Introduction

Patrick: [00:00:49] My guest this week is Bill Gurley, general partner at Benchmark capital. Our conversation is about one specific issue that has popped up as a topic of interest in the investment community in recent months. The comparison between bringing a company public through a traditional IPO and what's known as a direct listing. To be clear, this episode is very much in favor of direct listings instead of traditional IPOs. For those that want a good discussion of the IPO process and its upsides, check out episode 173 of the Exponent podcast with Ben Thompson, which I'll link in the show notes. Now, please enjoy my very interesting conversation with Bill Gurley.

The IPO Process and Its Weaknesses

Bill, we're going to tackle a single issue on the podcast, which I think the first time that we've done that and a fun framing for introducing what this issue is, is the Warren Buffet idea that if you're at a poker table and you don't know who the patsy is, you're probably the patsy. Maybe you can begin by describing what the table is, what game is being played and who is the patsy.

Bill: [00:01:41] Yeah. So, I've been spending a lot of time diving deep into how the IPO process works. And I have to give a huge nod to Barry McCarthy, the CFO of Spotify who, years ago, started banging on this drum and highlighting the fact that the kind of core process and the core way we go about pulling off an IPO, that was designed four decades ago. And it hasn't been changed and it hasn't been updated for modern tools, modern algorithms, modern technologies. And as a result of that, it has resulted in what Jay Ritter at the University of Florida calculates as 171 billion of underpricing. And it's my view as someone who's spent the past two decades as a part of Silicon Valley, that Silicon Valley's been this patsy. It's the Silicon Valley companies that are getting the short end of the stick on this IPO process and they're the ones who were basically funding this massive value transfer that happens on the first day of an IPO.

Source: Jay Ritter

Patrick: [00:02:46] Just to put some more context around it, I always think analogies are more helpful, Daryl Morey, of all people, had a really interesting analogy for this. Do you mind sharing that?

Bill: [00:02:53] Yeah. Daryl had ... because he saw me talking about this and he said, "you know I always thought this was strange, you said it'd be like when people celebrate a pop on an IPO, it'd be like a sports team owner or someone that owned an arena selling their tickets and then seeing them pop in the aftermarket and being excited, going, 'Yay, that worked out great for us.'" Henry Blodget has another analogy that relates to this kind of pop thing. He said, "It'd be like selling your house and then waking up the next day and finding out that the broker that sold your house sold it to someone else for 80% higher than you sold it to.... before." How would you feel about that?

Patrick: [00:03:32] Moronic.

Bill: [00:03:33] Yeah. That's correct.

Patrick: [00:03:34] So what we're going to do is go through what the process is today, what the alternative is, what we call direct listing or direct public offering, and why that might be more attractive to founders, employees of early-stage companies, kinda Silicon Valley writ large. To do that we have to first unpack what actually happens in an IPO. Embarrassingly even I, you, and I have been going back and forth about this, even I didn't fully understand all the details behind this. It's one of these like arcane processes that you just sort of take for granted and nobody has really challenged. I think, to lay the groundwork would be to describe what is actually literally happening when a company engages a famous Wall Street firm to help them underwrite the IPO and then brings it public.

Bill: [00:04:13] Yeah. If we could, Patrick, before we dive into that, I want to make one other point, which is the reason that I think this happens and the reason that it's been so systematic and happened over and over and over again, is you have a massive frequency mismatch. And so a Silicon Valley entrepreneur founder and/or CEO is most likely to do one IPO in their lifetime. Well, actually, they have to be really successful and then they get to do one. The number of people that touch two is very rare if I dare. And so if you look at the other people involved in the process, let's just use the big three, the investment in the bank, the buysider mutual fund investor who's buying the IPO, and that founder. These other two parties are doing 20 to 40 a year, versus one in a lifetime. I think that's the primary reason that you have this problem that just keeps repeating itself. In Game Theory, they have this thing called Flow and they look at what happens if you have a game where certain players have way more experience than the other player. And what ends up happening is you have massive anxiety on the under-skilled player. And so I think if you're going to be anxious, you're very likely to fall back on tradition because it's the safest bet. It's like the old IBM ... you know, "You don't get fired for buying an IBM," that's a very old saying, but like it's the same thing were to do what Barry did, to do what Daniel did, to do what Stewart at Slack did, requires an enormous amount of confidence when you recognize this frequency differential.

In Game Theory they have this thing called Flow and they look at what happens if you have a game where certain players have way more experience than the other player. And what ends up happening is you have massive anxiety on the under-skilled player.

Patrick: [00:05:43] We're going to get into all these details. Do you think that we'll look back on this time period as sort of the turning point and 10 years from now we've looked back and think it's just ridiculous that anyone did IPOs? Do you think that that's possible?

