When it comes to transitioning from private to public, very few companies eschew the initial public offering (IPO). As the name implies, an IPO is the very first public sale of a stock issued by a company. By “going public,” companies can raise significant capital to fund their operations.
To be sure, IPOs are favored by the vast majority of companies wishing to list shares on any of the major stock exchanges. However, an IPO isn’t the only method for doing so. Some companies – and we mean some – have selected to list their shares directly. Over the past two decades, we’ve only found 12 examples of these so-called “direct listings.”
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Private companies wishing to list their shares directly usually follow a similar pattern: they issue a private offering of their own shares with a commitment to investors to list those shares for trading on a major exchange at some point in the future. An evaluation of 11 case studies conducted by Market Watch found that most direct listings vow to list their shares on the Nasdaq after one year.
The major benefit of listing shares directly is the speed of capital raising. Whereas an IPO requires up to a year to complete, a direct listing can be issued in as little as six weeks. That’s the average time it takes to complete due diligence, prepare necessary documents, find investors and raise the needed capital. The direct listing model also avoids the “clearance” process from the U.S. Securities and Exchange Commission (SEC).
However, the SEC can’t be avoided for much longer after that. In order to get listed on a major exchange, a direct listing still needs to go through the SEC process. As one would expect, the downside of a direct listing is the length of time it takes to get listed on a major exchange. To compensate for this, investors usually require a significant discount on share prices compared with an IPO.
In terms of transaction costs, direct listings and IPOs are fairly equal. In both cases, companies usually pay the underwriter 7% commission for raising capital. However, direct listings usually save on legal fees.
As one would expect, volumes and spreads associated with direct listings are initially weaker than in IPOs. However, these differences usually disappear after a few months.
How Direct Listings Are Priced
One area of confusion that arises from direct listings is determining how the new shares will be priced. The New York Stock Exchange (NYSE) clarified the process in 2017 by proposing new rules to accommodate direct listings. The changes, which came into effect in February 2018, address how companies can determine the opening price of their shares in the absence of an underwriter.
Under the new guidelines, the stock issuer must consult with a financial adviser to work with NYSE’s designated market maker to arrive at the opening share price.
A second rule change sought to clarify public float requirements for direct listings. In the absence of recent trading in a Private Placement Market, direct listings may rely solely on an independent valuation to determine their float – that is, if the valuation is at least $250 million. Previously, NYSE looked at independent valuations in conjunction with trading activity in a Private Placement Market.
The third rule change proposed by NYSE deals with eligibility requirements. Proposed in June 2017, the new rule allows companies to list shares once they fulfill an Exchange Act registration statement. This avoids the previous requirements of a concurrent IPO or Securities Act registration.
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The Case of Spotify
Direct listings are not just reserved for companies in need of a quick cash infusion. Larger, more established brands like Spotify can use direct listings as a means of providing liquid markets for their employees and founders. A direct listing would allow these players to benefit from the company’s growth and unrealized gains.
Spotify went the direct-listing route back in April in a smooth debut that could open the door to other companies wishing to circumvent Wall Street underwriters. On the first day of trading on the New York Stock Exchange (NYSE), the company’s share prices surged 12.9% to $165.90. NYSE had set the stock’s reference price at $132. Over the next two months, Spotify’s shares would prove much more volatile, trading between $150 and $171.48.
Disadvantages of Direct Listings
As the Spotify example demonstrates, direct listings must still rely on exchanges to do their job well. That is, market makers may find it difficult to price such securities without a reference point. Although recent NYSE rule changes allow companies to arrive at an opening price solely through an independent valuation, determining the share’s “intrinsic value” may be more difficult, especially just after listing.
Additionally, most companies that go this route do not have the advantage of Spotify’s powerful brand or business model, which could limit their ability to raise additional funds. Although capital providers may be more than willing to lend to established brands, extending the same opportunity to lesser-known or mid-market firms may be less likely. The analysis of direct listings conducted by MarketWatch suggests virtually all direct listings of the past 20 years were small-cap firms.
These are two important disadvantages investors need to consider before investing in direct listings.
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The Bottom Line
Direct listings can help companies overcome many of the initial bottlenecks associated with raising capital. However, from the standpoint of investors, the sample size of direct listings is too small to conclude whether this method yields better returns than a traditional IPO. Therefore, direct listings should be evaluated on a case-by-case basis.
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