This topic was top of the list during the Spring M&A and Governance Forum hosted last month by Freshfields Partner Ethan Klingsberg and Professor Steven Davidoff Solomon of the Berkeley Center for Law and Business. After a discussion – led by Wall Street Journal reporters Maureen Farrell and Eliot Brown, and UC Berkeley Professor Frank Partnoy – of the possible gatekeeper challenges, corporate governance decisions and business model issues that may have contributed to recent withdrawn IPOs, I joined former Spotify CFO Barry McCarthy, Lyft general counsel Kristin Sverchek and Morgan Stanley’s head of technology corporate finance execution Rizvan Dhalla to talk about today’s IPO market and how companies can successfully go public in 2020. We focused on several themes:
- the pitfalls of the IPO pricing process compared to direct listings, solutions to the securities law issues around inclusion of a primary offering alongside a direct listing, and a series of related innovative ideas for reforming lock-ups;
- the significance of different approaches to dual class structures;
- sustainability issues, managing and attracting impact investors; and the outlook for future IPOs by public benefit corporations; and
- how companies emerging from start-up culture should communicate with employees in the lead-up to an IPO, and how to transition this approach as the demands of being a publicly traded company set in.
Direct listings vs traditional IPOs
We began by discussing the relative advantages and disadvantages of traditional IPOs vs direct listings. Barry McCarthy, who pioneered Spotify’s direct listing model together with the company’s advisers Morgan Stanley, explained that the decision to pursue a direct listing was driven by the pricing inefficiencies that had plagued so many of the IPOs that came before Spotify. Many believe the investor education process in a direct listing is far superior, with a large-scale investor day conducted in advance of the listing during which investors can learn about the company, its revenue model and its ambitions for growth. Critically, the company also provides guidance as part of the process.
Another benefit of a direct listing is the fact that existing investors can avoid signing the much-dreaded lock-up agreement, freeing them to trade whenever they believe the price is right. Because investors value this flexibility, we expect there will be a corresponding change in lock-up practices in traditional IPOs. There are already examples of lock-up periods in traditional IPOs dropping below the historically standard 180 days, with investors instead released from the trading restrictions either on a staggered schedule, according to certain price targets or based on the amount of time elapsed since the IPO if certain conditions are met.
Our group also addressed the question of whether only companies with high brand recognition could execute a successful direct listing. While the first test case may be upon us, we were of the view that because of the superior investor education process for conducting a direct listing, including the investor days and the guidance, brand recognition was not in fact a pre-requisite to a successful direct listing.
We further discussed an issue that is currently before the SEC, namely whether the SEC will permit direct listings (which in all prior cases have not included a primary issuance of shares directly by the company) to include a capital raise by the issuer itself. The SEC has recently extended the deadline by which it expects to respond to the NYSE’s proposal for a relevant rule change to March 29, 2020, but has revealed that one of its concerns is the lack of disclosure in a direct listing regarding how many (if any), and at what price, shares are sold by the company. This is key information in a traditional IPO, in which the number of shares expected to be sold and the price range are disclosed on the front cover of the prospectus, with the final share number and price conveyed to investors when their participation in the IPO is confirmed as part of the pricing process.
What does the future hold for dual class structures?
The panel was in overwhelming agreement that dual class structures are not dead, but that recent events underscore the need for sage advice when making changes to the capital structure to provide disparate voting rights. To this end, who gets high vote shares (i.e., just the founder or all pre-IPO investors on a pro rata basis?), the terms and length of the sunset (do the shares flip to low-vote, if at all, after a fixed period of time or based on a price target or after the high vote shares cease to represent a minimum ownership percentage?), the voting ratio and the convertibility features (do the shares automatically convert to low-vote upon sale, death, or other triggers?) are all key features that should be carefully considered by boards and founders alike, ideally with both parties’ interests being represented by sophisticated counsel. In addition, we discussed the need for proper disclosure so that investors understand the motivations behind the dual class structure and what other governance features are in place to protect their interests.
Sustainability, impact investors and public benefit corporations
We then switched to sustainability and ESG, and the importance of these issues to investors. While Spotify is a Sweden-based company that follows heightened ESG and sustainability practices and disclosure obligations, investors in US companies, even in the absence of any regulatory requirements, are also very focused on these issues. Indeed, in recent years, investors as well as employees, customers and other stakeholders have been very vocal about their sustainability and ESG concerns, prompting companies to produce ever more detailed sustainability reports and craft thoughtful engagement and communications strategies to ensure all of their stakeholders understand the company’s position and strategy on these issues.
These issues are of particular importance to investors. Millennials are increasingly demanding that their investable dollars be directed towards impact funds, with estimates putting the assets under management of impact investing at more than $500 billion. This is causing investors to request, and companies to provide, more precise information about what they mean by sustainability, how it is measured and why it matters to the company. And as investors and companies are grappling with these threshold definitional issues, Larry Fink recently released the annual BlackRock letter in which he called on companies to publish disclosure in line with industry-specific Sustainability Accounting Standards Board (SASB) guidelines (or similar data) by the end of the year and disclose climate related risks in line with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations. He also threatened to have BlackRock funds vote against or withhold on directors at companies that fail to demonstrate sufficient progress on sustainability-related disclosures and the practices that underly them. While the SASB and TCFD frameworks certainly have their shortcomings, BlackRock may finally have done what companies have been wanting for years – set the market for which disclosure frameworks companies should follow.
As companies and investors become more sophisticated with respect to their expectations on the sustainability front, companies may find that they are called upon to increasingly fit the square peg of sustainability, corporate purpose and ESG into the round hole of Delaware fiduciary duties. Against this backdrop it is not unreasonable to expect that companies may more seriously consider the benefits of converting to a public benefit corporation (PBC) in Delaware (or its equivalent in other states). Unlike a traditional Delaware corporation in which directors are required to make all decisions in the best interests of the stockholders, the board of a Delaware PBC must perform a tripartite balancing and make decisions that take into account the shareholders, the company’s stated mission and the stakeholders most impacted by the mission. This therefore provides directors with much more latitude to make decisions that are not strictly profit maximizing.
Communications and blackout periods
One of the bedrock principles of start-up companies is the transparency that pervades their culture. From their earliest days, start-ups pride themselves on ensuring that all information is available to all employees as way of fostering collegiality, teamwork and inclusiveness. And while this commitment to the broad sharing of information is admirable, it can pose a unique set of challenges when a company decides to go public, as companies navigate the SEC’s strict rules about what a company can say as it goes through the various phases of the IPO. While a complete lockdown of information is certainly not required, companies need to implement careful processes to manage this issue. And the problem does not disappear once the IPO is completed. To the contrary, insider trading rules prohibit employees from trading in the company’s securities while in possession of material non-public information. If all your employees have access to all your most important information all the time, this will severely limit the windows during which they can trade in the company’s securities. Over time it is not unusual, therefore, to see processes introduced that restrict certain employees’ access to some information to avoid the need to prevent all employees from trading. How best to achieve this result, while maintaining a dynamic and creative culture, needs to be managed carefully.