Bill: [00:05:53] When we get into the details, I hope that everyone will see that the way the process is run today, an underpricing is tautological. It is exactly what you would expect because the process is so broken. Look, I'm not mad about it, I'm not angry about it, I'm not like, "Oh my god, someone should do penance." But there is a new way that I think makes so much more intellectual sense to anyone with a comp sci degree, anyone with a finance degree. And we should just move on. We should move past this archaic process.

Patrick: [00:06:24] We'll make sure to touch on who this impacts because people listening will want to know, "What does this matter to me? How does this flow down to something that's important to me as an investor or me as a venture capitalist or me as the founder or employee?" We'll try to hit all those angles as we go. Maybe you could begin now to describe literally what happens in the engagement between, say a new company going public and their counterparty.

Bill: [00:06:47] It may not matter to everyone. I think it should matter to people that are investors, it should matter to founders and executives, and it should matter to employees of companies that are about to go public. Those are the people that are impacted. When you start an IPO process, first of all, there are a lot of esoteric details and we may touch on them, or we may not because some of them are so down in the weeds. And everyone of these things has a nice narrative about it as to why it exists and why it's happening. And because you've never been through it before, you've got all these handlers who are telling you, "This'll be okay, this'll be okay, this'll be okay."I've said that it's a bit like a grand southern wedding. They tell you, "Hey, this is a once in a lifetime thing and we're going to pull out all the stops. And you have so many advisors, you have lawyers and bankers, and everybody telling you how to do it. And once again, they have narratives around all the little things as to why this is the right way, that's the right way.

But once you get the S-1 file ton of detail there, once you get your roadshow presentation ready to go and once you get through all the SCC reviews, you get to the point where you're going to go out and talk to investors. This used to be like a three or four-week process that included going to Europe and a whole bunch of other places. They've actually kind of backed down on the number of accounts you meet with, I want to talk about that a bit later, but you get out on the road, it's usually you and your CFO or sometimes there are different combinations of founders but usually the CEO and the CFO. You go visit accounts for 45 or 50 minutes. And you go through the same presentation over and over again. Sometimes you'll do a lunch where they'll be, they’ll invite more accounts. And you give this kind of... it's a PowerPoint presentation. It's not much different from what a founder would've used in a previous, private company raise. And so anyway, after these meetings, the bankers talk to the accounts and they get indications of interest. And these come in with multiple pieces. There's how much are you willing to buy, and at what price? And of course, some people just say that they're not interested. But, am I interested? And at what price? And they write all these things down. And as they write them down and put them in a book, for years they didn't even share that book with the company. And then all the smart founders and CEOs say, "Oh, I got to look at the book."That became a thing, to look at the book. Not to make decisions, but just to look at the book. And so now, in some of the IPOs I've been fortunate enough to be involved in, I've been able to look at the book and here's what happens.

First of all, the highest level of interest you can give is to give a price of market. Market means I'll just take whatever the price is, I want it no matter what. There will be orders in the book at market. You might see hedge fund X, 100 million in the market. And then you might see hedge fund Y, 75 million at $26 a share. And as you get closer and closer to the date, they start telling you that certain accounts are more important than others.I found in the past year or two that that's literally down to like five or 10 accounts. It used to be that you went out and … and I looked up, I just did a quick Google search that said there's 9,000 plus mutual funds in the world. so It's odd that massive sales forces you're supposedly paying for distribution, that there would ever be a discussion that like these five to 10 are important when the whole reason you've hired this bank and this sales force is to promote the concept of the company far and wide and to get as many orders as possible. That's going on, and you're starting to hear that that ...And then the other crazy thing that starts to happen, and we're recording this on the day that I think Datadog's going to price, was probably happening, with that management team, as we speak. They tell him that the ultimate goal is to be 10 to 20 times oversubscribed. This has been common for five or 10 years now. If you were to...and anyone that's involved in an IPO process right now that's talking to their banks and you say, "What should our goal be as we get towards that last week of the roadshow?" And they'll say, "10 to 20 times oversubscribed." Now, that is an exact euphemism for, "We're about to ignore 95% of demand."This is why, I'd say the way the process is run today, a pop or an underpricing event should be so expected. Because if you're going to design the process around being 20 times oversubscribed, that's exactly what's going to happen. And so as you get to the very last day, where they're now deciding where are you going to price and who's going to get the shares, this is the real problem with the traditional IPO, these decisions are all made by hand. And so some humans going to guess that this account's worth more than that account, this account is worth more than that account, this account is worth more than that account, and who should get the shares and what price we should open at. And what I've seen over the past, once again, five years, they've reduced this number of quote, "Important accounts," to like 10, many of whom are already on the cap chart these days because they've started doing private.

