Direct listings vs IPOs

On the surface, a direct listing — or a direct public offering (DPO) — looks a lot like an initial public offering (IPO). While the two have a lot of similarities, they’re not the same beast. Here’s the rundown on the IPO vs direct listing, risks and rewards associated with investing in direct listings and a bit of history on direct listings in the news.

TL;DR

  • IPOs and direct listing are two different ways for a company to go public. They both have the same end goal of gaining access to public investors, but the process to get there differs.
  • Companies often choose direct listings because the process is easier, there’s no underwriters involved and there’s no lockup period. Existing shareholders can sell their stocks immediately. IPOs have an underwriter, a lockup period and various pre-trade steps.
  • In a direct listing, liquidity is typically more important than capital. In an IPO, the opposite is true.
  • For the general public, both IPOs and direct listings are risky investments. You can win big, but market volatility isn’t always on your side.

What is a direct listing?

In the process of going public, one route that a company can take is a direct listing. This is a public offering that’s not backed by a bank (AKA underwriter). Here are the steps direct listings usually take:

  1. Existing shareholders — namely employees and private investors of the company — sell their stocks on the secondary market. The secondary market is where preferred investors trade. This is where we get a valuation and price-per-share.
  2. Ultimately, these shares become available to the general public based on the per-share valuation deduced on the secondary market.
  3. At this point, anyone who held stock in the company prior to the direct listing can sell their shares immediately (if they choose). There is no lockup period (we define this below).

IPO vs direct listing: The rundown

Both an IPO and direct listing have the same end goal, which is to help a company acquire capital from public investors. Historically, IPOs are more common, but direct listings have become increasingly popular in recent years. So what are the differences?

  • Companies who go through an IPO use underwriters to help them determine a price-per-share. In a firm agreement, the underwriter financially backs the company themselves. This means the weight of selling the initial shares is on the back of the bank, not the company. Alternatively, companies who go through a direct listing do not use an underwriter (which means they don’t pay the bank fees). They rely on the secondary market to get their shares in the hands of the public.
  • The IPO process includes a lot of steps before the first trade. This includes the IPO roadshow, where underwriters court investors (typically over a two-week period). A direct listing is more, well, direct. Because there’s no underwriter in direct listings, there’s also no roadshow.
  • For IPOs, companies have to go through a lockup period. Lockup periods are periods of time where existing shareholders cannot sell off their stock for cash; these periods are typically 90 days long. Direct listings have no lockup period, which incentivizes existing shareholders to sell.

With all these variations, one thing remains the same in the IPO vs direct listing debate. On the day a company officially goes public, both IPOs and direct listings look the same on the market index. From there, it’s all in the hands of the market.

Why do companies choose a direct listing over an IPO?

Companies who select direct listings instead of IPOs typically seek a more seamless route to liquidity (for all the shares their employees and investors already hold). They don’t have to deal with all the pre-trade logistics that accompany an IPO, nor the IPOs lockup period, which means they can get straight to the good stuff. On the contrary, IPOs are geared more to securing capital than liquidity.

With all this in mind, you can see why so many companies are intrigued by the notion of direct listings — but it’s not for every entity.

Without an underwriter, a company’s existing shareholders take on great risk. The business needs to be willing to bear this weight, and they ought to be confident that the general public will hop on the bandwagon before market close. However, there is a plus side. Direct listings can (and do) use banks as financial advisors. Oftentimes, there are multiple banks giving these companies advice, meaning there’s no shortage of instruction for the company going public.

One more thing: Popularity goes a long way in a direct listing. Sure, small companies have taken the direct listing path in the past, but household names are more likely to do well. Since there’s no roadshow in the direct listing process to convince institutional investors to take on pre-trade shares, people need to know about the company to take the necessary action. Without a certain level of brand recognition, a direct listing is less likely to succeed once it hits the market (though it’s still possible).

The risks & rewards of direct listings for investors

Just like IPOs, investing in direct listings carries greater risk than the average trade. Quick, buying and selling of a new ticker can make the price of a share fall just as fast as it rose. In the market, demand reigns supreme — and newly public companies have more volatile stocks.

It’s possible this risk is enhanced further with a direct listing, if only due to the fact that the process of going public is rooted more in liquidity of existing shares than it is in gaining capital from new investors. Also, price per share of a direct listing depends on market supply and demand, which can be really good or really bad for investors.

The Council of Institutional Investors also argues that investors may have fewer legal protections with direct listings as opposed to IPOs.

Despite these risks, direct listings do carry the potential of rewards.

There is potential for big gains, but you have to know when to stay in and when to get out.

For the general public, a good option for direct listings to invest in are companies who are transparent with their financial data. How have they performed in recent years? What’s their fundraising history? For businesses, it’s easy enough to go public via a direct listing, but being honest about where the company stands is a more nuanced take that investors should notice.

Famous companies that opted for direct listings:

  • Spotify wasn’t the first company to opt for a direct listing, but they were the first famous company to do so.
  • Asana announced they were heading for a direct listing in February 2020. They’ve been trading on the secondary market throughout the year to figure out an accurate company valuation.
  • Slack went public in April 2019, and they did so via a direct listing.
  • Bottom line

In August 2020, the SEC approved a request from the NYSE to allow companies to raise capital through direct listings. Before this move, only IPOs could do this on the NYSE. Maybe it’s the increase in famous companies opting for direct listings instead of IPOs, or perhaps it’s the Exchange’s natural tendency to adjust their rules with the times — whatever the case, direct listings don’t seem to be going anywhere, so it’s important for investors to know what they are, why companies choose them and the rewards and risks in store for folks who have a stake.

Rachel Curry is Pennsylvania-based content writer and journalist talking all things finance. She likes to give meaning to numbers by humanizing them. You can connect with her on Twitter at @writingsofrach.

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