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Spotify IPO: Music company won't be cashing out to same old Wall Street tune

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Spotify is going public, but it's doing so in an unusual way that poses some risks for would-be investors. The Swedish music-streaming company filed confidential documents in late December with the Securities and Exchange Commission to list its stock on the New York Stock Exchange. Spotify plans to debut in the next few months.

So what's the twist, and what are the risks?

Spotify will skip the traditional method of going public — the initial public offering, or IPO — and instead list its shares directly on the exchange. Spotify is not looking to raise cash from its debut by using an investment bank to sell newly issued shares, the typical IPO process. Rather, in a direct listing, a company's insiders — early employees and backers — sell their stock right on the exchange, bypassing Wall Street's banks. They cash out, while new investors buy stock directly from these sellers.

The direct listing is an unusual way to massage your stock into the market, especially for a highly valued company like Spotify. (Its most recent valuation was nearly $20 billion.) Usually, a direct listing is the province of small companies that don't anticipate a lot of trading volume, and that's definitely not the case for Spotify.

It's not entirely clear why Spotify is going this route. Whatever the rationale, forgoing the IPO process means that some of the traditional measures and safeguards are no longer in place. That creates new risks for those looking to buy stock, especially early in the process.

Here's how Spotify's stock debut will be different.

1. Shares will filter into the market only as insiders want to sell

In a traditional IPO, investment banks line up buyers for huge blocks of newly issued stock, helping satisfy demand before the stock's public debut. So these large institutional investors get their fingers in the pie and can often fill their needs before the frenzy of IPO day. While investor demand is rarely completely satisfied — as evidenced by the often-substantial first-day "pops" of IPOs — these big boys often can quickly build a stake.

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Unlike the traditional route, where a predetermined number of shares will become public on the day of the IPO, in a direct listing there are no guarantees. In this case, going public simply means that the stock can be traded on the exchange; not that it will be. Shares will be traded publicly only as insiders sell them. Maybe a few shares are sold, or maybe many are. So there won't be much of a market unless insiders sell a lot of stock, and the lack of selling may end up creating a topsy-turvy market.

2. In a direct listing, prices can be volatile

In a traditional IPO, underwriters actually support the stock price. Not only do they help hype the new listing with road shows and investor presentations, but when the stock debuts, they help keep the stock from falling below its issue price. This support is important because it helps establish a price range for the stock, or the perception of what is a "fair" price. In short, an IPO helps establish an orderly market for the new stock.

With a direct listing, however, this support does not exist. The stock may debut one day when the market is weak, setting a low stock price. Or it may debut when the market is strong, setting an exorbitantly high price. Or perhaps buyers and sellers are not able to find a price at which they're willing to trade shares, and the stock doesn't trade at all.

Moreover, because only a limited number of shares are likely to come public, especially at first, investor demand may be much greater than the available supply. Some investors may cavalierly buy at any price, while others wait on a lull in the market. It's a recipe for a volatile stock, and there's no guarantee the stock will trade anywhere close to that estimated $20 billion valuation.

3. The optics don't look great

While the method of going public is different, investors must still read the fine print in the company's financial filings, just as they should for an IPO. And what those documents show doesn't look great for Spotify.

Spotify's losses are worsening, at least according to its annual financial statements released in June 2017. While the company's revenue grew 52%, to about $3.3 billion, losses mounted even faster. The company lost more than twice as much money as in the year before, $600 million versus $257 million. Spotify's management thinks it can become profitable as it grows, but that remains to be seen. In mid-2017, the company reported it had 140 million users and has said it has 60 million paying users.

To recap, Spotify is losing a lot of money and there won't be much of a market unless insiders are selling in droves — and those two signs together don't look so hot. Plus, the "lock-up" restrictions on when and how much stock insiders can sell following the stock's debut are not as strict in a direct listing as they are in an IPO.

For investors, responsibilities don't change

These factors don't mean Spotify can't be a great investment, but it's important to know what you're buying. And it's important to recognize that a stock is only one part of your overall portfolio, whether it's an IPO, a direct listing or an already-existing stock.

If you're just starting out investing, it can be tempting to put your whole nest egg in one place. But that's very risky and you need a long-term strategy. If you don't have one, you'll want to read up on how to start investing before buying newly listed companies, which tend to be riskier than most.

This article originally appeared on the personal finance website NerdWallet.

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