The New Kid on the Bourse — Part 2: Direct Listings

Source: WSJ

Traditional IPOs are witnessing competition from an alternative — direct listing. This piece looks at what direct listings are, its advantages and disadvantages for various stakeholders and some examples of direct listings on The Street...

What’s one thing common to Spotify and Slack apart from the fact that they are both immensely popular apps? Both these companies went public, not via the traditional IPO process, but through a direct listing. In my previous piece, I delved into SPAC (Special Purpose Acquisition Company) mergers as an IPO-alternative to go public. This piece covers direct listings, another alternative to an IPO.

Direct Listing

In an IPO, a company issues new shares, which represents a certain percentage stake in the company, and sells these shares to the public via an elaborate process involving multiple intermediaries and underwriters and events like roadshows (where banks and the management pitch the firm to drum up investor interest). The costs amount to quite a considerable chunk of the money raised. In contrast, the direct listing route is one where a company doesn’t issue any new shares but directly sells its existing stock to the public. There are no underwriters involved, no settling on a price range for sale of shares, no roadshows and, effectively, no new capital which enters the firm’s coffers. The company just opens the doors for its existing investors and shareholders to sell their shares via the exchange whenever they want to.

Price Determination

Price determination is an important component of traditional IPOs. An order book is prepared by the underwriting banks after collecting indications of interest from potential investors during events like roadshows. Discussions are held with other investors, with the company and experts. Based on all this data, a price is chosen as the opening price. During the day, there are chances of prices falling below or rising significantly above this determined price as demand fluctuates. While a price rise is a good indication for the company, it also means that loads of capital has been left out on the table which the company cannot cash in. The end-of-day trading price is essentially the market value of the share at that point in time, while the book value remains equal to the opening price. So, investors who bought the shares really early are the ones who gain from this price differential. This is referred to as the IPO discount. Banks have been called out for pricing IPO shares in a manner that results in their prices rising by upto 36% during the first trading day.

Since there’s no price setting prior to listing day in a direct listing process, the stock exchange collects bid and ask orders and opening prices are arrived at on this basis. Thus, it’s a purely market-determined process. Reference prices based on private market valuations may be provided prior to listing day, but that isn’t an indication of the opening price.

The main stakeholders involved in a direct listing are the company, existing shareholders, new investors and banks. Each one derives certain advantages and disadvantages from this process…

The Company

Advantages

• Companies needn’t have to pay huge sums to investment banks as underwriting fees (usually 3.5%-7% of the capital raised)
• Companies needn’t bear the brunt of big IPO-day discounts.
• The process is much quicker than an IPO and there’s less IPO-related documentation.
• Companies can go public without diluting ownership stake.
• The upside from a successful direct listing is huge as it’s indicative of positive market sentiment and investor belief in the firm

Disadvantages

• The safety and assurance of underwriting would not be present. The underwriting banks would have also helped in building investor interest in the company’s shares.
• Since there aren’t any roadshows, the company must rely on its brand image and recall for a successful listing.
• There could be high volatility in share prices since it’s now purely left to supply and demand forces of the market. In contrast, underwriting comes with certain levels of price guarantees.
• In case shareholders aren’t putting enough of their shares on the market at particular points of time, especially on the day of the listing, low trading volumes can ensue and this is a dampener.
• Since no dilution of company ownership occurs here, there’s no additional capital generated for the company. Existing shareholders just gain liquidity in their holdings. This method is appropriate for firms whose underlying motive is to go public, enhance shareholder liquidity and receive that visibility. Capital raising objectives won’t be met via this process.
• There’s no ‘greenshoe’ option like in an IPO where, in the event of oversubscription of shares, underwriters can issue new shares to stave off huge price shifts.

Existing Shareholders

Advantages

• There occurs no dilution of ownership and existing shareholders gain the choice, but not the obligation, to sell their stock. They receive an immense liquidity boost.
• In many IPOs, there are clauses preventing existing shareholders from selling their shares during the first few months following the IPO to prevent supply surges (as this can then bring down the price). Direct listings have no such lock-up periods, so shareholders can freely sell their shares from the moment the company gets listed.

Disadvantages

• Due to a market-determined price that isn’t informed prior to the listing, shareholders do have to bear some uncertainty regarding the sale of their shares at their desired price and the execution of their order.
• With no roadshows to drive up investor interest, unless the company possesses heavy brand power, the direct listing may not be very successful. This can result in poor share prices which wouldn’t bode well for the shareholders.

Investors

Advantages

• Investors would have an opportunity to invest in a company that may not have had the appetite to go public via a traditional IPO.
• Direct listings offers unfettered access to shares to all types of investors as opposed to traditional IPOs, where institutional investors and HNIs can get preferential first allotment of shares.

Disadvantages

• Since early shareholders must decide to give up their shares, liquidity issues may be present if enough people aren’t placing their shares on the market.

Banks

In a traditional IPO, banks serve as underwriters and offer price guarantees and execution certainty. In direct listings, banks serve, instead, as financial advisors and don’t take on any underwriting risk.

Direct Listing in Action

In addition to going public, Spotify wanted to partake in a market-driven price discovery process and offer its existing shareholders with greater liquidity without raising additional capital and immediate access to trade their shares after the listing process. A traditional IPO would have surely not satisfied these requirements. Further, given the company’s cash-flow positivity and immense popularity, a direct listing was the way to go. To ensure maximum transparency throughout the process, Spotify hosted an Investor Day that was live streamed and also produced market guidance of depth fit for a public company. On April 3rd, 2018, the direct listing was effected, providing it a $29.5 billion valuation.

Following Spotify’s big listing, Slack opted for its own direct listing in June 2019.

Palantir Technologies and Asana Inc. also took the direct listing approach recently. Palantir’s process included a slight twist though. Investors were allowed to sell upto 20% of their shares after listing and the rest is subjected to a lock-up period until the firm announces its FY20 results.

With such popular names opting for the non-traditional approach, direct listings are gaining ground. Along with SPAC mergers, IPO alternatives are witnessing rising demand. The NYSE recently won approval for a hybrid listing mode which combines aspects of direct listing and traditional IPOs, another indication of this steady shift. While this doesn’t mean that IPOs are irrelevant, more and more options are developing for firms to meet their fundraising goals and the choice is in the company’s hands.