Forward
In an upcoming post, I’ll (hopefully) do a valuation of CoinBase.
However, for now, my article covers three related topics:
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Understanding the different dynamics behind Direct Listings vs. IPOs. This should yield useful for DeFi investors as well, as equity capital markets are crucial for not getting rugged.
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FYI… this section is a bit long. There’s a TLDR at the bottom of the section.** But, here’s a even quicker TDLR: the debate between IPO and Direct Listing isn’t as clear as VCs are making it out to be.**
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Feel free to skip to the next section.
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Cautioning retail investors from Coinbase’s 'purported’ $100 billion valuation. Look to the equity grants.
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A discussion on why the Coinbase transition to public could not have been better timed, as I believe Brian Armstrong ultimately knows where the crypto-industry is truly heading.
First, Direct Listing vs. IPO.
Let’s get into it.
In the past few years, there's been a number of silicon valley proponents criticizing the IPO process, instead electing for a direct-listing. They allege the IPO process is broken because:
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Incentive misalignment. Underwriters systematically structure the IPO price to be lower in their book-running process to capture the 'IPO pop' price for themselves and their legion of select investors.
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Pop Effect. Because of the lock-up period (90-180 days typically), the reduced float eventually leads to imbalances in the market-clearing price which has the net-effect of the 'IPO pop'. Then, when the lock-up ends, there is downward pressure on the price per share.
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Dilution. And, of course, the effect of raising capital is dilutive to existing shareholders.
Often, it easy to frame the evil bankers for profiteering off of their financial services. And in many cases, it would be appropriate. But this doesn't seem like the easiest vector to attack.
Here is the pitched rationale from tech-guys for doing a direct listing:
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There is no incentive misalignment, because there is no book-running process. Let the open-and-public market do its job.
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Direct listings are in fact non-dilutive, as no capital is being raised, and thus, no opportunity to leave money on the table.
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And, DPOs can create better demand-and-supply dynamics with more float on the market.
The first reason, incentive misalignment, does have some merit — but not enough to tarnish the IPO process itself.
No ECM team is pitching to their prospective clients that they’re significantly underpricing their previous books. And no ECM team, when they're on a road-show, is pitching to their institutional buyers that these shares are significantly overpriced. There's a market dynamic here that on average tries to find the appropriate price for buyers and sellers. (I admit, there is some incentive misalignment, but market-forces seem mute the extreme egregiousness some are claiming. Again, it is well documented that institutional investors do in fact capitalize on retail on IPO days… I don’t debate this).
Moving on.
The second reason, dilution and pop-effect, suffers from technicalities and half truths. Here's why:
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Let's start with the weakest argument, that direct listings aren't dilutive. This is definitionally true, but it’s a classic ‘red-herring’. Dilution, for a company that truly requires equity capital, will occur regardless of which stage it happens. And what we’ve witnessed in the past ten years has been the explosion of private financing relative to public financing… no need to do public market financings anymore since technology and lower barriers to entry have democratized this part.
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It's the pop-effect that really concerns VCs, 'we're leaving money on the table when the share-price shoots up'. However, IPOs aren't ***as ***dilutive as one thinks (h/t Brad S at NZCapital).
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When the lock-up period expires, dilution occurs if insiders are selling at a depressed share-price, one that is lower than the IPO closing price. If the price clears above the IPO close day — typically +18% — when the lock-up expires, the dilution would be about 1.41% if they raised 10% of their float. (But again, if you need/want equity capital, you’re going to get diluted).
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Moreover, lock-ups exist in the first place to prevent 'dumping' on retail investors in one big swoop at peak-pricing. We often see this within our DeFi universe. Low-float creates a pop and then a deluge of emissions creates a dump.
Check out Andrew Kang’s excellent thread below, and look at $CRV and $MTA.
The third reason, better float dynamic, is in some sense connected with the second reason. As mentioned, for a company that is seeking equity capital, dilution will happen one way or another. However, there are times when late-stage private rounds, 'cross-overs', 'pre-IPO rounds', seeks another goal beside simple equity capital raising. The round is instead simply creating a sufficiently liquid market on the direct list day.
There could be a scenario where existing shareholders aren't willing to part ways with their stock. Informational misunderstanding, vesting, and faith in a much larger valuation could be attributed here. Without a pre-IPO round, this scenario could create quite a volatile demand-supply imbalance itself.\
Supplementary Reason
Though VCs don't particularly champion this idea, management effectively loses the relationship building process with long-term institutional investors by opting for a direct-list. This is a common issue with SPACs as well. You want the buy-in from the strongest cheer-leaders. And this why is the ‘VC bad’ narrative in DeFi is toxic.
