Why Did Spotify Do a Direct Public Offering This Week?

In this segment from the MarketFoolery podcast, host Chris Hill and Motley Fool Total Income's Ron Gross discuss the debut of Spotify (SPOT -1.49%) on the U.S. stock market this week.

The company could have done an initial public offering -- and we all know what an IPO is. Instead, it went the direct public offering route. The differences are significant, and some of them speak negatively to the investment thesis of a company that uses the method. Should a Fool buy in?

A full transcript follows the video.

This video was recorded on April 3, 2018.

Chris Hill: We have to start, though, with Spotify, which is going public as we speak. Again, this is a DPO, not an IPO.

Ron Gross: Sure.

Hill: Why are they doing the direct public offering? It seems like the financial upside for them is smaller. Or, do I have that wrong?

Gross: Well, the company gets no money at all, and they don't necessarily need it, so, OK. The reason you would do a DPO instead of an IPO is because it's a shorter process, it's less expensive, there's no dilution because there are no new shares created, you're just selling existing shares, and typically there's no lock-up period, which is a period of time where the shareholders are not allowed to sell shares. Those reasons, I think, are valid.

But then you have to say to yourself, do I want to buy shares in a company where an existing shareholder is selling their stock to me, and they're probably an insider that knows way more about the company than you do? And the company is not raising capital for any type of future growth. So, that's a decision every investor happens to make. I'm on record as saying a company should really only go public if it needs access to capital markets for growth, not because their investment venture capitalists or the insiders need an exit strategy, and this is kind of what that is, so count me as not a fan.

Hill: I was just going to say, safe to say you will not be buying shares of Spotify?

Gross: Right. But there's actual risks to the company, too. In a typical IPO, you kind of know how much capital you're going to raise, because the investment bankers are involved and it's kind of set. You don't know how the stock will trade after the company goes public, but you know how much money you're going to raise. In a DPO, you're not raising money, so it kind of doesn't matter.

It's probably going to be a more volatile stock, at least in the early stages, with a DPO, because again, you don't have the investment bankers looking after the stock in the same way. You probably don't have the same research coverage, certainly don't have the same research coverage from the investment bank or bankers that are taking you public, so the institutional banks are not as interested, let's say. So, there are downsides. But, again, the biggest one for me is that the company is not raising money, it's just that insiders are selling stock.

Hill: I don't want to give Spotify's management any more credit than they necessarily deserve, but I sort of want to assume that they have thought the investment banker piece of this through. I always like to imagine the conversations that happen in the conference rooms, and I have to believe at least one person at Spotify in that conference room when they were debating the strategy said, "Let's be very clear about what's going to happen here. The investment banking community has no incentive whatsoever to be nice to us, even remotely. And, by the way, they probably have incentive to not be nice to us." All that being said, that makes me think that if they have at least thought that piece of it through, maybe they are confident in their business model.

Gross: Perhaps. I think they would be less confident in going this route if they actually needed to raise money in order for their survival or for some great growth opportunity. Since they don't really need to, I think it takes the pressure off, and they can go this disruptive route. The typical investment banking IPO model hasn't changed much in a very long time. Perhaps it is ripe for some sort of disruption, like direct offerings. But, again, it really depends if a company needs to raise capital or insiders are just selling.