And they say, "Oh you got to have this person because they're one of the key anchor accounts that's going to hold the stock for a very long period of time. In the IPO's I've been involved in, the companies that they're telling you that about are the ones with the lowest prices in the book. so In addition to the fact that we're going to shoot for 20 times oversubscribed, we're going to ignore the hedge fund that put in the order for 100 million at market because you have to have this account over here, say at a much lower price, it's at 24, or 22 or whatever. And this conversation, fortunately, being at a venture capital firm, we have a little more frequency than the companies themselves. I've seen it over and over and over again. And I've even been in a situation where the bank says, "If this one account isn't in, we're uncomfortable going forward," literally threatening the whole of the IPO on behalf of a single account, which makes no sense, what you're really out to do is price this IPO optimally. Now, someone might say, "How in the world could it possibly work that way?" And I think you have to keep in mind that there's a variant of economic analysis called the agency problem which a lot of people have probably heard about.

Patrick: [00:13:02] Yeah.

Bill: [00:13:02] They talk a lot about used car sales or real estate sales. There's a variant of that called the Multiple Agency Problem. And in this case you have an agent who has multiple constituents. One of them that does it once in a lifetime and one of them that does it 20 to 40 times a year. And I think you have to understand that they're, because of that conflict, the very likelihood here based on how the process works, and we haven't gotten into this kind of results by underwriters, but we will ... It appears that that's the customer, that the person who's being served by this, what I would call broken process, is the buy side, not the company.

An Analysis of IPO Underpricing

Patrick: [00:13:38] One interesting way to put this in terms that any founder will understand is in cost of capital terms. You and I were talking about this ahead of time, if you could talk about that math and why view it through that lens ...

Bill: [00:13:48] Let's get into some of the numbers. Once again, Jay Ritter, who is known as Mr. IPO-

Patrick: [00:13:53] Mr. IPO, yeah.

Bill: [00:13:54] ... he's a professor at the University of Florida ... which happens to be my alma mater. So Go Gators, but-

Patrick: [00:13:59] Good alignment there.

Bill: [00:14:00] Yeah. First of all, there's a four-decade number, which I mentioned, which is 171 billion, so what is this number? He's looked at all the venture-backed IPOs and looked at the price that the hand allocated, handpicked by the banker and that closed the very next day. I view this as true wealth transfer because it's just a 24 hour holding period. And there's no ... you know we talk about whether or not these accounts are long term holders or not, they have no legal restriction whatsoever on holding or how long they have to hold, they can flip the next day no problem and so it is a value transfer from my point of view. And that's the number that if you look at four decades that’s 171 billion. In the last 18 months that's 12 billion. It's been accelerating lately, and for those people that track IPOs, you've seen the articles in the past six months about the Zooms and whatnot that have just been pop after pop after pop.

Patrick: [00:14:54] Two data points you sent which really stuck out, if you just look at the founders alone, just the founders of Zoom and Elastic, two you know big companies to go public, the deficit, if you will, in the founders' pockets was like $200 million as part of that 12 billion.

Bill: [00:15:09] Yes. Right, and Elastic is a company we're involved in so the numbers are particularly interesting to me. But Zoom was obviously we were recording this podcast on Zoom. There's a very popular company, an exciting company. And so what I call the one big giveaway in the Elastic case was $338 million. That's the difference between had you sold the same amount of shares at the price that's the next day close versus the hand allocated price, you would've had that much more money on the company's balance sheet. You could also say they could've sold that much less equity, in which case all the other shareholders would own that much more of the company so that that money would've been in their hands. In the Zoom case, it was $623 million...And It's just massive. And in Elastic, the handpicked price was 28, first trade was 70. Today it's at 93. In the Zoom case the handpicked price by the bankers is 36, first-day close, 62, today it's at 85. And those if you consider, the company might go up 10X from here, those giveaways over the long run are worth even more.

But yeah, let's dig in beneath it. In the Elastic case ... These companies are owned pretty much by three different people, the founders, the investors, and the employees. And the employees own pretty significant pieces of these companies by the time they reach the IPO price. In Elastic, the investors gave away $126 million, the founders gave away $106 million, but the employees, they missed out on $106 million also. And that's value that would've been in the share of the employee auction holders that was given away on day one to generate this pop. And in Zoom's case, very similar, founders 100 million, investors 342 million ... because investors own 55% of Zoom, and employees missed out on $175 million all because they decided to go with this hand allocated IPO. And I think in both these cases, had they done a direct listing none of that wealth transfer happens. I think what's interesting is these are tech companies, right?

Patrick: [00:17:22] Right.

