If necessity is the mother of invention, then new business owners are getting very inventive in the ways in which they access cash. Relying on some long-tested and some new avenues to raise money, entrepreneurs are finding more ways to get public market cash faster than they would have in the past.
Whether it’s from Reg A crowdfunding dollars, Special Purpose Acquisition Companies (SPACs) or direct listings, these somewhat arcane and specialized financing vehicles are making a comeback alongside a rise in new funding mechanisms to get to market quickly and avoid the dilution that comes from private market rounds (especially since those rounds are likely to come at a reduced valuation given market conditions).
Some of these tools have existed for a while and are newly popular in an era where retail investors are driving much of the daily fluctuations of the public markets. Wall Street institutions are largely maintaining their conservative postures with regard to new offerings, so secondary market retail volume growth is outpacing institutional. Retail investors want into these new issues and are pouring into the markets, contributing to huge pops to new public offerings for companies like Lemonade this Thursday and creating an environment where SPACs and crowdfunding campaigns can flourish.
The rise of zero-commission brokerages and the popularization of fractional trading led by the startup Robinhood and adopted by every one of the major online brokers including Charles Schwab, TD Ameritrade, E-Trade and Interactive Brokers has created a stock market boom that defies the underlying market conditions in the U.S. and globally. For instance, daily trades on Robinhood are up 300% year-over-year as of March 2020.
According to data from the BATS exchange, the total trade count in the U.S. was up 71% and May trading was up more than 43% over 2019. Meanwhile, E-Trade daily average revenue trades posted a 244% increase in May over last year’s numbers.
Don’t call it a comeback
The appetite for new issues is growing and if many of the largest venture-backed companies are holding off on going public, smaller names are using SPACs to access public capital and reach these new investors.
Many of the investments these retail traders are making could be considered … questionable. Just look at the furor surrounding the bankrupt car rental company Hertz, which after filing its bankruptcy, attempted to return to the public markets in a secondary IPO to raise money. Despite the company acknowledging that none of the money investors put into the company would generate returns, retail traders still poured into the stock.
Historically, SPACs have been equally as risky a bet for retail investors. As Revolution Ventures partner David Golden wrote for TechCrunch three years ago, SPACs have notoriously underperformed equity markets as a whole.
As a conduit for weaker public companies, SPACs have an unparalleled record: They consistently underperform the broader equity markets and there is scholarly research that proves it (since 2003 SPACs have returned, on average, a negative 19.7%). That shouldn’t be surprising, because the quality of the acquired businesses — by definition — is lower than those that have been vetted by underwriters and the market. Historically, the companies that SPACs acquire make lousy public market investments, and that is because those companies are not mature enough for the pubic markets, and the public markets make lousy venture capitalists.
Golden was prompted to write by the news of Chamath Palihapitiya’s SPAC, Social Capital Hedosophia Holdings, which had raised $600 million worth of stock from investors on the promise of finding an asset to take public that would return their capital. Its ultimate choice? Virgin Galactic, the spaceflight company that now has become a glorified spaceflight travel agency.
Still, the buzz around SPACs created a number of copycats and the heralding of a new age of the IPO 2.0, which would provide companies with alternatives to traditional roadshows and public offerings (there but for the grace of greed goes WeWork).
It’s worth reading Golden’s article, because it lays out some of the structural problems that SPACs have when it comes to the alignment of interests between investors and the operators of the blank-check companies. For entrepreneurs, the benefits are also … questionable.
“Historically, SPACs have been the avenue of last resort for companies that want to go public but can’t — either because underwriters won’t take them public or the public markets won’t embrace them,” Golden writes.
Still, companies like Velodyne and Shift, which are going through their own SPAC processes right now, are undeterred by that legacy, perhaps because the historical conditions for private company investments have changed in the past few years. With the economy in the midst of a pandemic-induced existential crisis (market conditions seem largely divorced from stock market prices and performance), private capital may not be as willing to invest in companies at higher valuations than public markets anymore. And, judging by Hertz’s performance, dumb retail investors will invest in anything.
That dynamic may actually be good for retail investors or qualified investors who are able to access the startup pipeline a little earlier through mechanisms like crowdfunding offerings.
The wisdom of the crowd(funding)?
These are relatively new investment vehicles created under the Obama Administration as part of the 2012 Jumpstart Our Businesses (JOBS) Act. The rules around equity crowdfunding were finalized in 2015 and the mechanism has been growing in popularity among entrepreneurs ever since.
Companies that turned to the crowdfunding mechanism as a way to generate investments include NowRX, which recently closed a $20 million round through SeedInvest; Miso Robotics, a developer of restaurant robotic equipment, is raising $30 million through the crowdfunding platform; the Israeli crowdfunding investment service OurCrowd has backed a number of promising technologies including Jugano, a smart lighting and network infrastructure company; and Tovala, which makes smart ovens.
“The Regulation A had been really interesting to us,” said NowRX co-founder and chief executive, Cary Breese. “We’re excited because once you get qualified as an emerging growth company you get a glide path to an IPO.”
