Bill Gurley is the picture of the folksy, laid-back Silicon Valley vet who’s a natural at mentoring the whiz kids of tech as he lounges in his Bay Area backyard. We’re speaking via Zoom late on a Tuesday afternoon, and Gurley, attired in a maroon Nike T-shirt and baseball cap, is recalling the moment that set him on a mission to fix the broken system for taking young companies public. “It was when we were planning the offering for [software provider] Elastic,” recalls the venture capitalist at Benchmark who backed Uber, Zillow, and Stitch Fix. “We suddenly realized that the investment banks were way underpricing the shares, and that the market cap would jump by $70 [million] to $80 million the first day.”
Gurley was appalled that the banks were going to deliver their prized customers gigantic instant gains at the expense of owners, including Benchmark’s investors. The partners held an emergency meeting and settled on a way to avoid surrendering all that “free money” to Wall Street: They requested that the investment bankers allow Benchmark itself to purchase a chunk of the new shares at the bargain price. That way, if the price bounced as they expected the first day, those original Benchmark investors who’d been funding Elastic for years would pocket the gains.
“That’s how far off the price was,” says Gurley. “But would you believe it, the bankers turned us down. They refused to give us a position so they could reserve more for the mutual and hedge funds that pay them big commissions. It was then that I realized we were the patsies.” As it turned out, the stock rocketed 94% on opening day, so that gains of over $200 million went to the underwriters’ clients, not to original investors like Benchmark, or into the company’s coffers.
It was also the turning point that transformed the lanky legend into the venture capital world’s leading crusader for a new platform for public offerings. “I already knew the system was bad and was a big fan of auctions that prevented investment banks from underpricing shares,” he says. “But the Elastic experience convinced me to fight for change.” Gurley asserts that any fair process for selling shares in IPOs, or all stocks, bonds, or commodities for that matter, most provide two essentials: prices established by the market, and access to all investors seeking to partake in the sale.
The system that has reigned for many decades fails on both counts. First, prices are set not by buyers and sellers bidding freely, but by the investment banks leading the offerings. “The banks want every deal to be oversubscribed 30 to 1 when they presell the offering, meaning that just 3% of the investors who want to own shares get to buy them,” says Gurley. The banks create all that extra demand by setting the price well below where they, and the institutions they’re selling to, think it will open the first day. All the funds denied allocations in the underwriting phase, along with hordes of retail investors, pile in at the opening, sparking those famous “pops.”
“I hate pops,” says Gurley. “You keep hearing from the investment banks that pops are a good thing, that they’re a marketing event, and the business press keeps praising the big run-ups. That’s ridiculous. The pops are just a sign that the shares were way underpriced.” It’s a mystery, he observes, why owners would trade hundreds in millions in extra funds in the treasury for a photo op on at their stock’s debut on NASDAQ, or the privilege of ringing the opening bell at the NYSE.
As for marketing, he notes that every $20 million left on the table could buy four Super Bowl ads. The old incentive of trading a low price for a pledge of favorable coverage by the banks’ all-star analysts is long gone, says Gurley. The so-called “Sptizer Rule” established in 2003 by then New York State Attorney General Eliot Spitzer establishes a wall between the two camps. “An investment banker needs a lawyer on the line even to talk to an analyst,” says Gurley. Newly-public companies now pursue their own relationships with the analysts, he says, that are completely outside the their ties to the investment banks.
Gurley also notes that pops are biggest when the most prestigious investment banks are leading the deals. In a presentation at a conference on reforming IPOs he sponsored in October, Gurley cited that over the past 10 years, when Goldman Sachs is head underwriter, prices spiked 33.5% on average during open day trading, and Morgan Stanley ranked second, scoring jumps of 29.2%.
Wall Streeters frequently argue that the top investment banks secure the biggest pops because they get to take the best companies public. The idea is that the higher the quality of the company going public—and the Goldmans and Morgan Stanleys get the cream—the bigger the run-up. To Gurley, that explanation rates as surreal. “The pop is a cost of going public,” he says. “Where else do you find that the highest-quality customers pay the biggest fees? Do real estate agents charge the highest commissions on the most expensive houses? Or the highest-rated bonds pay the highest yields?” He also rejects the notion that having a top name lead the offering conveys a lasting emblem of prestige. That Deutsche Morgan Grenfell, not Goldman or Morgan Stanley, led Amazon’s 1997 IPO did nothing to harm its prospects. “After the offering, nobody even remembers what investment bank led the IPO,” says Gurley.
