Road To Where? What Spotify’s Direct Listing IPO Means

Jenny Kane/AP
– Spotify

The Great Green Hope is going public. Spotify, the world’s largest music streaming company and a key driver in the global record business’ recovery, has decided it will trade on the New York Stock Exchange.  

The decision to trade publicly answers two questions that have persisted for years: would Spotify be acquired or will it go public?

There seemed to be no ground in between. A stock offering would give early employees and investors a much-needed exit.

But many suitors would love to have Spotify’s 150 million monthly users. This won’t be a typical stock offering, though. Spotify will do a direct listing, a route to the public market that diverts the large, institutional banks that normally buy initial public offerings and turn to sell shares on the public market. It’s a risky move.

The IPO process allows a company to set an IPO price based on feedback from banks. Spotify will have fewer and weaker signals to inform the initial price. But there are benefits. A public listing requires less paperwork and is faster from start to finish. Plus, selling directly to the public avoids the seven-percent fee charged by underwriting banks.

Companies tend to use IPOs to raise capital to fund future growth. Netflix’s IPO raised $82.5 million in 2002 when it was still only a DVD subscription business. Pandora’s 2011 IPO raised $235 million. But Spotify isn’t selling its shares to raise funds for itself.

(By not selling shares, Spotify will depend on the roughly 1.5 billion euros in liquid assets on its balance sheet on December 31, 2017.) Instead, the direct listing will allow shareholders to cash out and capture the unrealized value Early employees, venture capital firms, private equity firms, and record labels—they collectively own 18 percent of the company—want a return on their investments.

A rush for the door could bring harm, however. There won’t be a waiting period to limit shareholders from selling on the open market. The share price could decline if shareholders flood the market simultaneously. An exception, Chinese social media company Tencent, will hold its shares for three years. Prospective buyers might wonder what they’ll get out of their investments. Unlike the typical shareholder-corporation dynamic, Spotify shareholders could have little say in running the company.

Wall Street (Robert Linder)
– Wall Street

Co-founders Daniel Ek and Martin Lorentzon own directly or indirectly 37.3 percent and 43.1 percent of voting power of outstanding voting securities. Each share gives the owner a “beneficiary certificate” that grants voting rights (but has no economic value). As a result, Ek and Lorentzon will have over 80 percent of voting power. The filing is clear about the implications: “[I]f our founders act together, they will have control over the outcome of substantially all matters submitted to our shareholders for approval, including the election of directors.”

The founders are also insulated from outside threats. Beneficiary certificates can be canceled if they’re sold or transferred, making a takeover “difficult or expensive” for an outside party. The certificates can also become worthless if the number of shares owned by Ek and Lorentzon falls below a specified amount. In other words, unless the board — where Ek and Lorentzon are board members — approves an acquisition, Ek and Lorentzon can, if they act together, “have total control over the outcome of substantially all matters submitted to shareholders-including the election of directors.”

Spotify describes its business model as a momentum-building sequence of events: give it for free, offer a reduced price, improve features, keep people engaged, reduce churn, gain subscribers, and grow revenue. The ad-supported service is meant to funnel listeners to the premium service; the company says free listening drove 60 percent of subscriber gain since February 2014. Discounts and trials have also been net-positive, the company says.

Bi-annual trial programs — three months free, 60 days free, three months for 99 cents — drove 20 percent of subscriber growth in 2017. Other factors play into subscriber growth: greater engagement and discounted plans are beneficial because they reduce churn, the company says.

The model has created the world’s largest audio streaming company (YouTube is in a different category). At the end of 2017, Spotify had 71 million subscribers and 159 million monthly users of its ad-supported tier. (Apple announced Feb. 5 its Apple Music streaming service had 36 million subscribers globally.

Apple Music does not have an ad-supported version.) North America had 22 million subscribers and 30 million ad-supported listeners per month. Europe is Spotify’s largest region with 28 million subscribers and 31 million ad-supported listeners per month. Revenue grew 39 percent to 4.1 billion Euros.

Size doesn’t mean profitability, however. Spotify’s operating loss was 378 million Euros in 2017 while net loss before tax was 1.2 billion. But size does have advantages.

Last year, Spotify’s renegotiated licensing contracts with record labels helped ease the cost of revenues from 87 percent to 79 percent of revenue. The resulting improvement in gross income (revenue minus cost of revenue) exceeded the growth in operating expenses. In other words, Spotify’s operating loss deepened a slight 8 percent while revenue grew 39 percent and royalties eased their strain on profitability.

Spotify has bold ambitions that reflect its race to build a vast, scalable streaming service. CEO and chairman Ek explains his wishes in a note included in the prospectus. He wants to “democratize the industry” and provide artists “a fair and open market” (lack of transparency is a hot topic).

He wishes to allow artists “to break free from their medium’s constraints.” Ek also wants to create an experience that allows listeners to “empathize with each other and to feel part of a greater whole.” The question is whether Spotify is on the path to music Nirvana, a road to nowhere, or a highway to hell.