Inside Spotify's Unconventional – And Risky – Stock Debut

SMITH BRAIN TRUST – What’s the big deal about Spotify’s unconventional IPO? The music-streaming giant is set to come to market next without the help of some big investment bank. It’s a known brand, and it’s shown growth in its niche. So, why are investors so jittery about this initial public offering?

The Smith School’s David Kass says it comes down to risk. And with Spotify’s IPO, he says, “There is an enormous amount of risk and volatility implied.”

The Stockholm-based Spotify is shaking up the financial world with a so-called direct listing, turning up its nose at traditional IPO conventions that brought other tech innovators like Facebook, Amazon and Netflix to the public market. And while the music-streaming giant’s direct-to-market approach is drawing some praise for its democratic approach, the initial public offering does come with some additional risks, says Kass, a clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business.

Kass says it’s not surprising that Spotify is doing things a little different with its IPO – it’s a disruptor by its very nature. And it’s not unheard-of for the tech sector to flout IPO conventions in some way.

Google did so – with a Dutch auction IPO in 2004 that bypassed underwriters. Kass teaches this example in his IPO class – how, in a Dutch auction, bids start at a high price and continue at lower prices until they reach a price where all of the shares available have been bid for at this price or higher.  All of the IPO shares are then sold at this price. Flower auctions in the Netherlands function in the same way, says Kass. It’s serious business there.

By bypassing the underwriters, both Spotify and Google democratized their debut sales, accepting bids from major institutional investors and individual investors alike. In the underwriting process, investment bankers typically will arrange to sell first to their best customers including pension funds and large investment managers who buy up tens of thousands of shares at a time.

“With Google, and now with Spotify, the little guy can bid alongside the big boys,” Kass says. “And they will pay the same price, at the same time, whether they are buying 10 shares or 40,000 shares.”

Kass admits he likes the democratized aspect of the move. “It means that everyone who buys in receives the same opening price”  he says. But the approach won’t be for all investors.

The lack of underwriting could deter managers of large pension funds and other institutional investors, Kass says. “They will understand the risk and volatility implied by this arrangement,” he says. “I expect that the shares will be bought up by younger investors, maybe millennials, who might not know what the stock is worth.”

The company itself is not yet profitable. Even though its revenue is growing rapidly, its losses are too. For 2017, Spotify had roughly $5 billion in revenue and $1.5 billion in losses, for a profit margin of minus 30 percent. “The company is selling memberships, but not enough to keep up with their costs,” says Kass.

For its IPO, Spotify has retained financial advisers, but it’s foregoing many of the traditional underwriting services those investment banks like Goldman Sachs or Morgan Stanley typically provide.

For example, it won’t have the ritual pre-IPO roadshow. This is the weeks-long event, in which investment bankers fan out around the world to visit institutional investors – hedge funds, pension funds and the like – to promote the company’s initial offering and to gauge buying interest. The roadshow helps drive interest among big-money investors, and helps the underwriters determine a likely opening price per share.

That’s one thing that may put potential investors on edge – that feeling that the price is being set without that broader gauge, Kass says.

The underwriting services don’t come cheap, of course. The investment banks charge a fee, typically between 3 percent and 5 percent, depending on the level of risk that is assumed to be associated with the IPO. For Spotify’s IPO, the financial advisers are being paid a fee, said to be around $35 million.

And, after the IPO, Spotify won’t have underwriters working to stabilize the price of the nascent shares for a period of time. That’s one of the key functions that underwriters perform as part of its portfolio of IPO services.

“After an IPO, a stock will fluctuate in price,” Kass explains, “and the underwriters will often agree to go in and buy shares if the price falls below a certain level, to stabilize it for a period of time.”

Nor will it have underwriters to impose a lockup period after the public offering. The traditional lockup period bans insiders who already own from selling their shares for a number of months, often six. “This helps align the interests of insiders with new stockholders at least for that set time,” says Kass.

That’s part of what has investors feeling nervous about Spotify’s IPO – the fact that there’s not a major investment bank putting a floor below the share price. They’ve seen how tech stocks, even well-established, well-known unicorns like Spotify, can be volatile. Just look at Blue Apron, or Snapchat.

But then the tech sector has always been a game of thrones. Some 95 percent of technology startups fail, after all, Kass notes.

Kass says he’s heard a lot of excitement among his students for the Spotify IPO. They’re bringing it up in class during his pre-lecture current events discussion time. “People in their 20s and 30s, people who were enthusiastic about Snapchat’s IPO and who use Spotify, they’re excited for this debut,” he says.

He anticipates that Spotify will follow an even more volatile path than the one that SNAP has coursed. “It might open at a certain price and rise sharply, but if it suddenly goes down,” he cautions, “there’s no floor.”

Spotify is not raising new capital with this IPO. Instead, it is permitting its current owners to sell some of their shares and establish liquidity for them.

Spotify plans for its shares to start trading April 3 and will provide financial guidance on March 26.