Once uncharted territory, pursuing a direct listing is becoming less and less an anomaly. “An IPO is no longer a one-size-fits-all path to public,” according to the New York Stock Exchange.
A series of recent high-profile IPO failures of companies valued sky-high in the public eye have proven that a successful IPO isn’t guaranteed. Companies like Uber, Lyft, Endeavor, and Peloton all had highly anticipated IPOs that ended in failure. For example, on its first day of trading, Peloton’s stock plunged 11%. Uber’s shares dropped more than 7% on opening day in May 2019, continuing to slide. (Since then, it has recovered to nearly its introductory value.) At the eleventh hour (the day before it was scheduled), Endeavor decided not to go forward with its IPO. What was once the “only way” to go public is proving more and more not to be a foolproof step forward.
This series of public, lackluster performance seems to be a cautionary tale. And, while a direct public offering sounds fret with opportunities for things to go wrong, high-profile companies like Spotify and Slack are proving otherwise.
Here’s what you should know.
What Is a Direct Listing?
A direct listing or DPO (direct public offering) is a less conventional way to go public. What makes a direct listing so unusual? First, it allows companies to go public without raising capital, making it much different than an initial public offering (IPO).
In an initial public offering (IPO), companies establish an initial public stock price. By offering public ownership, IPOs are able to raise capital from public investors. To do so, a company will offer a certain amount of new and/or existing shares to investors.
Typically, stocks are sold by one or more banks that act as underwriters. These banks also help to market the company, including to institutional investors on a “roadshow” to the tune of millions of dollars. Institutional investors then filter the shares to the larger market, such as the NYSE, for example. In this somewhat exclusive process, only then do the shares become truly available to the public.
Following the IPO big debut, early investors are typically barred from selling their shares for 90 to 180 days, also known as a “lock-up period.” This has the potential to limit how much money those investors can make on the sale of their stock, which is determined by how the price of the stock fares in the public market.
A DPO skips the step of working with an investment bank to underwrite the issue of stock. Rather, “existing stakeholders basically sell their shares to new investors.” In other words, the company doesn’t have to go through the hoops of marketing the company or selling stock to raise cash before the stock goes public. This makes it faster and less expensive than a traditional IPO. It also equalizes the playing field because the stock is openly listed on the market, therefore accessible to everyone.
It should be stated that once a company is listed, even by way of DPO, the company then becomes subject to the “reporting and governance requirements applicable to publicly traded companies” as mandated by the Security Exchange Commission.
Why Are More and More Companies Choosing DPOs?
By using the less conventional DPO, companies can save a lot of cash— by skipping the IPO process, there is no need to pay banks huge underwriting fees.
But, even though there are major cost savings, DPOs are not ideal for every company. What happens if the stock for your little-known company arrives on public markets and no one knows what your company is?
The likelihood is, no one will buy it.
And, without the IPO process, there’s no initial price established by underwriters. For this reason, companies that pursue a DPO generally have better luck if they have “a lot of money and brand recognition.
Another major perk of a DPO is that there is no lock-up period. For early investors, including employees who may have accepted shares in the early days of a company to offset for a lower startup salary, the opportunity to sell shares right away when the stock might hold the most value is a huge perk.
To this point, because no new shares are created in advance of trading, the dilution of existing stock value is prevented.
DPOs are not without risk, however. For one, price volatility, even in the best of circumstances, can be enough to scare companies off. In a DPO, a reference price is typically established by “buy and sell orders collected by the applicable exchange from various broker-dealers.” However, without the support of underwriters who set an initial price, the stock becomes dependent on market conditions and demand.
Moreover, because the number of shares available on the market in a DPO is determined by the number of shares that employees and investors choose to list, there can be less control overall.
Consider Spotify, which successfully pursued a DPO. The stock hit the market at $165.90 in April 2018. On its introductory day, Spotify was ready with a reference price of $132. Even though it had plenty of brand recognition, there was worry that shares flooding the market without a price established by underwriters could lead to a steep fall.
On its first day on the market, it closed at $149. A little more than two years later, the stock is currently trading at $260.44.
Spotify is not alone in its DPO success, though. Slack had similar success after its direct listing in June 2019.
If an IPO seemed like the bar for startup success before, that’s no longer the case. Earlier this spring, Asana filed to go public via direct listing. Other companies that have been rumored to pursue a direct listing include DoorDash, Airbnb and GitLab. Needless to say, looking forward, it is quite possible (if not probable) that the DPO approach becomes a well-traveled path for companies aspiring to go public.
Investing in Direct Listings
For investors, there is functionally little difference between buying shares in an IPO vs. a direct listing. The difference comes in the source of those shares and the way they are priced at the start.
By converting insider ownership shares into publicly-listed stock, pricing on a direct listing can be volatile and a difficult way to access new companies. For investors looking to get into the IPO and DPO market without taking this risk, a search on Magnifi suggests that there are a number of different options in ETFs and mutual funds.
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The information and data are as of the August 4, 2020 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