Bill: [00:17:22] So, I think you could be a university sophomore that's in their second year of comp sci courses and if someone described what you need to do here and said, "Write a program," they would write it like a direct listing. They would never ... no one that's either in finance or comp sci would have come up with this convoluted, archaic scheme. It's just, it's you know very...it's a legacy of history. A lot of the silly things or a lot of the silly details just evolved because they happened once and then got reinforced. It's an algorithmic match. You line up supply, you line up demand and you match the two people that are willing to pay the most with the people that are willing to sell for the least.

Patrick: [00:18:03] Before we dive into why maybe direct listings are simpler and more intuitive, I just want to create like a little block section here for some of the deeper details even of the IPO process which may interest people. And some of these terms like people may not have ever even heard of, for example-

Bill: [00:18:18] Hey, wait. Before we do that I want to mention one other thing that's somewhat controversial and I know causes a lot of anxiety when anyone says it out loud. I'm going to take that risk and cross that bridge. At one point I was having a conversation with Jay Ritter and I said, "Hey, can we talk? Is it possible to run an analysis of this underpricing phenomena by lead left investment bankers?" So, the banker that's in control of the IPO. And he did it very quickly. He has all of this data in a very quick, easy to query database. And he sent me something back and it was fairly shocking. He ran it over 10 years, VC backed IPOs over a 10 year period. And so Hundreds and hundreds of IPOs.

If GM were out buying steel, you'd expect them to get the best price. If Amazon were out buying cardboard, you'd expect them to get the best price. So, why is it that when the best companies in Silicon Valley, the very best, pick the very best banks, they get the worst execution? It's not what you would expect.

And so the average underpricing that's been happening as a result of this process is about 18%. But what he sent me back was fairly shocking. The bank that underpriced the least across 35 IPOs when their lead left was Credit Suisse, but that was 3.3% underpricing, hardly any underpricing at all, and very far away from the average. And the bank at the top, with 111 IPOs is Goldman Sachs at 33.5% underpriced. Now, this is 10 years of data. It's not like we're saying, "Here's one example of it or here's another," it's 10 years, over 100 IPOs. Morgan Stanley second, 29%. And you have this highly variable spread depending on who the lead left banker was. And that was really really surprising to me because I think the general perspective across the investment community is the two very best banks you could choose are Goldman and Morgan. But when it comes to executing on behalf of the company, they give you the worst execution. And that's for me, but it's about trying to understand what's wrong with the system. And this looks like this highlights that there's a broken market inefficiency. If GM were out buying steel, you'd expect them to get the best price. If Amazon were out buying cardboard, you'd expect them to get the best price. So, why is it that when the best companies in Silicon Valley, the very best, pick the very best banks, they get the worst execution? It's not what you would expect.

Source: CNBC

Patrick: [00:20:45] This data is maybe the most interesting in all of this and we didn't talk about this ahead of time but it's just such an interesting topic which is the psychology of all this. If I were to try to describe the job being done, so to speak, to use Clay Christensen's framework, part of this is like a blanket of comfort. You mentioned the anxiety and the game theory that comes with being the least experienced person, and to me, I would think Goldman and Morgan because of their reputation provide the most comfort, that they're going to do a good job.

Bill: [00:21:13] I think that's exactly right, but keep in mind this is before the fees. You had mentioned earlier the cost of capital, if you're paying 33% underpricing plus a 7% fee, you're paying a 40% cost of capital to go public. Now, imagine ... Here's another way to prove it. I already say all bonds priced through algorithmic matching, that's been happening for years. If you were to go execute a shelf registration or a secondary as a CFO, you would look at discount and fee, that's all you would do. You, you wouldn’t be... Because you're already public, you don't have this grand southern wedding coming-out party on your mind.

iI you're paying 33% underpricing plus a 7% fee, you're paying a 40% cost of capital to go public

And you would never, ever think about anything else. You wouldn't be like, "Oh, I need to get the stock in the hands of the right person." You're liquid, you're trading every day, you wouldn't think that way. And it all goes back, I think, to the anxiety and the pageantry that surrounds an IPO. Keep in mind, the minute you're done with this thing and your stock's popping, they put you on a pedestal and they ring a bunch of bells and throw confetti and tell you what a wonderful job you did. And that's the pageantry element of it that exists. And I think it's all to make you feel good about something that you really shouldn't feel that good about.

Source: Jay Riter

Patrick: [00:22:28] And of course everyone's typically showered with money as it is. Like everyone's still doing very well.