Second, investment banks deny access to all but a tiny sliver of investors seeking to purchase shares in a given IPO. “The underwriters seek to get 90% of their top clients to subscribe,” says Gurley. “They reserve 65% to 70% of the shares for their 10 to 15 biggest accounts.” The rest goes to 50 smaller money manager clients. Once again, even those chosen few get only 3% of the shares they want. And neither America’s other 9,000 funds, nor retail investors, typically get anything. “The banks intentionally ignore the vast majority of the demand,” says Gurley. It’s those 10 to 15 top most prized accounts, he says, that drive the pricing. During the underwriting process, those big funds are the lowest bidders, and to please them, the investment banks set the offering price near what they want to pay. That number is often far below where the price would settle in an open auction.
What determines which customers get the best treatment (or “which fat cats get the rich milk,” as a founder of a startup that became one of 1999’s biggest IPOs once told me?). The most generous allocations go to mutual and hedge funds that do their stock, bond, and commodity trading at the investment banks and pay the largest commissions. “The funds repay the banks for putting them into underpriced IPOs by paying commissions, or ‘soft dollars,’ far in excess of the costs of executing the stock or bond trades,” says Jay Ritter, a finance professor at the University of Florida who’s the leading academic expert on the workings of public offerings.
For Gurley, the quest for reform is especially urgent right now because of a fresh flare-up in underpricing. Highlighting the trend are four deals in the first two weeks of June that left the staggering total of $1.7 billion “on the table.” The extent of lowballing, and the billions investors and managers sacrificed, recalls Wall Street’s feast during the tech bubble. “The stock market has been hot, which led to more IPOs,” he says. “But a hot market also leads to bigger pops, which made the IPO market great again for the investment banks.”
It’s important to put the costs heaped on these new offerings in perspective. The peak of IPO abuse came in 1999 and 2000, when Wall Street bestowed $30 billion and $37 billion respectively in quick profits, chiefly by underpricing tech crowd-pleasers. Based on dollar value of all the deals in those two years, the IPOs delivered average gains of 50% on their first days of trading. The volume of new offerings, and the depth of the discounts the bankers provided, shrank substantially after the frenzy ended. In 2016, for example, the U.S. saw only 75 IPOs, and total first-day jumps of merely $1.8 billion.
Starting in 2018, the raging bull market recharged new offerings, and last year 112 recruits debuted, raising $54 billion, the biggest haul in two decades. The amount they sacrificed in debut spikes totaled $7 billion. That means Wall Street sold their shares at what amounted to a 17% markdown—costly to be sure, but way below Wall Street’s 50% take during the tech bubble.
This year, huge pops returned in force. From June 2 to June 8, Wall Street hosted four big IPOs, and all of them took scored double- or triple-digit sendoffs. ZoomInfo jumped 61%, Warner Music 31%, Shift4 Payments 46%, and Vroom 118%. All told, the big four raised $2.94 billion, and yet the shares they sold were worth $4.63 billion at the end of close of their first day as public companies. Hence, it “cost” $1.7 billion, or 63 cents for every dollar raised in forgone funds that could have gone to paying down debt or growing the business.
Prior to that quartet of back-to-back offerings, 41 IPOs launched in 2020, and of those, another 19 popped in a big way. Those earlier offerings got an even worse deal, raising $3.324 billion, and leaving $3.1 billion on the table, for a bite of 93 cents for every dollar collected. All together, through mid-June, U.S. companies have harvested $6.3 billion and effectively handed $4.8 billion in instant profits, equivalent to 76% of the dollars raised, to funds favored by the underwriters. “The U.S. is on pace for the largest amounts left on the table since the craze of 2000,” says Ritter.
