Roblox Corporation, a video game company with an in-game purchase model, was supposed to complete its initial public offering (IPO) in December of last year. The company delayed its IPO after seeing Airbnb, Inc. (ABNB) and DoorDash, Inc. (DASH) post incredible first-day pops that challenged the valuation models for tech IPOs. Instead, the company has announced it will go public through a direct listing. We'll look at what a direct listing is and why Roblox's decision is a sign of trouble for the traditional IPO market.
- Roblox has decided to go with a direct listing rather than its planned IPO due to the pricing issues apparent in the market.
- The company's decision highlights some issues with the IPO process, including the difficulty hitting the right price.
- Roblox instead completed another round of private capital raising, meaning retail investors are once again missing out on most of the early growth in a tech company.
How Direct Listings Work
There used to be a clear line between direct listings and IPOs. Direct listings were essentially undertaken for liquidity reasons, as new capital wasn't raised because only existing shares were auctioned on the market. Spotify Technology S.A. (SPOT) and Slack Technologies, Inc. (WORK) are two notable tech firms that went public through direct listings under the traditional process. In late December 2020, however, the Securities and Exchange Commission (SEC) changed the rules around direct listings to allow companies to raise cash through direct listings by auctioning new shares along with those of current shareholders looking to sell.
With the recent rule change, direct listings are even more attractive than before. Prior to the rule change, direct listings still allowed companies to save the money paid to underwriters in an IPO, but they couldn't raise new funds. With the rule change, companies can undergo a direct listing, raise capital, and still save money. The direct listing process also doesn't involve a lock-up for existing shareholders like an IPO requires.
The IPO Issues
The rule change around direct listings – one pushed for by the New York Stock Exchange (NYSE) – is tied up with larger issues related to the IPO market. The idea behind an IPO is that a company pays a fee for expert help and support pricing its shares so that the market buys all of them at the right price. The fees paid as part of an IPO are the biggest direct cost, and PWC estimates that the average underwriting fee is 3.5% to 7% of the gross IPO proceeds. Generally, the larger the deal, the smaller the percentage fee – although the dollar amount will of course be much larger when we are talking billion-dollar-plus IPOs.
While the costs are significant, the fees would be a non-issue if the companies felt they were getting full value on the pricing side. Unfortunately, the massive IPO pops of companies like Airbnb suggest that these companies are leaving money on the table when they do go public. There is a very good argument that we are in a bit of an IPO bubble, but that doesn't excuse the professional that companies are paying tens of millions of dollars leaving billions of dollars of capital on the table.
Why Roblox Chose Direct Listing
We don't have to spend much time guessing why Roblox has walked away from its IPO. The Wall Street Journal reported that it was the trading action on Airbnb and DoorDash that caused company executives to delay rather than leaving capital on the table. After postponing the planned IPO, Roblox raised over half a billion in a Series H funding round. The latest funding round values the company at $29.5 billion – a massive jump from $4 billion in its previous funding round.
This probably means that Roblox is less concerned with raising more capital as part of a planned direct listing. Instead, the direct listing is merely giving existing investors a planned liquidity event to cash out if they want to. Roblox will still have the option to raise more capital when the time comes, of course, and the direct listing is planned, not imminent. Roblox can always change those plans as it did with the IPO.
Bottom Line: IPOs Need to Change
Direct listing is just one alternative to skirting IPO issues, of course. For years now, we have also seen companies choose to stay private and do more private funding rounds, only going through an IPO at a much more mature stage. This is what Roblox has done with the Series H round, although it has stated that the direct listing is in planning stages, thereby giving all the current investors a commitment toward eventual market liquidity.
The fact that companies are going so far beyond Series A, B, and C funding is a sign that something isn't right. While this trend is understandable from the company perspective, it also means that retail investors miss much of the growth in these companies. When companies in the late stages of development undergo an IPO, retail investors are mainly helping early sophisticated and institutional investors cash out with a lot of the gains. Clearly, the IPO process needs to change, or we will be seeing a lot more direct listings and/or delayed IPOs in the future.