DISRUPTING THE IPO PROCESS: DIRECT LISTING THREAT TO BANKS

Aswath Damodaran

2

Rumblings of Discontent

¨ In the age of disruption, where young companies are challenging the status quo and upending conventional businesses, it was only a matter of time before they turned their attention to the process by which they are taken public.

¨ For decades, the standard operating procedure for a company going public has been to use a banker or a banking syndicate to market itself to public investors at a “guaranteed” price, in return for a sizeable fee. That process has remained surprisingly stable even as the investing world has changed.

¨ In the aftermath of some heavily publicized let downs in the IPO market this year, there is now an active and healthy discussion about how companies should make the transition to being public.

3

Going Public: The Status Quo

4

Going Public: Direct Listing

5

The Banker’s Case for the Status Quo

¨ Timing: Finding an optimal timing window for the public offering.¨ Filing/Offering Details: Navigate disclosure and legal requirements for

going public.¨ Pricing: Estimate a market-clearing price for the stock and help the

company frame its story to public market investos¨ Testing: Test the price out on preferred investor clientele, to check for

enthusiasm, and adjust it accordingly.¨ Selling/Marketing: Use sales teams and investor contacts to expand the

company’s investor base and follow up with a road show to whip up enthusiasm.

¨ Underwriting Guarantee: Set the offering price, with an underwriting guarantee to make up the difference if it crashes and burns.

¨ After-market Support: Go in and out of the market, giving pricing support for your IPOs, in the post market. Also coordinate with equity research reports to get ”good news” about the company out.

6

The Bankers’ Cost: Issuance Costs

7

The Bankers’ Cost: Underpricing

8

The Diminution of Banking Value Added: Part 1¨ No timing skills: No one can really time the market, though some

bankers have been able to smooth talk issuing companies into believing that they can. For the most part, they have been able to get away with it, but when momentum shifts, as it seems to have abruptly in the last few weeks in the IPO market, bankers are exposed since they did not see it coming.

¨ Boilerplate prospectuses: When I wrote my post on the IPO lessons from WeWork, Uber and Peloton, I noted that these three very different companies seem to have the same prospectus writers, with much of the same language being used in the risk sections and business sections.

¨ Mangled Pricing: This should be the strong point for bankers, since their capacity to gauge demand (by talking to investors) and influence supply (by guiding companies on offering size) should give them a leg up on the market, when pricing companies.

9

The WeWork Pricing

10

Mispricing Mistakes?

¨ The first is that bankers are mispricing these companies, using the wrong metrics and a peer group that does not quite fit, not surprising given how unique each of these companies claims to be.

¨ The second is that the bankers are testing out prices with a very biased subset of investors, who may confirm the mistaken pricing.

¨ The third and perhaps most likely explanation is that the desire to keep issuing companies happy is leading bankers to set prices first and worry about their reasonableness afterwards.

11

The Diminution of Banking Value Added: Part 2¨ Ineffective Selling/Marketing: The first is that issuing companies,

through their product or service offerings, have a higher profile than many of the investment banks taking them public. The second is that the 2008 banking crisis has damaged the reputation of bankers as arbiters of the truth, and investors have become more skeptical about their stock pitches.

¨ Empty guarantee: The under pricing of IPOs are under priced dilutes the underwriting guarantee.

¨ What after-market Support? . Bankers are on weaker ground with the companies going public now, as opposed to a decade or two ago. ¤ Buying shares in the after-market becomes more difficult to do for larger

companies because banks don’t have the the capital to be able to pull it off. ¤ The same loss of faith that has corroded the trust in bank selling has also

undercut the effectiveness of investment banks in hyping IPOs and turning out sell side equity research reports.

12

Why change has been slow to come….

¨ Inertia: The strongest force in explaining much of what we see companies do is inertia, where you stick with what's been done in the past, mostly because of laziness.

¨ Fear: The fear that shunning bankers may lead to consequences that can affect their stock prices in the offering and in the periods after, ranging from negative recommendations from equity research analysts to bankers actively talking investors out of buying the stock.

¨ The Blame Game: One of the reasons that companies are so quick to use bankers and consultants to answer questions or take actions that they should be ready to do on their own is that it allows managers and decisions makers to pass the buck, if something goes wrong.

13

End Game for Issuing Companies and Private Investors¨ Choose the IPO path that is right for you: If you are a company with a

higher pricing (in the billions rather than the millions), with a public profile (investors already know what you do) and no instantaneous need for cash, you should do a direct listing. If you are a smaller company and feel that you can still benefit from even the diminished services that bankers offer, you should stay with the conventional IPO listing route.¤ If you choose a banker, remember that your interests do not align with those of the

bankers, be real about what bankers can do for you and negotiate for the best possible fee, but tie it to the quality of pricing.

¤ If you choose the direct listing path, note that the market may not agree with you on what you think your company is worth and not only should you accept and move on, you should recognize that this disagreement will be part of your public market existence for your listing life.

¨ In either case, you should work on a narrative for your company that meets the 3P test, i.e., is it possible? plausible? probable? You are selling a story, but you will also have to deliver on that story. Fairy tales have happy endings only in the Disney version.

14

End Game for Investors

¨ Choose your game: You can play the pricing or the value game. There is nothing inherently more noble about either game, but you should decide what game you came to play and be consistent.

¨ Keep the feedback loop open: Both investors and traders often get locked into positions on IPOs and are loath to revisit their original theses, mostly because they do not want to admit mistakes. With IPOs, where change is the only constant, you have to be willing to listen to people who disagree with you and change your views, if the facts that merit that change.

¨ Spread your bets: The old value investing advice of finding a few good investments and concentrating your portfolio in them can be catastrophic with IPOs. No matter how carefully you do your homework, some of the investments in you make in young companies will blow up and if your portfolio succeeds, it will be because a few big winners carried it.

¨ Stop whining about bankers, VCs and founders: If you lose money on an IPO, the truth is that it may not be your fault or that of any of the players, but the consequence of circumstances out of your control. In the same vein, when you make money on an IPO, recognize that it has much to do with luck as with your stock picking skills.

15

The End Game for Bankers

¨ Get real about what you bring to the IPO table: It behooves bankers then to understand which of the many services that they used to charge for in the old days still provide added value today and to set fees that reflect that value added. This will require revisiting practices that are taken as given, including the 6-7% underwriting fee and the notion that the offer price should be set about 15% below what you think the fair prices should be.

¨ Speak your mind: If one of the reasons that the IPOs this year have struggled has been a widening gap between the private and public markets, bankers can play a useful role in private companies by not only pointing to and explaining the gap, but also in pushing back against private company proposals that they believe will undercut the offering.

¨ Get out of the echo chamber: An increasing number of banks have conceded the IPO market to their West Coast or tech teams, staffed with members who are bankers in name, but entirely Silicon Valley in spirit. It is natural that if you rub shoulders with venture capitalists and founders all day that you relate more to them than to public market investors. I am not suggesting that banks close their West Coast offices, but they need to start putting some distance between their employees and the tech world, partly to regain some of their objectivity.