IPO vs. Direct Listing: An Overview
Initial public offerings and direct listings are two methods for a company to raise capital by listing shares on a public exchange. While many companies choose to do an initial public offering (IPO), in which new shares are created, underwritten, and sold to the public, some companies choose a direct listing, in which no new shares are created and only existing, outstanding shares are sold with no underwriters involved.
- A company looking to raise interest-free capital from the public by listing its shares has two options—an IPO or a direct listing.
- With IPOs, the company uses the services of intermediaries called underwriters, who facilitate the IPO process and charge a commission for their work.
- Companies that can't afford underwriting, don't want share dilution, or are avoiding lockup periods often choose the direct listing process, a less-expensive option than an IPO. Without an intermediary, however, there is no safety net ensuring the shares sell.
- Direct listings are also known as Direct Placement or Direct Public Offerings. In this process, the company sells shares directly to the public without getting help from intermediaries.
Initial Public Offering
In an IPO, new shares of the company are created and are underwritten by an intermediary. The underwriter works closely with the company throughout the IPO process, including deciding the initial offer price of the shares, helping with regulatory requirements, buying the available shares from the company, and then selling them to investors via their distribution networks.
Initial Public Offering (IPO) Explained
Their network comprises investment banks, broker-dealers, mutual funds, and insurance companies. Prior to the IPO, the company and its underwriter partake in what's known as a "roadshow," in which the top executives present to institutional investors in order to drum up interest in purchasing the soon-to-be public stock.
Gauging the interest received from network participants helps the underwriters set a realistic IPO price for the stock. Underwriters may also provide a guarantee of sale for a specified number of stocks at the initial price and may also purchase anything in excess.
The underwriter has two options for distributing shares to initial investors—book-building, in which shares can be awarded to investors of their choosing, or auctions, in which investors who are willing to bid above the offer price receive the shares. While auctions are rare, the most notable example is Google's IPO in 2004.
All of these services come at a cost. Underwriters charge a fee per share, which may range anywhere from 3.5% to 7.0%, based on a sampling of public filings from PwC. This means that a notable portion of the capital raised through the IPO goes to compensate intermediaries, sometimes totaling in the hundreds of millions per IPO.
While the safety of an underwritten public listing may be the best choice for some companies, others see more benefits with a direct listing.
Direct Listing Process
Companies that want to do a public listing may not have the resources to pay underwriters, may not want to dilute existing shares by creating new ones, or may want to avoid lockup agreements. Companies with these concerns often choose to proceed by using the direct listing process, rather than an IPO.
The direct listing process (DLP) is also known as direct placement or a direct public offering (DPO).
With a direct listing process (DLP), the business sells shares directly to the public without the help of any intermediaries. It does not involve any underwriters or other intermediaries, there are no new shares issued and there is no lockup period.
The existing investors, promoters, and any employees already holding shares of the company can directly sell their shares to the public.
However, the zero- to low-cost advantage also comes with certain risks for the company, which also trickle down to investors. There is no support or guarantee for the share sale, no promotions, no safe long-term investors, no possibility of options like greenshoe, and no defense by large shareholders against any volatility in the share price during and after the share listing.
The greenshoe option is a provision in an underwriting agreement that grants the underwriter the right to sell investors more shares than originally planned by the issuer if the demand proves particularly strong.
Both those companies that elect to follow the direct listing process and those companies that undergo an IPO must publicly file a registration statement on Form S-1 (or another applicable registration form) with the Securities and Exchange Commission (SEC) at least 15 days in advance of the launch.
Upon listing of the company’s stock (whether it's through a direct listing or an IPO), companies are subject to the reporting and governance requirements applicable to all publicly traded companies. The SEC requires all publicly traded companies to prepare and issue two disclosure-related annual reports—one that is sent to the SEC and one that is sent to the company's shareholders. These reports are referred to as 10-Ks.
New York Stock Exchange (NYSE) and Nasdaq Explore Direct Listings
On November 26, 2019, the NYSE laid the groundwork with an SEC filing to allow listed companies to raise capital and go public through a direct listing. The NYSE has allowed them in the past with companies including Spotify and Slack but was hoping to expand the practice, pending the results of the public comment period on the proposal.
Under the NYSE's proposal, a direct listing would let both the company and company insiders sell stock at listing, provided that the company sells at least $250 million worth of shares. There are no new lockup requirements, in that insiders can sell shares of the company as soon as it lists rather than wait up to 180 days to do so.
On December 6, 2019, the SEC rejected the NYSE's proposal, although the NYSE says it will continue trying to appeal the decision. The Nasdaq is also reportedly working with the SEC to offer direct listings as well.
On December 22, 2020, the U.S. Securities and Exchange Commission announced that it will allow companies to raise capital through direct listings, paving the way for circumvention of the traditional initial public offering (IPO) process. In a direct listing, a company floats its shares on an exchange without hiring investment banks to underwrite the transaction as an initial public offering.
In addition to saving on fees, companies that follow the direct listing process may avoid the usual IPO restrictions, including lockup periods that prevent insiders from selling their shares for a defined period of time.
IPO vs. Direct Listing Example
Spotify Technology S.A. (SPOT) went public on April 3, 2018, using a direct listing, making it one of the more prominent companies to do so.
According to a case study on Spotify's direct listing done by Harvard Law School Forum on Corporate Governance and Financial Regulation, Spotify chose a direct listing over an IPO because it offered greater liquidity, allowed existing shareholders to sell shares directly to the public, and allowed transparency with market-driven price discovery, among other reasons.