Spotify is taking a big risk using a direct public offering

Spotify's planned direct public offering comes with a notable risk, according to an expert on large-cap privately traded companies.
Spotify can manage that risk by making an agreement with investors for a share lock-up period.

Spotify's planned direct public offering could backfire for its investors.

The benefit of using a direct public offering, in which the company takes its shares directly to market rather than using an investment bank to set a price as in a traditional initial public offering, is that a company can get its shares to the market quickly, and pay less in fees in the process. In a traditional IPO, the issuing company hires an investment bank to market their shares, and ultimately raise capital for the company.

Spotify is skipping those steps, in part because it's not looking to raise capital. Instead, its shareholders are looking to sell their existing shares. But that strategy also has its risks, as it's not clear how much Spotify's shares are going to be worth.

The risk "lies in the unknown," according to Rohit Kulkarni, head of private investment research at Sharespost, a platform that connects buyers and sellers of privately traded shares. Kulkarni said that the uncertainty about how Spotify should be valued and how the shares will trade may very well "translate into a greater discount to the shares."

But there are ways to reduce that risk, according to Kulkarni.

"If the company is able to approach existing investors and negotiate share lock-ups, that would be one way for the company to mitigate volatility in the first few months," Kulkarni said.

In that scenario, some investors would not be able to sell an agreed-upon number of shares for an agreed-upon amount of time, which would effectively restrict the supply of shares on the market.

And according to the WSJ, the company is expected to use private market trading to guide investors towards a public market stock price. Spotify's latest valuation in December was at $19 billion. That could help give take some of the "unknown" from the valuation process.

Still, "if investors believe there is volatility, they tend to discount the value of the shares," Kulkarni said.