Bill: [00:22:32] Yeah, Jay has a theory that he's written about where ... specifically for the founder, probably not as much for the CEO but maybe ... they own so much stock that ... you know and this is the difference from the Henry Blodget real estate story, they own so much stock that maybe they just feel good about the stuff they still have left and don't think about, the stuff they missed out on. But I think you have to go back to the board and the leadership team have a fiduciary duty to shareholders. And just giving away $400 million or $500 million when you don't have to is not what we're supposed to be doing. You have people talk about the pop ... And the press, I got to say, I don't like talking negatively about the press because they're powerful and they might come back after me but the press reinforces this. The press thinks a pop is good and a stock that trades down is bad. There's a huge irony there because the press is also very outspoken about the fact that they think Wall Street is short-term oriented and that owe quarterly earnings and all this stuff. But thinking that a pop is a marketing event is about the most short term oriented decision a manager or CEO/CFO could think because it happens and it's over. And then the rest of your corporate life is based on how the company performs. And the notion that I'll get some lasting benefit by paying $500 million for this marketing event flies in the face of long term thinking. I have a great trivia question which you may know the answer to, but out of Google, Amazon, and Facebook, which of those companies traded below their IPO price?

Patrick: [00:24:15] That's unfair because I do know the answer, it's all of them.

Bill: [00:24:17] It's all of them. And the bigger an IPO is and the more you're raising I think the harder it is to create this artificial pot. And so you end up with better execution. And all of those companies, even though they're the things now, they're the most valuable companies in the world. But they all broke issue. And so the notion that oh my god, you got to have this pop as a marketing event also flies in the face of that data point.

Patrick: [00:24:42] One of the things I've thought about as an analogy too is comparing this to like how an earlier stage founder might choose a venture capital investor where, again, Benchmark being a successful venture capitalist firm maybe get some better access or maybe even better pricing in the eyes of the founder, but because it's the capital is not commoditized, you're getting something of value attached to it. And I think founders would probably say, I certainly would've said Goldman and Morgan provide some equivalent to that, what a great VC might provide attached to its capital in the IPO process.

Bill: [00:25:13] Keep in mind, once again, the IPO is a transaction. It's very quick and then everyone moves on. And another key difference, and I understand the argument you're making from the VC is, our average time from investment to liquidity is 10 years and we join the board and we're in the rumble sheet with you. And that's not what happens here, these people can sell the shares the very next day.

IPOs vs Direct Listing

Patrick: [00:25:37] Let's round out the other couple of things about an IPO relative to direct listing and then we'll describe direct listing and why that might be a better route.

Bill: [00:25:45] Yeah, yeah. There are two things that I would mention, although there are many, many more esoteric details. One of them is the greenshoe. Most people don't know what a greenshoe is. Most people that know what a greenshoe is don't understand the greenshoe. It couldn't be more esoteric. It's named after a company, the Green Shoe company where this first happened. But I'll give it a very quick effort to try and explain. But in every IPO they sell 15% more shares than ... it's called the over-allotment option, and you can read about it in the S-1. They sell 15% more shares than you talk about the entire time you're planning the IPO. And if it pops and goes up, which is what happens the majority of the time because we've talked about these underpricings, you just did a bigger, 15% bigger raise than you were really planning on. And that's what happens most of the time.

To the extent that ...The reason ... No, I'll tell you. To the extent that the stock breaks issue, the bank is then allowed to use the 15% to buy shares underwater and then they cross those out. And in that case, you didn't sell 15% more of the company than you were planning to. And the bank argues that having this extra buying power is for stabilization. Now, one huge, massive irony is that the bank actually gets to keep that profit. And so in the Uber case where we were involved, and the company did break issue, the bankers made over $100 million on the greenshoe alone, double the fee. And so what I have found in, you got to have a lot of experiences to know that what happens, in that case, is, because they get to keep the delta, they're more focused on profit maximization. Trading when they think it's the lowest, rather than getting in there and defending the stock. Because they argue it's for stabilization. The whole word underwriter's funny because years ago, they would guarantee that they would sell it and then they'd go sell it. They were literally putting up their capital -

Patrick: [00:27:44] Taking the risk, yeah.

Bill: [00:27:46] There's no risk taken today. And the only stabilization that's guaranteed is this greenshoe thing that you're funding. The other thing is, I've looked at a number of IPOs and if you compare the greenshoe to the 30-day average, it's like 3% of volume. And so I don't think you're going to defend a company with this thing. One of the great things about the direct listing is it just simplifies so much stuff, but this just goes away. I think it's like an appendage that evolution has outlived that should just go away. The other one that ends up causing a lot of issues is the lockup. And so every company that goes through an IPO is told, "The best thing you can do is have a 180-day lockup on all the investors prior to the IPO." The argument for this is, "Hey, before the people that invested prior to these new investors get rich, let's let this thing trade and prove itself as a company." And some have argued, "Look, these companies are waiting much later to go public, that's kind of unnecessary. But there's a little esoteric thing you should know about the 180-day, we've tried to fight it because it creates this massive anxiety six months after the IPO. We've tried to suggest price based lockups, staggered lockups. We've had some success, but there's quite a bit of pushback from the banks so that you don't have this one day kind of overhang that's just sitting there. And what I found is, in most IPOs, about a week or two after the IPO ... so the data team will find this out a few weeks later ... they start telling you, "Oh my god, you've got this huge problem," which is 180 days from now all the stock's coming on the market, you really need to solve that problem. And I've always been like, "Well, that's a problem you created, you wanted that problem." And the reason they want the problem is because they want to sell the secondary. They want to do this hand allocation, hand pricing game all over again, and often time make more fees on the secondary than primary. And I would say ... I don't know the numbers, I should probably get them, but I would say in 50 or 60% of the cases they get exactly that. And the bankers go around a secondary process and go through everything we've talked about all over again. And those typically go off at about 25% less what the stock was trading at when they were announced.

