Mar 1, 2018 · 5 minutes

“Transparency breeds trust,” Spotify CEO Daniel Ek tweeted after his company filed for a direct stock listing.

Ek is certainly right, and so it may be a bit churlish to point out that, whether a company goes public through an IPO or a direct listing, the SEC still requires a certain degree of transparency on financial and operational matters.

As expected, Spotify is listing its shares directly on the NYSE without the help of underwriters, although three Wall Street firms will receive a flat fee to act as advisors. Or, as Spotify put it in its F-1 filing, "the listing... is a novel method for commencing public trading in our ordinary shares."

A direct offering isn't novel in itself, but it is for a company privately valued in the tens of billions of dollars, let alone one with a brand well known to hundreds of millions of people around the world. But while Spotify's direct offering may be cheaper and simpler than an IPO for Spotify, it brings new risks for investors who buy during or shortly after it happens.

Which leads to this novel warning in the filing:

“This lack of an initial public offering price could impact the range of buy and sell orders collected by the NYSE from various broker-dealers. Consequently, the public price of our ordinary shares may be more volatile than in an underwritten initial public offering and could, upon listing on the NYSE, decline significantly and rapidly.”

In bypassing the IPO process, Spotify will engage in the traditional roadshow where potential investors can ask questions of management and where underwriters can gauge market appetite. There will be no book building or processes by underwriters to try and find an efficient opening price. And that could leave the stock volatile – often Wall Street-speak for “falling” - right out the gate.

There's more. It looks like Spotify won't see a cent from the direct offering. That's not terrible in that it's cash-flow positive and able to finance itself through operations. The offering's proceeds will not only go to existing shareholders, but Spotify won't even have any input on how many shares will sell and at what price. It gets better: The costs of the offering won't come from selling shareholders, but will be recorded as an expense to Spotify itself, according to the filing.

On the positive side for new investors, there is more transparency on Spotify's financials, which are at once better than feared and still very mixed. Revenue last year rose 19% to €4.1 ($5 billion), although that is down from the 52% growth rate in 2016.

Spotify's revenue growth has trailed that of the broader industry: Streaming-music revenue grew by 60% in 2016 and 48% in the first half of 2017. The growth in streaming-music revenue may be declining overall, with Spotify continuing to lag. Spotify's filing warned that Apple, along with Amazon and Google are able to pre-load their music apps onto devices they sell, "which puts us at a significant competitive disadvantage.”

One pleasant surprise in Spotify's F-1 is that the cost of revenue fell to 79% of revenue last year from 86% in 2016. The royalties paid to music studios is a big component of these costs, and last year Spotify renegotiated lower fees with Universal, Sony and other labels. That matters because 47% of Spotify's monthly users are subscribers, contributing 90% of its annual revenue.

Those lower fees allowed the company to spend more money on operating costs, which rose to 30% of revenue last year from 25 a year earlier. Marketing and administrative costs both grew by more than 50% - much faster than revenue did – while R&D costs nearly doubled. As a result, Spotify's net loss more than doubled last year to $1.2 billion.

It's not clear whether the labels will continue to negotiate lower royalties with Spotify in coming years, but it's fairly likely Spotify will have to keep spending on R&D and marketing to compete with Apple, Amazon and Google. If losses keep growing, Spotify can look to Pandora as a cautionary tale: Its stock has fallen 89% in the last four years as losses have grown.

The biggest question facing Spotify's listing is one the filing didn't answer: What's its valuation going to be once public? Here's how the company explained it:

"The fair value of our ordinary shares is determined using recent secondary market transactions in our ordinary shares and the Probability Weighted Expected Return Method (“PWERM”), which is one of the recommended valuation methods to measure fair value in privately held companies with complex equity structures in the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. We first used the Market Approach, Guideline Company Method, to determine the indicated equity value considering four scenarios: the High Case Public Company, the Low Case Public Company, the High Case Transaction, and the Low Case Transaction...."

Got that? The explanation continues on, and if you plunge into that dense forest, say hi to Hansel and Gretel if you see them wandering lost there. Ek may champion transparency, but Spotify still needs to clearly justify the $23.5 billion valuation it claimed to have in February. Using the above calculation, Spotify says its fair value has risen 160% to $132.50 a share from $50.70 one year earlier. That's a heady rally for a company with slowing revenue, rising operating costs and stiff competition from Apple Music.

The $23.5 billion valuation represents a premium over the $20 billion that Spotify was valued at when it entered a share swap with Tencent last December. Companies like Cloudera and Blue Apron, which took the IPO route, went public at discounts to their previous private valuations. Dropbox may do the same. But Spotify may not, an apparent perk of the direct offering. The recent valuation also values Spotify at 4.7 times its 2017 revenue. Pandora, by contrast, is has a 0.7 price-to-sales ratio.

What happens with Spotify's offering will have an influence on other offerings. Should the stock tumble soon after it debuts, it may put a damper on plans from other private unicorns who may be considering a direct offering.

Beyond that, it could also help determine the mood of investors regarding the IPO market in general. Things have been looking up for tech IPOs in the past several months, and may improve further with Dropbox approaching. Should Spotify's stock price sink after launching into public waters, it could sap some of the momentum that the IPO market has been slowly building up.