It is no surprise that after reaching a certain threshold, companies go public for several reasons. Investment banks play a crucial role in the process, form a syndicate in case a large IPO. They provide advisory and underwriting services. They look at the data, exercise due diligence and come up with a valuation in line with the management and the business plan. It is not different from the acquisition of a private company. Then, (equity) underwriting process begins. Banks buy shares at a determined price and sell to their network. Generally, they charge fees 1.5% to 7% dependent on the size. Considering a 20 billion USD IPO, investment banks collect 300 million USD for the services they provide. Because some say it is moronic to pay those fees, we can dig up further and compare two alternatives.
DPOs are far cheaper as a company does not pay underwriting fees. However, please remember that IBs still take part in the advisory part. For example, Spotify hired Morgan Stanley for advisory. However, they got rid of the huge underwriting fees. For example, Uber paid 106 million USD to its underwriters, while Spotify gave about 32 million USD to its financial advisers. Surely, bankers use the money to reach investors and understand their willingness to pay — roadshows — before listing. Since Spotify is well-known all around the world, the management probably did not need to present the company disclosing its full financials during those roadshows.
Bankers usually define the price of the stock at a discount to attract investors and keep the liquidity high in a conventional IPO. As a rule of thumb, stock prices go up on the first day. However, sometimes it goes up to 50% higher than the starting price. It means that shareholders miss a great chance and leave too much on the table. Therefore, the valuation, which investment banks define and the management approves has the utmost importance. Because that’s the price bankers market the securities. Conversely, in DPOs market forces define the price.
IPO is a tool for raising capital. The company with the help of the investment bank issues new shares and sells it to the public. DPOs do not enable companies to raise capital. Previous shareholders sell their stock to the public. Although it seems counterintuitive for companies going public, it was the case for Spotify. Spotify closed a funding three months before the IPO. Therefore, it has all the money they needed. Therefore, investors should believe the growth trajectory if they invest in DPO. Although it seems DPO is the favourable option, please keep in mind that DPOs can have the first day crashes.
Companies usually distribute the employee stock option plans to attract the top talent. Considering the size of the company, even thousands can have those plans. After years of employment, IPOs are a good way to turn those years into cash. Yes, and no. Yes, you can sell your stock in the public market. But you cannot do it right after the IPO. The employees must keep those stocks for a decided period — 1 year, mostly. It helps to stabilise the first day and later pricing. However, in DPOs, employees may sell their stocks when they want, despite the possibility of creating volatility. Spotify should have trusted that employees still see growth potential in the company and they do not sell all their stocks right away.
Traditional IPOs provide stability and liquidity that are both important but they charge for that service. They do. On the other hand, DPOs are more adventurous method betting higher. Does DPO make sense? Yes. Is it the future of going public? Not likely. I assume that other companies continue to try DPOs but I think DPOs are suitable for a few. Spotify was a B2C business and had a huge brand name. Millions of people used it every day, and it did not need to market its name. Besides, it did not have to raise money closing a funding round a few months prior. Therefore, it had a somewhat unique path to going public. The management trusted investors to value the company higher and higher without marketing the company — providing financial documents, management plans, etc. Consider an American B2B food company produces crackers and sells to grocery retailers (supermarkets, etc.). It would have a different trajectory and possibly need the help of investment bankers for underwriting and roadshows. European and Asian investors would know little and see all the financial data, growth story, business plans, etc. A DPO would be a disaster for that hypothetical company. To sum up, DPOs will still be a less likely option for companies going public. Companies that have certain treats like Spotify could exercise but need to be ready for 40% valuation losses.
