Each individual is different in what they want from a startup. There can be the typical VC type person, who’s only in it for the potential millions. There’s the visionary type, who’s in it because they believe in the future the startup is crafting. Then, there’s the aristocratic type who’s in it for the fame, and the accompanying prestige, that comes with an association with a successful startup. The road to achieving each of these individual goals is different, as each has its own metric for success, but the de facto comprehensive milestone has long been an exit.
There are many ways of exiting a startup venture, but it mostly boils down to 2 big categories: an acquisition, or an IPO. An acquisition is straight forward; you find a suitable buyer for the business, and sell. This has long been the predominant exit strategy for startups large and small. YouTube, Waze, even Paypal were all acquired by bigger players in the market. Heck, even Google was once considering selling themselves to Yahoo early on. The math, and the legal background for an acquisition exit is rather straight forward. It’s much like buying a house — you judge its value, and you negotiate the final price.
The IPO is where things usually get complicated. And it’s one that a lot of people want to change. TechCrunch had an interesting article earlier this month, proclaiming the death of the IPO. But, don’t let this click-baity title fool you, it’s actually a good read. It’s less a proclamation of the death of IPOs and investment banks, and more an introduction to other options for startups to explore in their pursuit of capital. Definitely worth a read, but the TL;DR version of it is that there are alternatives to the traditional IPO that are showing massive promise. The article mentions 3 in particular: direct listing, ICO, and secondary buyouts.
But before we move on, what, exactly is an IPO?
IPO: The Best Method?
An IPO stands for Initial Public Offering. Essentially, it’s the first time a company’s stocks are available to those who are not, otherwise, accredited investors. If you invest in the stock market via your bank, or your mutual fund, it’s safe to assume your first chance to buy a stock of a company would be through an IPO. What you also need to know, for the purposes of this piece, is that an IPO usually requires the company to issue more stock.
Companies have many ways of going about this, but the most prevalent is to go through an underwriter. An underwriter is a person, or an institution (i.e. an investment bank), who agrees to sell the newly issued stocks of a company, guaranteeing the sales at a price that the two parties are to negotiate by the date of the IPO. Any surplus stock is then bought by the underwriter.
This has long been the most popular way of going public, mainly because going through an underwriter takes on much of the burden of an IPO, namely setting the stock price, and finding buyers for the stocks. It also guarantees a sale at a price, which allows a company to be more certain in its financial road maps.
Going public also has its benefits. It offers investors a way to liquidate their holdings, and relieve themselves of affiliation with a company, in search of new ventures. This means more liquidity in the VC market, which I’ve always been an advocate for. It also allows founders and employees to do the same, which allows them the same liberties in cutting ties with an entity that may no longer reflect their values. Or, conversely, it allows founders to consolidate control via buying up shares in the open market.
But what do the underwriters get in return for this guarantee? A 7% fee. Sometimes 15%. It depends on the company, and the underwriter. But they get compensated. Rather nicely, if I do say so myself. Moreover, they get the reputation boost, which helps in acquiring new business down the road. You can clearly see this in The Wolf of Wall Street, which is a fantastic movie if you’re interested in understanding how the finance industry is structured.
And it’s a great movie to understand just how shady the industry can be.
There’s a fantastic Reuter’s piece that was referenced by TechCrunch briefly, outlining the malignant practices Goldman Sachs carried out as underwriters of IPOs in the ’90s. It’s an interesting insight into just how the industry works, and just how shady their “best practices” can be. You can read it for yourself, but all you need to know is that Goldman Sachs purposefully undervalued the IPO, then crafted deals that garnered them 40% of any profits that institutional investors made off of first day profits, which is to say Goldman made 40% of any jump in the stock price within a 24 hour window of the IPO.
Are these practices common? It’s impossible to know, since these documents are strictly confidential, and are difficult to get a hold of. Are these practices ethical? Probably not. Are they warranted? If you consider the risks associated with underwriting an IPO, then they may be justified. But, considering most companies reaching this state have significant VC backing, perhaps the risks have been overstated. What is obvious is that the traditional IPO may not be such a great deal for VCs, angels, or even the founders. Especially when the alternatives to this process are showing so much promise.
The most direct competitor to the traditional IPO is the direct listing, which is, essentially, a DIY IPO. Unlike the traditional approach, however, the direct listing does not necessitate issuing of new shares. It is simply making the shares already issued liquid by way of public markets. This method is becoming more and more a viable option, with Spotify going public via this method, while the NYSE seeking a policy change from the SEC to allow for direct listings on its index.