NowRX has a $65 million pre-money valuation on its $20 million Series B round determined by SeedInvest’s underwriting committee. The company currently boasts over $1 million in monthly revenue.
For the entrepreneurs at Miso Robotics, the decision to go to a crowdfunding service was about democratizing the fundraising process a bit more. The company has reserved a certain amount of money for traditional venture capital investors.
“I suspect that venture capital is potentially going to be disrupted,” Buck Jordan, the co-founder and chief executive of Miso Robotics said in a pre-pandemic interview. “Crowdfunding is just coming into its own … there was a whole lot of noise in 2012 [but] the SEC didn’t come around to it until 2016.”
Jordan has seen rounds of $10 million and $20 million happening on platforms like SeedInvest. Brewdog, a U.K.-based chain of pubs, raised $100 million in crowdfunding before partially exiting to a private equity firm.
All of this crowdfunding activity is a way for entrepreneurs to get access to capital coming directly from the folks they think have the best understanding of their businesses — their users and customers.
While these business owners are making their moves to overcome obstacles between their businesses and the money they need for future success, investors are trying to break down the barriers they see between themselves and future returns.
Direct listings or virtual IPOs
For the past few years, Bill Gurley has been engaged in a one-way fight with big Wall Street banks over the initial public offering process. Last year, he even convened a conference to discuss the problems with Wall Street’s control over access to public markets.
Gurley is one of venture capital’s most successful investors whose bets include Jamdat, Vudu, OpenTable, Zillow, and more recently, Uber and Nextdoor.
For Gurley, the public offering process is one that lines the pockets of investment banks at an extreme cost to the businesses that want access to public markets and the investors that back them.
“Most people are afraid of backlash from the banks so they don’t speak out,” Gurley, a partner at venture firm Benchmark, told CNBC in an interview last year. “I’m at a point in my career where I can handle the heat.”
The issue is the way that banks price the companies during their initial public offering. Gurley and others suggest that banks will significantly underprice the value of companies to maintain cozy relationships with the institutional investors who invest several billions of dollars on behalf of wealthy individuals, pension funds and huge money managers.
Critics maintain that underpricing shares, fees from banks and discounted shares bought by the underwriters themselves can cost companies 40% of the eventual money they raise, according to CNBC.
Investors may have ulterior motives for their advocacy, given that secondary listings are great ways to sell existing shares, but don’t allow companies to issue new shares to raise money. It’s a pure liquidity event for existing shareholders, not a way to pump additional money into company coffers.
Spotify and Slack are two companies that pursued the direct listing route with highly divergent results. Nearly a year after its offering Slack is in the doldrums, still trading below its share price while Spotify’s value has exploded on the back of a series of high-profile podcasting acquisitions and, potentially, interest from retail investors in a well-known brand.
Gurley told CNBC that a new pre-IPO financing vehicle from the white-shoe law firm Latham & Watkins can help ease the corporate-level liquidity problems that direct listings entail.
At the same time that investors are decrying the initial public offering for being unnecessarily costly, time-consuming and expensive for companies, the stock markets themselves are adjusting to the new COVID-19 reality by turning to virtual roadshows to drum up business support.
After the market’s absolute COVID-19-induced collapse in March, NYSE and Nasdaq Inc. had nine public offerings in April, 15 in May and 37 in June, according to data provided by Dealogic through June 30 to The Wall Street Journal.
“When the coronavirus started the perception was that that’s going to close the IPO window,” said Tomer Berkovitz, the chief financial officer at life sciences investment firm aMoon. “If you look at the month of March, in the first half of the month there was [just] one IPO … In the second half of the month there were zero biotech IPOS … in April you saw four IPOs and then one of them again in May.”
The conventional wisdom was that investors would never adjust to virtual meetings, but the reality has proven the virtual IPO process and the roadshow surrounding it to be much simpler. “The IPO roadshow is a complete nightmare, but people used to think about it as a necessary evil. The thought that you could do an IPO over Zoom is surprisingly easy.”
The presence of huge late-stage investors in the pre-IPO rounds of companies also means that there’s less cause to drum up institutional support through a roadshow, because the institutions are already in the deals.
Banks are already moving to work closely with companies earlier, in anticipation that public offerings may change. “What banks are going to have to do — and you’re seeing it already — they’re starting to work with companies earlier in the process,” Berkovitz said in a May interview. “They build a relationship in the late private rounds.”
Gurley thinks the ease of these virtual public offerings gives away the game on the importance of bankers in the public listing process.
What does it mean?
Even as the economic shocks caused by the global response to the novel coronavirus continue to reverberate through businesses worldwide, entrepreneurs and investors are adapting to the new reality by using a more broad set of tools that are at their disposal. Funding mechanisms that may have seemed less palatable under different economic circumstances are now being embraced without hesitation. Like the other changes that COVID-19 has brought to society, it remains to be seen whether these alternative mechanisms for listing and offering equity to investors will become normalized, or whether businesses will revert to the old ways if and when other parts of the world return to what had been standard practices.