TLDR: In sum, the IPO vs Direct Listing debate that SV VC’s purport isn’t as clear as day. A lot dilution occurs in private markets anyways and pre-IPO rounds may be necessary (and therefore dilutive) to create better float scenarios on direct-list days.
(H/T @nongaap for really fleshing most of this debate out).
Caution... Whose Holding the Bag
So what’s going on here? Why have VC’s flipped so anti IPO in the last decade?
The truth of the matter is VCs and insiders want to cut out the middle-men to capture the IPO pop for themselves, as they'll be able to distribute the peak-pricing shares to their LPs or to the open market during a direct listing. No lock-up, free-range to do what one wants. It bears repeating, VCs / Insiders want the flexibility capture the pop against retail for themselves.
And when we look at Coinbase and equity compensation, one has to have alarms going off.
Here’s Simon Hunt from Bloomberg reporting on Armstrong’s equity grants (bolding mine),
Armstrong, 38, founded Coinbase in 2012. In August he received 9.3 million options, equal to roughly 3.8% of the company’s outstanding stock. They came with an exercise price of $23.49, which the board determined was the fair value of the firm’s shares at the time.
Following the IPO, the awards vest in six increments if Coinbase’s average share price over a 60-day period exceeds thresholds ranging from $200 to $400. The top target would be equal to a roughly 1,600% increase.
Based on Coinbase 'finding' a market-reference price on the secondary market (bolding mine),
Armstrong might not be so far off. According to online news site Axios, a buyer bought 127,000 shares of Coinbase in a Feb. 19 private transaction for $373 each, which is within striking distance of his top target. At that price, the options are worth more than $3 billion on paper.
So Mr. Armstrong needs a reference price of $200-$400 for 60 days to reach his top target. Interesting.
In any case, at 10-12x of projected FY 2021 revenue, $8 billion, the valuation seems a bit over-stretched; are those revenue numbers realistic given the hot year and given DeFi adoption is still it’s infancy? Nasdaq trades around 4-5x revenue on $4-6 billion of revenue.
Chamath Palihapitiya, two steps ahead as usual, professes similar concerns for retail 'bag-holders' in the tweet below.
While retail investors are increasingly more sophisticated -- see $GME gamma squeeze -- their adoration for crypto projects like Cardono suggest the maturation of retail in equities is a little stronger than in crypto markets.
Ultimately, like Chamath, I'll be on the sidelines.
Sieze the moment
Given Coinbase's strong balance sheet and bread-and-butter business model, a DPO makes sense here. (Let me clarify, I'm simply concerned that this direct listing could be a particularly dangerous buy for retail; I’m not against direct listings).
Nevertheless, I believe the up-coming public launch could not been better timed. Here's why:
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While many discuss the CeFi DeFi bridge, investors who believe NFTs are a fad are neglecting the NFT DeFi bridge. NFTs have the ability to usher non-technical consumers and creatives into custodial wallet offerings such as MetaMask and exploration into NFT exchanges such as OpenSea.io.
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And, once you’ve tasted the forbidden fruit of MetaMask and Defi, there’s no going back. Even Fred Erhasm seems to agree, which runs counter (at least in my opinion) to the future of Coinbase.
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Competition from the likes of FTX.US, Kraken, Binance.US, and other CeFi intermediaries such as BlockFi and Celsisus, are likely to eat into the company's strong market presence over it's coveted retail customers. While they still have significant US market-share over their competitors, this is an ability to further entrench themselves or seek a handsome exit.
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No one knows whether this bull-cycle is the 'super-cycle', but I hazard a guess that Coinbase, with extensive retail data on their customers, feel the opportunity is ripe before the 'bubble burst' (as it will invariably will). Moreover, with uncertainty on the impacts of a rapid recovery vs. uptick in both nominal and real-interest rates, the global macro landscape could turn and crush trading volume.
It feels to me that Coinbase knows the decentralized ethos and infrastructure is going to eat their lunch and that trading volumes are incredibly inflated right now given the Elon Musk, Gary Vee, and Michael Saylor induced retail and institutional mania.
Said differently, this is the perfect opportunity to seize the crypto hype before an overwhelming amount of participants realize there's a shadow system lurking in the background and/or the bubble pops.
Pour L’avenir de la france,
A.K
Sources:
https://nongaap.substack.com/p/direct-listocracy-giving-bag-holders