Can Direct Listing Disrupt the IPO Process?
The month of September 2020 has recorded a milestone for direct listing as a means of taking companies public. For the first time, the New York Stock Exchange (NYSE) has welcomed two tech unicorns, Palantir and Asana, on the same day through this unconventional method. As the two companies release a combined $29 billion into the public market and a backlog of private unicorns continues to accumulate, questions emerge surrounding the appeal of direct listing and the extent to which its growing popularity may drive out interest in IPOs.
As with an IPO, direct listing allows companies to trade their shares publicly on stock exchanges. However, while an IPO involves selling new shares to institutional investors before the launch, a direct listing helps the founders, employee shareholders, and other private investors sell their existing shares directly to the public. Put another way, direct listing enables the transfer of ownership from the company’s private investors to public investors without raising new capital.
Direct listings offer a cheaper and quicker way for firms to go public compared to IPOs. Since companies do not raise cash, they eliminate the need for investment banks to underwrite a listing price for newly issued stocks prior to the public debut and pitch the stocks to institutional investors by organizing roadshows. While investment banks charge a hefty fee of 7% of proceeds when underwriting an IPO, their fees drop to 2% of proceeds in a direct listing. This percentage difference translates into significant amounts for companies raising billions of dollars. While investment banks may pocket less money from direct listings, the IPO alternative opens a pool of opportunities to service private candidates who are eager to go public but feel intimidated by the IPO fees or discouraged by the underwriting process.
Without an agreed-upon price provided by investment banks, market supply and demand govern the opening price upon a public debut. For investors, the lack of a price anchor obliges them to judge the fair value of the stock, exposing them to great levels of risk as they struggle to correctly time trades. Varied opinions among investors could lead to wild price swings, especially during the earlier periods of trading. But for the firms going public, price discovery could unlock opportunity for a greater market value than under an IPO. To boost demand for the stock, underwriters sometimes deliberately set the listing price to below the stock’s fair value through a common practice called underpricing. As a result, founders feel cheated when they see a “pop” in their share price on the first day of trading as the stock rises to its fair value.
Direct listing also guards existing investors from potential losses regardless of the path they want to take. If existing investors wish to continue investing in the company, they can cash in on the stock without having their investments diluted by a flood of new shares. If existing investors want to exit, they can immediately cash out. This differs from an IPO, where current investors must patiently wait for a certain lockup period – starting at a minimum of 90 days – to start selling their existing shares to prevent an influx of shares in the market.
Spotify first took the direct listing route in 2018, followed by Slack over a year later in 2019, and most recently by Palantir and Asana. Just as changes in capital market practices have brought along a boom in Special Purpose Acquisition Companies (SPACs) as an IPO alternative, changing practices have also marked a turn for direct listings. While the inability to raise funds through direct listing may have stifled its growth, a shift in the way in which firms acquire financing has partially erased the concern. Over the last decade, venture capital funding for private firms has grown substantially, both reducing and delaying the necessity for companies to go public. Recent developments have worked to remove the limitation, as stock exchanges NYSE and NASDAQ have proposed including new capital raises as a part of direct listings. In August 2020, the Securities and Exchange Commission (SEC) gave the NYSE the green light, heightening the attractiveness of direct listing and narrowing the gap between direct listing and IPO. This new hybrid model – a direct listing combined with a capital raise – offers the best of both worlds: companies can raise new funding and allow existing investors to cash out from day one, while saving money on underwriters. However, following concerns raised by the Council of Institutional Investors regarding investor protection, the SEC has pressed pause on the new model.
Direct listing acts as a cost-efficient and faster alternative to the IPO. With more firms testing waters by going public through direct listing, both public investors and soon-to-be-public firms will need to see more examples to diligently assess the efficiency of the process. As the distinction between IPO and direct listing narrows however, the two will need to battle for the spotlight. The swift adaptation of direct listing to incorporate new fundraising along with the dry powder in private markets have expanded its addressable market. If the SEC approves its revamped version, direct listing will disrupt equity capital markets.
– With assistance by Can Atakol