The ground has been shifting in the going-public landscape. Special purpose acquisition companies (SPACs) became all the rage in 2020 after regulators changed some of the rules governing this private-to-public structure. Direct listings, until recently another mostly unused process for going public, have caught investor's attention after a new listing rule from the New York Stock Exchange. This listing rule allows companies to sell new shares, not just existing shares, via direct listing, something that previously was not allowed.
Here’s what you need to know about direct listings, with a focus on how they compare to the traditional initial public offering (IPO) process.
What is a direct listing?
A direct listing, also referred to as a direct listing process (DLP) or direct public offering (DPO), is the listing of the stock of a private company on a national stock exchange without the use of an intermediary. The role of an intermediary (i.e., an underwriter) in a traditional IPO is to act as the middleman between a private company and the investing public. Generally, the underwriter does the due diligence to determine the IPO stock price, mint new shares of a company, and facilitate stock sales before the IPO date. Consequently, underwriters can be a costly component of the going-public process.
Direct listings skip the middleman. Instead, DPOs allow existing shares held by investors and employees to be sold directly to the public along with newly issued shares. Companies who elect to direct list still must publicly file with the Securities and Exchange Commission (SEC) and, upon listing, comply with the same governance and reporting standards as any other publicly traded company.
In the past, direct listings were generally only used by small companies who couldn’t afford the underwriters of an IPO, and normally on smaller exchanges. The first direct listing was the ice cream company Ben & Jerry’s in 1984, then raising only $750,000. In 2018, however, Spotify became the first corporation to use a direct listing on the New York Stock Exchange (NYSE), followed by Slack in 2019. This year, companies such as Squarespace and Roblox plan on filing publicly via direct listing.
Direct listings vs. IPOs
The traditional IPO process is thorough but costly to a company. After a company decides to go public via an IPO, it chooses a lead underwriter to help with the securities registration process and selling of shares to the public. The lead underwriter (there can be several underwriters for a single IPO) then assembles a group of investment banks and broker dealers—a group known as a syndicate—that is responsible for selling shares of the IPO to institutional and individual investors. These underwriters perform due diligence to recommend a target price and create new shares of the company. In an IPO, current private shareholders are often locked from trading their shares in a moratorium period. Because the company going public is selling new shares, IPOs help the company raise capital. While the cost of an underwriter can be substantial, they are providing financial expertise and the ability to raise funds that the issuer may not have.
Direct listings are becoming an ever more favorable route for companies to go public. Instead of using underwriters, companies in a direct listing use financial advisors to help evaluate and plan the offering. Because there are no underwriters helping with marketing and taking commitment for future sales before the listing date, they can bypass some of the significant costs associated with underwriters.
Some market participants also think that direct listings provide a more accurate initial price at which the security trades for a company’s listing. Without the use of underwriters to help support the offering price, a DPO’s initial price at which the security trades is driven predominantly by market discovery. Additionally, direct listings provide greater liquidity to existing shareholders, as there is generally no “lock-up” period for existing shareholders as in a traditional IPO.
Risks of direct listings
Direct listings present most of the same risks to the investor as traditional IPOs. Individual investors that lack the experience or expertise necessary to evaluate the available financial data, as well as the ability to consider the implications to future operating results of the transition from private to public company, can face substantial risks.
Specific to direct listings, without the presence of underwriters who are tasked with performing due diligence, the initial price of a direct listing can present additional risks to potential shareholders compared with that of a traditional IPO—especially for the investor that does not have the time and skill needed to evaluate all of the available information.
The bottom line on direct listings
The SEC has stated that the IPO process is “far from perfect” and that “among other things … it often imposes relatively high fees on issuers.” This has led the SEC to state that markets should continue to innovate and modernize the IPO process. The rise of direct listings (and SPACs) is clearly an effort by market participants to do just that.
Although direct listings may allow companies to go public more nimbly and at less cost without the use of an intermediary, direct listings presents additional risks compared to traditional IPOs. It is important to understand the many risks involved when investing in a direct listing and to do your own due diligence. This can include researching a company's management team, target market, competitive landscape, the company's financials, expected price range, and potential risks. Most importantly, be sure to review the company’s prospectus before considering a direct listing opportunity.