I've looked at a number of IPOs and if you compare the greenshoe to the 30-day average, it's like 3% of volume. And so I don't think you're going to defend a company with this thing.

Patrick: [00:30:03] Wow.

Bill: [00:30:04] Once again, a discounted, underpriced offering. And people have said to me, "Bill, the real problem out there is that the VCs won't sell and the reason you have float issues in these highly volatile IPOs is because the VCs aren't willing to participate." And I say, I just described you two of the most horrific price optimization techniques you can possibly have. It's no wonder the VCs aren't willing to get into those processes, because they're not efficient. And that's another key benefit of the direct listing. The other problem that the lockup causes is the only people allowed to sell a stock the day after the IPO, in most cases, are the people who were given the stock the night before. You have these extremely low float situations, you have high volatility and so stocks will fly up, you've seen like Beyond Meat. I've seen this in a lot of companies. They just fly up. And then Beyond Meat announced a secondary, came down 25% like I'm talking about, and there's just this high volatility. These buy-side firms are like, "Well, we like these companies but we get a super low allocation on the IPO, and then it's highly volatile, and they find they can't get a position until 18 months after the IPO and once all this kind of silliness is gone on all these restrictions and all this engineering. And I've already seen some data from the Slack situation where because you know you don't have the lockup because you have way more liquidity day one that buy-side firms are able to get positions that are meaningful to them much sooner and-

Patrick: [00:31:37] So-

Bill: [00:31:37] ... you got much, much lower volatility as a result.

Patrick: [00:31:40] All right, now that we've talked so much about the IPO process, let's talk about the alternative. Maybe not that many people will be familiar with what a direct listing actually is and how it contrasts against an IPO, so just describe in simple terms what it is and how it differs.

Bill: [00:31:54] A huge credit to Barry McCarthy for figuring this out and pushing it through with Spotify and, once again, Stewart and the team at Slack for doing it also. But I really wanted to know the answer to that question in detail rather than just at a high level and so I went and spent a bunch of time. And the thing that I discovered that is most kind of amazing and elegant is that the direct listing process leverages technology and human processes that have been in place for years on Wall Street. And what they're riding the back of is the exact same process that's used to open every stock every day. And so on the NYSE, which both of these were listed on, they have direct market makers. And direct market makers are responsible each morning for opening a stock. And so everyday a stock has to start trading, sometimes it's at a different price than the night before. There might've been news that came out or whatever. And someone has to line up the supply and demand and kind of do the first block that then gets the stock trading every day. And that technology is a simple algorithm that matches supply and demand. It's called price-time priority. And you have a whole bunch of people that put in, "I'm willing to sell this stock at this price. I'm willing to sell this much at this price," and you have people in the buy-side say, "I'm willing to buy this much at this price, this much at this price. And you just run a simple algorithm and find out where you have overlap.

When they work on the direct listing because they need to bring everyone into the same place, they'll start that process and then they'll give indications of ranges to people so that they can reiterate on what they're willing to do so that you bring more people together. And both Slack and Spotify, one of them I think they opened with 5% shares outstanding in a block and one with 9. But the way the price-time thing works, so there were two questions I had. I actually spent a bunch of time with Citadel, who was the DMM on both of these. And I had two questions for him, I said, "One, if I put in a trade, whether it's through E*TRADE or Robinhood or whoever, I'm a retail investor and I'm a pay-me above where you guys open this thing, am I filled?" They said, "Absolutely, you are filled."And this is what they mean by price and time. If your price is above the price you clear, that's not happening in a traditional IPO. There's tons of demand that is intentionally ignored. And a lot of its retail, retail is particularly cut out of the IPO process. And the second thing I said to him is, "Does the name on the order matter?" He said, "No, we don't look at it, it's anonymous." Like you don't get credit for having a reputation or, as some people would argue, having an economic relationship with the investment bank. You actually ... what the price time thing means is, if you're a penny above your filial ... if you're at the exact price, whoever had the order in first. And those are the only two constraints, price and who had the order in first. And it matches at one time oversubscribed. You don't intentionally ignore demand in either way. Once again, this is how all bonds are priced. And from a fairness and access standpoint, it's exactly how it should work, this was my point earlier about saying if you were a comp sci student or a finance student, isn't that how you would design it? Why would someone get an unfair advantage at the table when you're talking about an offering?

