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Breaking Down Spotify's Potential Non-IPO: Why Would the Company Roll the Dice on a Direct Listing?

Founder and CEO of Spotify Daniel Ek speaks onstage during the Spotify press announcement on May 20, 2015 in New York City.
Noam Galai/WireImage

Founder and CEO of Spotify Daniel Ek speaks onstage during the Spotify press announcement on May 20, 2015 in New York City. 

News that the company is mulling a direct listing rather than an IPO spurred plenty of confusion. How could it all shake out?

On Thursday, the Wall Street Journal reported that Spotify -- long rumored to be planning an IPO in the next year -- might remix its plans. Instead, the report claimed the world's largest streaming service would go public with a direct listing, rather than an Initial Public Offering, an option that is much more common for smaller companies that don't expect a big publicity splash when entering the market, and one that is exceedingly rare for a company that, well, makes a big splash with just about every move it makes.

An important caveat: Spotify was said to be "seriously considering" the move, meaning it's not set in stone, and the company itself declined to comment. But the report raises several questions: some complicated, some more straightforward.

Here's a breakdown of what it means, why it's important, and what it could lead to down the road.

What is an IPO?

When a private company takes itself public, it generally does so with an IPO, or Initial Public Offering, in which it lists itself on a stock exchange by offering new shares of the company to the public at a set price that, taken collectively, adds up to the total value of the company. In an open market, the demand (or lack thereof) of stocks in a particular company determines the rise and fall of its stock price; the higher the demand, the higher the price, the higher the value of the company and the more money the company makes.

In order to offer an IPO, a company hires an underwriter (read: a bank with a hefty fee) that prepares the public offering; handling regulations, assessing and accruing demand, issuing reports from its analysts and connecting the company to potential investors that would form a viable backbone to support the business model -- generally long-term investors that won't flip shares quickly and leave the stock in an unstable condition. But most importantly, the underwriter will use its connections in the financial world to come up with a valuation -- essentially the opening stock price -- that becomes the accepted consensus of how much each share is worth on the stock exchange. (For reference, at press time Apple's stock price was $143.54; Google's $842.81; Amazon's $894.96.)

"A company's dream investor is a big one, like a Fidelity, who would come in and buy the shares, even if there's no profitability, but they believe there's a path to profitability and believe in the story," explains Santosh Rao, head of research at Manhattan Venture Partners. "The worst thing that can happen to a company at an IPO is someone who buys the IPO and flips it around, or sells it right away; then the stock goes down, the reputation goes down, and then it's tough to build that back."

What is a direct listing?

A direct listing is a way to list a company on a stock exchange without issuing new shares to the public; it's like an IPO, but without offering the public a way in unless someone within the company already wants to sell. With no new shares to offer to the public, there is no underwriter, and thus there is no consensus valuation of how much money the company is worth outside of its own self-valuation. 

Spotify was last valued at $8.5 billion -- in June 2015, when it had 20 million global subscribers and no real competitors in its sector (Apple Music would launch at the end of that month). At 50 million subscribers, the company has grown significantly since then. Without an IPO, the company's true value will be what it believes it to be, rather than what the market dictates.

So how much would a share be worth?

That would be for the market to decide. "The stock is just listed and the valuation is effectively discovered by the buying and the selling in the market," explains Alun Simpson, corporate finance director at Eleven Advisory. "So it isn't supervised and managed by an underwriter who is making sure that the right investors are specified and is also sort of controlling, to a degree, who those investors are. What it would do is put the stock on the market, and the process of buying and selling would be what discovers the actual price."

Doesn't that seem kind of risky?

The short answer is, well, yes. "The market price could be a lot less than you would want, particularly if there are too few sellers or too few buyers in the market," Simpson continues. "But there may be specific things they are doing to protect themselves within the direct listing that might mirror what would happen on an IPO anyway. That might include putting some controls over how many people can sell their shares within a certain period of time. That typically happens with an IPO: You would have what's called lock-up periods for shareholders, which means there's a period of three or six or 12 months after the IPO where people are not allowed to sell, or sell large shareholdings."

But there is a more tangible risk as well. "The price discovery is not going to be as unanimous -- it's the company's word against yours," Rao says. "It's not taking advantage of the bidding process of an IPO. You're going to miss out on the momentum and the full force of the underwriters. But you never know."

Why would a company go public in the first place?

Startups need money to realize their business plans, and that generally comes in the form of investors, who pour money into a company in exchange for equity -- and a payday if it succeeds and goes public. "With a private company, these people have shares -- early investors, employees, founders -- and those shares come to market," Rao says. "So when they start trading, everybody can sell shares, and that's how you build a company."

"The two reasons a company usually IPO's is, firstly, to raise cash," says Simpson. "The second reason is usually to give the current shareholders a way of exiting their shareholdings. In particular, that's the founders and private equity funders."

Why would Spotify go public?

For the same reasons, but Spotify has another more pressing concern: In March 2016, it raised $1 billion in convertible debt, with terms that punish the company financially the longer it delays its IPO. Convertible debt, unlike an equity investment, can be exchanged for stock in a company at a discount when it goes public rather than a share of the company immediately. Spotify's deal required the company to go public by 2017, at which time those investors would convert their debt into stock in the company. But it reportedly came with stiff caveats: Every six months that Spotify delays going public, the interest rate on that debt rises 1 percent, and the discount -- which reportedly started at 20 percent -- increases 2.5 percent. The clock, as they say, is ticking.

Why would Spotify do a direct listing rather than an IPO?

If the first reason companies go public is to raise money, that might be one reason why Spotify would avoid the process. "Spotify just raised a billion dollars over a year ago," Simpson notes. "Although they've spent a fair bit of that -- we don't know exactly how much -- they probably still are sitting on quite a lot of that cash, so they might not actually need to raise money." Rao is more straightforward: "If they're doing it direct, they don't need the money, because they're not going to issue new shares."

Would a direct listing fulfill that $1 billion debt deal?

That's a good question, and would depend on the specifics of the deal itself. "The whole idea of the convertible debt is that it would be converted into equity at a discount of the valuation, and that valuation is usually what is set at the moment of the IPO," Simpson says. "The question would be, a discount of what? Because the valuation isn't being set in the typical way it would be for an IPO."

But again, this plan isn't set in stone, and Spotify may also have a different reason for mulling a direct listing. "Two things could be happening: One is that Spotify might want to go to the convertible lenders and say, 'Let's renegotiate, because we're not going to do an IPO, so there's nothing to give you a discount from,'" Rao says. "Or they're just positioning themselves, they're posturing to underwriters, to debt-holders: 'Hey, we're going this route, both of you are going to get hurt if we do this, so let's talk about it.'"

All things considered, would this be a smart move?

"There are a few precedents before, and they're not great," Rao says, citing Google's not-quite-IPO, not-quite-direct-listing a few years ago that caused a bit of a PR headache before it smoothed itself out. But that doesn't mean it wouldn't work for Spotify's specific situation.

"If they don't need the cash, it would give their initial investors an exit, and it may satisfy the criteria of the terms of their convertible debt and stop the clock on it, effectively; for those three reasons, you could see it would make sense," Simpson says. "If they were to go that route, all things being equal, it would appear that it would be a less controlled situation rather than having an underwriter who would try to secure a degree of certainty about the valuation, about who's selling and who's buying."

"There are a lot of headwinds, I'll say that," Rao adds. "There are more headwinds than tailwinds when you don't do an IPO."

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