Why Spotify Needs to Go Public Before July 2

In early 2016, Spotify raised a cool $1 billion in convertible debt, giving it some much-needed cash to help continue expanding its global footprint while improving its service and competing with Apple (AAPL 0.58%) Music, which had launched less than a year prior. The company had long operated at a loss, too, burning nearly $140 million in operating cash flow between 2013 and 2015.

However, that paper had some onerous strings attached.

Spotify CEO Daniel Ek. Image source: Spotify.

A bad deal

Details regarding the terms were reported by The Wall Street Journal at the time, and Spotify's recent F-1 Registration Statement confirms other aspects of the deal. It was structured in a way that pressured Spotify to go public. The longer it waited, the worse the terms were for the company.

If Spotify had gone public within a year, private investment firms TPG and Dragoneer (who led the funding round) would get to convert their notes to equity at a 20% discount of the offering price. If Spotify did not go public within a year, the discount would go up 2.5% every six months. Furthermore, TPG and Dragoneer would be free to sell shares just 90 days after an initial public offering (IPO), much sooner than the standard 180-day lockup period that applies to most early investors, insiders, and employees.

Spotify on iOS. Image source: Spotify.

The notes were issued on April 1, 2016, and carried a 5% interest rate. After two years, this interest rate increases by a full percentage point every six months. Here's how Spotify describes the notes in its filing:

Upon a specified conversion event occurring, the Convertible Notes will convert into ordinary shares at a conversion rate reflecting a conversion price equal to the lesser of a price cap per share or a discount of 20% to the per share price of the Company's ordinary shares. If a specified conversion event has not occurred within twelve months, the discount will increase by 250 basis points and then again, every six months thereafter until a specified conversion event has occurred. A direct listing is not considered a specified conversion event. 

The "conversion event" is that IPO that private investors were hoping for. This also provides some additional insight into why Spotify is pursuing such an unorthodox route to market with a direct listing instead of a traditional IPO, which has been puzzling investors for months. Next month will mark two years since the deal, which would translate into a conversion discount of 25%, all while the interest rate is similarly about to start rapidly escalating.

Saving on investment banking fees is one thing, but avoiding having to convert all that debt into shares at a massive (and increasing) discount is another.

A new deal

TPG and Dragoneer ended up converting some of the bonds into Spotify shares that were subsequently sold to Chinese tech giant Tencent, Recode reported in January. This is all confirmed in the filing: $301 million worth of notes were converted to 4.8 million shares and then sold to Tencent in December 2017. There was a second, unrelated transaction directly with Tencent that month in which Spotify and Tencent exchanged shares as equity investments, and now hold minority stakes in each other.

That same month, Spotify entered into another agreement with bondholders to exchange $110 million of convertibles for 1.75 million shares. In January, Spotify entered into yet another exchange agreement with investors holding the remaining $628 million worth of convertibles for 9.4 million shares. Here's how all of these exchange agreements translate into estimated conversion prices:

Data sources: F-1 and author's calculations.

Generally speaking, a higher conversion price (lower conversion ratio) is better for the issuer (Spotify), because it can then meet the conversion of debt obligations with a fewer number of shares, minimizing the dilution cost.

These estimated conversion prices were negotiated through exchange agreements, but we don't know what conversion price was originally baked into the bonds at inception in 2016 to compare them against. The exchange agreements, on the other hand, are attached to the F-1 (here, here, and here for those of you looking for some light reading). What we can say though is that Spotify's private market share valuation in 2017 skyrocketed from about $50 in February to over $120 in December. As Spotify's value rose, so too did the value of the bonds themselves, as well as the conversion discount.

Discover Weekly is one of Spotify's most popular features. Image source: Spotify.

It's quite possible that once it became clear that Spotify could effectively bypass the burdensome terms of the notes by pursuing a direct listing instead of an IPO, the investors were more willing to settle for new terms in the new exchange agreements. Put another way, the direct listing gave Spotify a much stronger hand at the bargaining table.

Besides, the bondholders are still earning an incredible return on their money.

Rising finance costs

Spotify's soaring private share price also resulted in an accounting cost related to these notes. The value of the notes has also increased dramatically since the underlying stock price has jumped. This upside potential combined with relatively limited risk is one of the key benefits of convertibles to bondholders, after all, and partially why it's a popular investment vehicle for private investors.

Data source: F-1. Chart by author.

These fluctuations in the fair value of the notes make up the bulk of Spotify's finance costs with "any changes in fair value recorded in the statement of operations."

Spotify has less than four months to go public

Following the exchange agreement in January, Spotify has no outstanding debt. It's all been converted to equity, either by exercising the original conversion rights or through negotiated exchange agreements. But there's a kicker. The January exchange agreement, which covers the majority of the debt ($628 million), essentially becomes invalidated if Spotify doesn't go public this summer (emphases added):

Pursuant to the exchange agreement we entered into in January 2018, subject to certain conditions, if we fail to list our ordinary shares on or prior to July 2, 2018, we have agreed to offer to each noteholder the option to unwind the transaction such that we purchase back the ordinary shares that were issued to such noteholder pursuant to the exchange and we will issue such noteholder a new note that is materially identical to its note prior to the exchange.

With the benefit of hindsight, it might be hard to fathom why the company would have felt so vulnerable back then. But remember, it wasn't clear how the competition would unfold. Apple Music was off to a strong start, with 11 million customers trying out the service within just a few months under the initial promotional three-month free trial.

A solid 6.5 million of those customers had converted to paying subscriptions by October 2015. Spotify ended 2015 with 28 million premium subscribers, a user base it had grown over the course of seven years. Apple had nearly a quarter of that in less than six months.

Facing competition from quite literally the richest company on Earth, the Swedish company felt compelled to bolster its war chest for the ensuing battle, agreeing to decidedly unfavorable terms in the process. It seems that Spotify has been trying to extricate itself from that situation in the years since, and there's now light at the end of the tunnel.

But if Spotify doesn't go public by July 2, the majority of that debt goes right back to where it started.