And I've seen interviews recently with chairman Clayton at SCC, and he talks about fairness and access. And I can't imagine how you could defend the traditional IPO process versus this direct listing process from a fairness in access standpoint. One other thing, if you go do a web search for Daniel Ek in direct listings, so he's the Spotify founder who I think you know, Patrick. There's a three-minute video on why he did it. And why he did it had nothing to do with all the stuff I talked about, I think Barry, the CFO, was focused on those things. His was all about fairness. And one thing that also happens as a direct listing is Spotify put out like 16 hours of video about their company instead of the roadshow presentation. And Daniel did refuse to go do the one on one’s because he didn't want any investor to have an unfair advantage relative to another. And so for him it was all about this fairness in access point.

Source: Morgan Stanley

Patrick: [00:36:23] That point is so interesting because building the book, building demand, which obviously boosts the price, which is in the interest of people selling the shares, is a marketing problem. And to the idea of, in the modern era, probably using platforms like they have to distribute information on the company evenly is just, it's fascinating.

Bill: [00:36:39] And by the way, I said earlier that the banks have lots of narratives around why we do things the old way. And even in this case when direct listings started to get more awareness, several banks said, "Yeah, you can do them if you have a big brand like Spotify but if it's a more esoteric company we have to get out there and meet with the accounts and explain it." I'm thinking to myself, "Do you realize we live in a day of Zoom and YouTube and all of these tools that allow you to disseminate information like broadly?" And why would someone be able to be more disclosive in a 45-minute flyby than in a 16-hour online briefing? It doesn't hold up, it doesn't make sense. And so I can imagine when we get to a day and age where every company's doing a direct listing, that you are going to have ... that even if the banks are resistant, you're going to have content sites, whether it's a Seeking Alpha or ...

Patrick: [00:37:38] Yeah, devoted to exploring these things.

Bill: [00:37:40] Yeah, devoted to exploring these things. And so you're going to have a lot of content, a lot of disclosure, a lot of discussion, way more than you could've ever possibly had with a traditional IPO.

Patrick: [00:37:51] I mean hell, anyone that's listening, I'll do it. Any of those founders that want to talk to me about the company, put it into an hour podcast, sounds great, I just-

Bill: [00:37:58] Well, I'd say the same thing if a small company that people don't know that much about that maybe is only going out at a billion dollars, or even at 500 million, and people are saying you won't get exposure around a direct listing, I'm going to jump on Twitter and I'm going to tell the world about you as well, because we need to move to this better process. You had mentioned about talking to the buy-side, maybe we should go there next.

Patrick: [00:38:21] Yeah, one other question I want to ask before we go there is just to maybe state the non-obvious that there is one key difference which is the actual capital raised by the company. It's quaint that companies used to go public because they needed capital to do stuff, and in many cases now, especially with some of these really successful technology businesses, they actually don't need to dilute themselves to go public. Just talking about that nuance quickly.

Bill: [00:38:44] Yeah, so it's true. In today’s... From a regulatory standpoint, today's direct listing does not allow you to raise capital. Ironically, this is the most capital saturated time I think in the history of Wall Street, in the history of business. And for those that roll around in the venture-backed world, there's big capital everywhere. As a result, a lot of these companies either don't need the capital or they could very easily raise 100 million like in a pre-direct listing convert and then go public and then they do a direct listing and then they could do a secondary thereafter. There are a number of people that I've talked to that are talking to the SCC about adding primary offerings to a direct listing, when I talk to the direct market makers at Citadel or to the NYSE, and I've had those conversations, technically there's no issue. Like it would be super easy to do. And ironically, in the Slack offering, E*TRADE actually raised money on behalf of the employees who had a tax hit on the liquidity event. And to me that looks like a primary raise. And so it may have already happen. So, I don't think there's a technical issue, it's a regulatory issue. And there are a number of people trying to make that happen. I would think, based on this fairness in access point, which I know is important to the SCC, that they would favor getting to that place. It's really just about there being another person at the table on that initial match that has shares for sale, in this case it'd be the company, and so I don't think it's that big a deal.

Privileged Access and Buy-side firms

Patrick: [00:40:17] Circling back to buy-side, any big issue like this, a change in tradition, often requires buy-in from a lot of stakeholders and one of those key stakeholders are buy-side firms. And it sounds like what's happened in recent years is that there's been more and more privileged access to these underpriced IPOs. Talk about any anecdotes that you've encountered with ... maybe with buy-side firms that are big but not big enough to participate in a way they would want to on day one of a pricing.