The 76% hit from underpricing isn’t the sole cost to new issuers. The investment banks typically charge around 5% of the amount raised in underwriting fees. That raises Wall Street’s total toll by around $300 million, to $5.1 billion. This year, the 19 companies experiencing underpricing, accounting for most of the big IPOs, are effectively paying 80 cents for every dollar raised.
A better way to go public?
For Ritter, the jump in the number of underpriced IPOs, and the return of gigantic pops, probably doesn’t signal the Wall Street has suddenly regained the kind of power it exercised in the tech bubble. Rather, he cites a two special factors at work this year. The first is the high proportion of biopharma offerings. Through mid-June, fifteen of the nineteen deals showing the biggest one-day gains are developing advanced therapeutics or providing software for drug discovery, among them oncology specialists Black Diamond, ADC and Revolution Medicines.
“Biotech deals are extremely hard to price because in many cases the therapies could either fail in trials or become blockbusters,” says Ritter. “So given their riskiness, it’s easier for the bankers to push for lower prices in the underwriting.” Second, for the offerings that took off on opening day during the first two weeks in June, the bankers began negotiations when the market were reeling months earlier. “The bankers are good at managing expectations,” says Ritter. “By talking about a low price in a down market, they can anchor the client’s view of a fair price for going public.” When stocks rebound, as they did in May and early June, the bankers can bump the price a bit, argue their raising more money for the clients, and still get the benefit of a super-pop courtesy of the new surge in optimism.
Gurley is campaigning to replace traditional IPOs with a system that eliminates their two shortcomings. His solution would both guarantee market prices, sans pops, and grant access to any investors, big or small, that seek to purchase the shares. The solution is called “direct listing.” It’s similar to the “Dutch auction” platform launched by William Hambrecht, cofounder of Hambrecht & Quist. Dutch auctions, in fact, were the first free-market departure from old-fashioned IPOs. Larry Page and Sergey Brin, major proponents of reform alongside Gurley, used a Dutch auction in their public offering for Google in 2004.
In a Dutch auction, the firm hosting the IPO uses its own proprietary software that all potential investors must access, so it can be a chore for all the funds and individuals to link to the offering site. Direct listing are also auctions. But they operate exactly like the universal process that the exchanges deploy to set opening prices every day, for every stock. For example, market makers on the NYSE such as Citadel Securities collect all the bids and ask orders prior to the start of trading and find the price “that clears the market,” the price at which every share gets sold. The bidders above that price get no shares, and those below get their orders fully filled. The shares open at that market level, and don’t jump because of a flood of excess orders waiting in the wings.
“The advantage to direct listings is that every fund, and anyone with a brokerage account, can bid on an IPO just as they put in orders every day for Apple or Home Depot,” says Gurley. The marquee maiden offering was Spotify’s successful IPO in May 2018 and gained credibility with Slack’s offering a year later. “It’s so simple,” says Ritter. “The marketmakers for Spotify and Slack didn’t do anything different to set their price in the IPO than they do for any other stock, every day, before the opening.”
To date, direct listings haven’t sold newly issued shares to raise capital. They allow employees and VC backers to sell stock and hence establish a market price. Then the issuers can go back into the market and get full value for any newly issued stock sold in a follow-on offering, raising raise cash to fund growth and repay debt. The companies get to sell shares at full value established by the trading following the direct listing, rather than raising new cash via IPOs underpriced by the investment banks.
Still, the question remains: Why do so many companies still go public the inefficient, expensive, old-fashioned way? Gurley compares an IPO to a wedding, especially a high-gloss Southern nuptial. “The owners do it once or twice in their lifetimes,” he says. “This is something they’ve never been through before, and they don’t want to suffer the anxiety that something might go wrong. So the easy way is not to ruffle any feathers and do what’s traditional.”
Joining Gurley in supporting direct listings are such Silicon Valley stalwarts as famed investment banker Frank Quattrone and eBay chairman Pierre Omidyar. Gurley is right to push for democratizing one of the last elitist refuges in the capital markets. On one side is tradition, on the other huge savings for owners and employees, and the basic appeal of letting the market do its thing. When the founders sound the opening bell on Wall Street as their stocks debut, a lot more will be sounding the bell for freedom that’s long overdue.
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