Spotify IPO Watch: Buy High, Sell Low

Is Spotify’s unusual “DPO” approach and bizarre $132 selling price simply a way for insiders to short the stock? See SPOT run! Run SPOT run!

Here’s an interesting anecdote about that imminent Spotify stock offering.  Remember, Spotify is rumored to price at $132 per share based on private market trades (on a split adjusted basis, I guess).

If the Spotify “DPO” actually does trade at $132, it will probably be the highest valued IPO stock ever.  Dropbox, for example, priced at $21 and closed at $28.48 on its first day of trading.  Facebook priced at $38, Google at $85, Alibaba $68, Amazon was $18.  So Spotify will have to be pretty special to actually trade at $132 on the public market.

It’s good to remember that most of these comparisons had what’s called a “full commitment underwriting” where the company issues new shares that are purchased by an underwriting syndicate and then resold to the public.  Spotify will issue no new shares.  So–one would surmise that the only ones selling will be those who already hold Spotify shares that have been allowed to be sold on the public exchange.  That appears to mean the shares that will be trading will be the insiders (or mostly the insiders), with no restrictions on which of those insiders can sell on the first day of trading.  (Most IPOs have a restriction (called “lockup agreements”) on when employees can sell their shares to avoid a rush for the exits.)

I happened to be chatting with two sophisticated investors in recent days, one from a hedge fund and the other an entrepreneur who has taken a couple companies public.  Both of them had the same reaction after we talked through Spotify’s competitive position and some of the disclosures in Spotify’s SEC Form “F-1”.

Let’s start with Spotify’s description of who it counts as a subscriber:’

We define Premium Subscribers as Users that have completed registration with Spotify and have activated a payment method for Premium Service. Our Premium Subscribers include all registered accounts in our Family Plan. Our Family Plan consists of one primary subscriber and up to five additional sub-accounts, allowing up to six Premium Subscribers per Family Plan subscription. Premium Subscribers includes subscribers who are within a grace period of up to 30 days after failing to pay their subscription fee.

If you think that a paid subscriber means a subscriber who paid, you’re probably not wild about this definition, and both my friends thought it was not only a meaningless number but also was deceptive.  My guess is that it conservatively overstates “Premium Subscribers” by about 20% given the number of freebies that Spotify hands out.  We were all actually surprised that the Securities and Exchange Commission allowed Spotify to get away with this kind of disclosure as the definition is buried in a footnote.  Neither friend had noticed it, and these were people who are too smart to miss these things normally.

Then there was a discussion about that New York real estate–Pandora is certainly learning its lesson about sky high overhead and is migrating gradually to Atlanta.  I’ve always been mystified why money losing companies like Spotify get away with locating in some of the highest priced real estate in the world–San Francisco and Manhattan.  And also get away with complaining about royalties instead of rents.  Rather than the labels rewarding them based on subscribers, why not reward them based on subscribers if and only if they also lower their overhead (called SG&A) by a certain percentage.

Both conversations ended with a discussion of the 10 second MBA–buy low, sell high.  This is what you do with a long position in a stock.  In Spotify’s case, we were discussing another kind of position, a short position.  Short selling reverses the equation–buy high, sell low.

This is because the short seller is betting that the stock will trade lower, and usually considerably lower, than the price at the beginning of the short seller’s round trip.  In brief, what happens with short selling is that you borrow the shares from someone who holds them.  You get to borrow them for a fixed period of time.  You then sell those borrowed shares at the then-current market price.

short_sell_example

Because your bet with “directional” short selling is that the shares will decline in value over time after that initial sale of the borrowed shares, you then essentially use the proceeds from the sale of the borrowed stock to purchase the shares before your short period expires.  You then return the borrowed shares after you buy them back.

Sometimes you can make a fortune selling short (which doesn’t require shorting stocks, see George Soros shorting the UK pound stirling and The Big Short).  Of course, it can go the other way, too, and result in a short squeeze if the price of the shorted stock increases and short sellers have to “cover” at a higher price than they sold the borrowed shares so they can return the borrowed shares and not default.

“Short interest” is a published number and can be used as a measurement of market sentiment about a particular stock.  It’s the aggregated number of shares of a stock that have been sold short but haven’t been closed out or “covered.”  (Similar to the “put to call” ratio in options trading.)  So it was a bit remarkable to me that both these friends said they’d probably short Spotify as soon as they could.

That’s an interesting question–when could the Spotify stock be shorted.  In order to short, there must be some inventory of shares available to borrow and trade such as from a brokerage house (who can lend the shares from clients’ margin accounts, for example).  Typically, underwriters of an IPO are not allowed to short their IPO stock for 30 days or so.  However, there is no such restriction on retail investors–and Spotify has no underwriters.

Therefore, there may be no restriction on when the Spotify insiders can short Spotify stock.

And if my anecdotes are any guide, it certainly does look like there will be a market for short sellers.  One could even say that insiders seeking to short Spotify shares are simply acting prudently to protect their downside, not unlike a “collar” or other hedging transaction.  This will be particularly true if there is a real run on the exits and early investors or other holders (like the senior management team) start selling right away given they have none of the usual lockup agreements or restrictions on trading as far as I know.

In the words of one of the friends, the shorting will begin at 9:31 on the first day of trading.  As someone who knows the importance of a few seconds in the world of automated trading, I believe him.

 

 

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