Why the sudden move away from traditional IPOs? It might be a part of a larger move away from big finance, especially with more startup founders shying away from an IPO as an exit option. This could be a part of the anti-Wall Street sentiment that’s so prevalent with the startup world, especially because there’s been this stereotype that’s been cast over the industry as a whole. Moreover, with the increase in favorable public opinion concerning Silicon Valley and entrepreneurship as a whole, Wall Street has been depicted more and more as the antagonist in any corporate story.
To be fair, Wall Street has been the antagonist in the greater narrative for the better part of the past century, especially with stories like Enron, and the 2008 recession still clear in many people’s minds. Perhaps the reputation is more deserved than ever.
Which is why this direct listing approach might be catching on. Because it aligns with Silicon Valley’s interests, not Wall Street’s. It prevents dilution, increases liquidity, and, ultimately, it’s cheaper. Of course, if you’re strapped for growth capital, and are looking to raise through an IPO, there’s still no alternative to the traditional IPO. There’s still going to be a market for that. But for companies that are stable in their business, simply looking to make their shares liquid, this might become the de facto IPO method.
You’re probably wondering what on earth an ICO is. As did I. And for those who are familiar with ICOs, you’re probably wondering how this has anything to do with startup fundraising. I’ll get to that in a bit, but let me start off with what an ICO is. ICO stands for initial coin offering. It’s usually reserved for when a new crypto currency is launched, and the operating team behind it is looking to raise funding for the new coin. So what does this have to do with startups?
Simple, you can use it to fundraise.
It’s explored more in depth here in this TechCrunch article, but the gist of it is that you create a crypto currency to act as your equity. Of course, for it to work, you need to somehow integrate it into your business, but other than that, it behaves much the same as shares would in a company. Except for one major difference.
Coins don’t vote.
Investors in your new crypto currency won’t be able to vote in managerial decisions directly, nor will they be entitled to dividends. They’ll simply be investing in the growth of a company, and the trust that the company will raise further rounds via coin offerings. It’s all a bit confusing, much too confusing for me to explain here, but the idea is that you can create a liquid asset out of your company early, while fundraising for an early stage startup.
Benefits to this are obvious — management stays independent of outside stakeholders, while shareholders can enter and exit as they please. What’s more is that there’s a fair market cap people can work off of in valuing the company.
But there are notable downsides. Namely, it’s increased risk for all parties involved. Valuation is the largest of this risk. Because it’s now floating, it’s susceptible to market risks. And, as startups are inherently high risk, this will be reflected in the coin price. This could be difficult for a startup to plan around, as opposed to traditional VC funding, where the capital is rather straight forward.
$100B and Beyond
Softbank seems to be going mad with its $93B Vision Fund. What’s more is that the company is just getting started. With plans to raise bigger rounds at 2-3 year intervals, Softbank may soon set a precedent that large PE firms, like Bain Capital, could soon follow.
What’s interesting is that they’re not set on a single asset class. With investments in Nvidia, and ARM, they seem to be using the investment vehicle to further their cause for Softbank’s core business of connected solutions. But what’s more interesting is its play for Uber.
I described in a previous piece that Softbank and Uber had a deal in place that saw Uber’s valuation fall from its peak at $70B to now just $48B. But the more interesting detail in that deal was that Softbank invested $1.25B at the full $70B valuation, with the rest of the $9B cash infusion being stock purchases from shareholders in a secondary buyout type deal.
This is interesting as it sets a neat precedent for startups, and their investors. Secondary buyouts may become a legitimate method for people to exit ventures, as opposed to being frowned upon as a sign of poor management, or judgement. In essence, Softbank could be the liquidating force for an otherwise illiquid market. That’s not to say Softbank will be the end owner of these enterprises. Softbank has a long, and storied past of making lucrative PE deals, delisting public companies, and listing private ones. Presumably, its role will be one of stabilizing capital, especially for those companies where the investors are pressuring the management for liquidity.
The Death of the IPO?
I understand the use of rather brash wording on the part of TechCrunch. It’s click worthy, and their arguments are rather well thought out. There is a compelling argument to be made for the death of the traditional IPO. But whether it’ll play out that way is another question altogether. There are hurdles to be had for each alternative, and there are benefits to be reaped. It’s probably a battle for public perception at this point.
Out of the three alternatives, the direct listing seems to be the one with the most support at this point, especially considering how much coverage Spotify will bring. It also seems to be the most favorable for founders and VC investors, which will probably help it proliferate.
But, in the end, does it really matter? Liquidity is a good thing for any market, and any option to help out is a positive in my book. So long as the risks and rewards are outlined clearly for potential investors, this should play out to the benefit of startups and VCs. I don’t think we should be debating which is better. I think we should be thankful that there’s disruption in this industry as well.