Spotify Stock: The Pros and Cons of the Company Going Public

This originally appeared on Quora. Answered by Jeremy Arnold.

Let's start with a layman's summary of what Spotify is doing here.

The normal path for a startup "going public" involves an Initial Public Offering, or IPO. It's a formal process that typically takes around half a year. You might consider it the equivalent of offering up an art collection for inspection prior to auction. Experts poke and prod and come up with recommended pricing. The underwriter (auction house) then leads the sale, offering the seller some guarantees regarding minimum expected revenues. The only people who can bid are those qualified to be in the room (though they can turn around and re-sell their purchases on the public market immediately after, if they so choose).

spotify logo
Spotify was set to head to the United States stock exchange Tuesday. Emmanuel Dunand/Getty Images

The process being used here is a Direct Public Offering (DPO). They're normally reserved for smaller companies and non-profits. You might call it the eBay option. The shares are offered up for anyone with a stock trading account to buy with little in the way of guarantees or guidance (buyers get the equivalent of minimal fraud protection, but no official recommendations re: fair pricing).

The upsides to Spotify:

  • Preparing for a normal IPO is a long process. And it so happens that Spotify's debt deal reportedly includes a rider that pushes up their interest rate by 1% every six months until they go public.
  • A normal IPO is incredibly expensive ($50-100m for a tech startup this size). This route is expected to cost Spotify only $30m or so.
  • An normal IPO is predicated on issuing new shares. This dilutes the value of every existing share. In a DPO, the only shares being sold are existing shares owned by employees and early investors.
  • A normal IPO requires something called a lockup period, wherein those who own shares at the time of the IPO agree not to sell them for 90-180 days. A DPO has no such requirement. All but one shareholder (Tencent, who owns around 7.5% of the company) will be able to sell immediately.

The downsides:

  • A normal IPO produces a tight price-range with strong guarantees if a market doesn't emerge. This lets the startup be sure of raising at least $x in capital. With a DPO, there's no way of knowing how many shares will sell, or at which price. (Private sales of Spotify shares have swung from < $60 to > $130 over the past 9 months. That's a huge variation.)
  • A normal IPO is shopped to institutional investors looking to hold for at least the mid-term (6-18 months). This creates some price stability. With a DPO, half the shares might end up going to short-sellers looking to bet against your success. You cede all control and assume all risk.

Untangling the decision:

  • I suspect that Snap's infamous IPO last year played a role here. They pushed back against normal expectations, giving up zero voting shares and very little insight on growth plans. They still over-subscribed by 10x (meaning there were 10 bids for every share offered). As I've written about elsewhere, there's a real opportunity crisis in finance. Those with cash are struggling to find good returns. Tech IPOs (rightly or wrongly) are still viewed as ideal vehicles for return. This is Spotify taking that "well, if they're all going to buy anyway…" logic a step further than Snap.
  • Spotify's two founders own almost 40% of the company. In the event that they're feeling at all queasy about the company's prospects of ever turning a profit, this lets them cash out some of their equity before having to release more negative earnings reports.
  • It seems more probable than not that Spotify is an unsustainable business. Despite their enviable market position (2x paying customers vs. Apple and 4.5x vs. Amazon), losses in 2017 were still $462 million (on $5 billion or so in revenue). At this point, they either have to negotiate their royalties down from a monopolistic position (difficult when you have competitors like Apple and Amazon) or take the Netflix path and shift users to original content (difficult when you have competitors like Apple and Amazon and approximately 1,038,947 independent podcasts).

All in all, this strikes me as a shrewd move by two founders who see the writing on the wall. They're giving up next to nothing for the option to buy some safety insurance on the cheap, premised on their faith that an irrational market hungry for tech listings won't call their bluff.

PS - There's been some talk that avoiding an IPO is Spotify's sneaky way of voiding an creditor option (they sold convertible notes that turn into shares upon an IPO — if an IPO never happens, do those notes ever convert?). It doesn't seem likely that this is true, but it seemed worth mentioning as a footnote.

Spotify Stock: The Pros and Cons of the Company Going Public | Opinion