct listing procedure or by regulated security token exchanges that are about to emerge soon is highly likely.
Tzero, launching within a matter of days as a fully SEC-regulated exchange, can become the first security token exchange and pave the way for the most promising trend of the coming years: asset tokenization.
We shall soon see how this story develops. We at United Traders keep a close eye on security tokens niche as it lies at the intersection of our key business lines: stock market investing and blockchain. We believe that venture investment industrys move towards tokenization would heavily boost forward the global financial system.
Takeaways for a Retail Investor
The future might be more exciting than we thought. The Year of Unicorns as predicted by astrologers economists is going to come true anyway, and we will still see enough tech IPOs.
Those investors, however, who have already made their lists of decent IPOs and now anticipate nice profits, should consider the OTC market: chances are that some of the startups on their radar may take the direct listing route. And large and well-known B2C companies boasting large customer base (yes, Uber, we are watching you too) are particularly likely to do so.
Security token industry also deserves your attention: it will likely be a consistent newsmaker in the investment world in the coming months as many other exciting companies, and not only Telegram, may seriously consider this option.
And finally, developments in this industry may be very fun to watch.