The vast majority of companies are privately held — not just anyone can decide to invest in them. But when companies are large, successful or ambitious enough, “going public” by opening their company up to outside investors can make a lot of sense.
It’s a chance for insiders to cash out by selling shares to new investors, often a chance to raise new money for the company itself, and it provides an attractive, highly liquid currency that can be used to acquire other companies and recruit talent.
For years, the traditional way to go public was through an initial public offering, or IPO. But more recently, different ways of going public have grown in popularity, including the direct listing.
Here’s a direct listing versus IPO comparison.
A direct listing is a process by which a company goes public by offering existing shares directly to the public, cutting out the underwriter and the fees that come with it.
— A direct listing is cheaper than an IPO, in which investment banks facilitate the process by finding a pool of investors to facilitate the offering for a fee.
— There is no “lock-up period” with a direct listing — a period of time after an IPO during which insiders aren’t allowed to sell additional shares.
— Direct listings generally don’t raise new money for the company or issue new shares; it’s just insiders selling existing shares to new investors. As such, there wouldn’t be dilution.
— Direct listings are considered better-suited for more cash-flush or well-known companies that don’t necessarily need new financing or suffer from a lack of public exposure.
“Direct listings were more seldom used but have become more popular after Spotify (ticker: SPOT) became one of the first notable companies to do it in 2018. Since then, Slack ( WORK), Palantir ( PLTR), Roblox ( RBLX) and, just recently, Coinbase ( COIN) have gone public via direct listing,” says Frederik Mijnhardt, CEO of equity advisory firm Secfi.
You’ll notice that the companies above are all rather prominent names. Each is a large-cap stock worth between $20 billion and $70 billion with a renowned name brand. That’s no coincidence.
Marcus New, founder and CEO of InvestX, a private equity trading platform, notes that with the recent blockbuster Coinbase direct listing, having an underwriter to guarantee a certain degree of investor interest was “unnecessary due to the overwhelming market demand.”
The strong demand and large following among retail investors theoretically allows existing shareholders to “liquidate their company shares at a full value based on market supply-demand versus the underwriting price” of an IPO, “which investment bankers set at lower prices to create profits for their clients,” New says.
“A direct listing saves the company a lot of money, as it eliminates underwriting commissions and share dilution. It’s a fairer process for the pre-IPO shareholders, allowing them to keep most of the profit made in the IPO process,” New says.
An initial public offering is when a private company offers shares to the public for the first time. The share offering is underwritten by investment banks, who publicize the offering and help sell shares to large institutional clients. They are paid a fee for this service. IPOs are typically more focused on raising money for the company itself, which creates new shares to sell, securing additional capital for expansion.
— IPOs are more expensive for the companies in question, which pay for their underwriters’ ability to connect to investors and guarantee a certain level of funding.
— Investor roadshows connected to IPOs help drum up investor interest and educate potential buyers about the company.
— IPOs can sometimes be “underpriced” by the investment bank to allow the banks’ other clients — in this case, the institutional buyers — a chance to benefit from an early IPO “pop.”
— The outcome is more certain than in a direct listing; with IPOs money is raised for the company itself rather than strictly insiders.
— Raising money for general corporate purposes should help to turbo-charge growth, but it comes at the cost of share dilution.
“Benefits of a classical IPO include extensive test the water meetings and a roadshow,” says Eric Richman, CEO at the publicly traded biotech company Gain Therapeutics ( GANX).
Richman notes that an IPO serves as a formal introduction to the investment community, which can be invaluable for companies that aren’t already extremely well known. He was part of a company called PharmAthene, which went public through a special-purpose acquisition company, or SPAC, way back in 2007, before they were all the rage.
“Then we spent two years trying to educate investors on what a biotech company was,” Richman says.
There are also some more obscure reasons IPOs can be attractive to issuers, says Richman, who mentions the “green shoe option,” a mechanism formally known as the over-allotment option.
Typically, this means underwriters sell 115% of the issuance, creating a 15% short position. Then, if share prices fall after the IPO, the company buys back that 15% at the lower price, pocketing the difference.
If share prices rise, the underwriters will have been given an option to purchase 15% of the offering from the issuer at the IPO price at a discount, and the underwriter will exercise that option, closing out its short position and raising more capital for the company.
[SEE: 7 of the Worst IPO Stocks.]
Direct Listings vs. IPOs: The Trend Away From IPOs
It’s not just the recent popularity of direct listings — even if it is with larger, more well-known “unicorns” in the private markets — that has changed the way companies go public. In 2020 and 2021, the SPAC has grown to become wildly popular in its own right.
The mainstream father of the SPAC, Social Capital CEO Chamath Palihapitiya, has criticized IPOs for enriching Wall Street clients at the expense of Main Street investors, and for inaccurate pricing that leaves far too much on the table for company employees and early investors.
More money was raised through SPACs in 2020 than in any year previously, but in the first three months of 2021, more money was raised through these blank-check companies — $87.9 billion — than in all of last year.
Direct listings, too, were barely discussed before just a few short years ago. Now, you can’t go a week without hearing the phrase. Instead of a de facto decision to go public through an IPO, tools like direct listings and SPACs make the going public choice far less obvious.
The company Richman leads, Gain Therapeutics, went public in March through an IPO. Regardless, he still thinks that going public through a SPAC is a trend that’s sustainable, even saying Gain Therapeutics considered it.
When all was said and done though, “the best way was a traditional IPO. The reason is the company was relatively unknown. Being able to meet potential investors was very important to us. It also was a very predictable outcome. At the end of the day, we wanted to be a listed company,” Richman says.
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