Bill: [00:40:43] As I said, I found that these investment banks are all focusing on like 10 accounts. And there's over 9,000. And if you're in the 10, you may not like this change because there's been $171 billion of single day wealth transfer and you've been a recipient of that. Some of that money goes back in commissions you have to give back to the bank to stay at the top of that list. You don't get to keep all of it. But obviously, those people are going to push back, and I would expect them to. And once again, I'm not angry about this, I just think it needs to change. For everyone else, I think that the process has metastasized to the point where it's just not working for them. And I've talked to several buy-side holders ... especially, this is super ironic, especially the ones that are very long term holders. I talked to a PM the other day, they have $2 billion under management and they like to have 10 to 12 positions. This is a classic buy and hold shop that wants to develop theses around a handful of companies to know them really well and hold the stock for a long period of time. Based on that math I just told you, they need a $200 million position. This PM told me, on almost every IPO they put in for, they get one and a half to $2 million worth of stuff. They get 1% of the position that they want to spend. And when they complain about it, they're told, "Oh, you're lucky you got that. You're at the top 90%." They got looked back.

And so in a DL, if they have more confidence than anybody else, they can get a $100 million or $200 million fill. They can get a fill with that size. And so it's just dramatically different. And once again, going back, the Slack data shows that companies were able to get into those size ownership positions much, much faster than they were in a traditional IPO process. And it makes sense that you'd be able to. And so for those few select firms who are able to take advantage of this wealth transfer, I think they probably wouldn't like a change, but for the vast majority of firms, and especially the ones that are long term buy and hold, this is a better way to go. I thought about something the other that's super interesting when these banks are running the IPO process and they're telling us, "You have to have this account in." I thought about the fact that what if you leave them out? Even a traditional IPO, if you have 20X oversubscribed at 30, why would you price at 24 to get this one person in? Because if you leave them out and they truly believe in the 24, you've left like potential energy out there and support, that's true stabilization support by leaving them out. They want to buy at 24. And so, the whole thing's just nutty. And once again, I just don't think the narrative makes any sense.

Patrick: [00:43:31] What do you think the path to making this change happen is? Is something regulatory? Is just reps just getting prominent firms to do direct listing? What do you think?

Bill: [00:43:41] I do think it's reps. I really do think it's reps, for all the reasons we talked about there's an anxiety about going first. There's an anxiety about, "Oh, this is my company's one time through, it's that grand Southern wedding, and I don't want anything to go wrong." The easiest way to avoid that is to pay the 40% cost to capital and get in line and do exactly what everybody else did. And in this Financial Times piece, Mike Moritz at Sequoia said the thing that separates companies from doing direct listing are intelligence and courage. And I think you need both. I don't dismiss how hard that might be to have that intelligence and courage, the courage primarily. Because the intelligence part I think, it’s anyone that listens through this, once again, I think it's fairly tautological but the courage piece is harder. And it's no different from most founders in the Valley of Red crossing the chasm. Right?

Patrick: [00:44:37] Right.

Bill: [00:44:37] You got the innovators and then the early adopters. It's those people that we need to step up and move through. And I'm already aware and I don't want to expose any names, but I'm already aware of very high profile, highly intelligent, highly courageous founders who are excited about going this direction.

Patrick: [00:44:56] One thing we haven't talked about is just why you got so interested. Like what specifically, apart from maybe the obvious that you're an owner of some of these businesses as an investor, are there any other reasons that you've become so passionate about this?

Bill: [00:45:08] Yeah. I mean obviously, our firm has a financial interest and investors are one of the ones that's cut out of this or that pays for the wealth transfer. I think there's two other components. I mean, one having been a successful and fortunate investor in Silicon Valley for a couple of decades now, I don't like the constituency that I spend the most time with being taken advantage of. And I would love, as part of my legacy and giving back to the Silicon Valley community to help create this change that makes this go away. I also, as someone that spends a lot time thinking about investing, I find it intellectually offensive. And you're someone that thinks about investing. And our friend Mike Mowensten is someone ... there are lots of people that go around thinking about ...And there's a desire to want the world to work in a way that's intellectually coherent. And this isn't that. And the fact that there is this new place, this new path to go to to get beyond this problem ... And once again, I'm not angry, I'm not looking to blame, I'm not looking to kind of get retribution, I'd just like us to get to a better place.

Patrick: [00:46:18] Yeah. It's been a fascinating zoom in on sort of an esoteric topic but one that obviously is celebrated often and taken for granted. Thanks for the exploration and the time.

Bill: [00:46:29] No worries. Take care, Patrick.

Created by @ekmokaya