Updated: Feb 9
Before we get into the crux of this article, I thought that it would be helpful to define some key terms that will come up quite frequently in this piece…
Capital – Financial assets, including cash, cash equivalents and marketable securities.
Underwriter – A party that assumes another’s risk for a fee.
Private Placement – Private sale of stocks to pre-determined investors, not on the open market.
Liquidity – How easily an asset can be converted to cash without affecting its market price.
A Direct Listing is a stripped-back method of listing existing stocks on the market without the use of underwriters (typically investment banks). It removes many of the formalities of more normal methods, whilst allowing increased liquidity and market forces to determine price.
Traditionally, for a company to go public, it would issue new shares and raise capital in the form of an Initial Public Offering (IPO). In an IPO, companies use underwriters to issue new shares to the public, often in the form of a bookbuild. A bookbuild is where investors express their interest in the stock, and quantities of stock are allocated by the issuing company in ways that align with their interests. These investors can be interested in the stock long-term (e.g. pension funds) or interested in the stock in the short-term (e.g. hedge funds). Companies are able to choose their allocation proportions of long/short term investors (assuming high enough demand) dependent on the company’s desires. Following allocation of the stock at the set price, these investors can start trading their shares.
In a Direct Listing, many of the procedures of the IPO are done away with. In the subheadings below I have outlined key differences between IPOs and Direct Listings to explain a company’s rationale for choosing one over another.
In a traditional IPO, existing shareholders will have their shares “locked up” for a specified period of time following deal completion. This stabilises the price as only new shareholders can trade, so the market can’t be flooded with shares, pushing the price down. However, it can put pre-IPO shareholders at a disadvantage if they wish to trade.
Direct Listings immediately are very liquid - any existing shareholder can sell their shares in the market with no lock-up period. This allows free trading of the shares. Furthermore, it gives anyone access to the shares, due to the lack of a bookbuild. For a company, this can be seen as risky, as there is no say in who purchases your stock. However, once shares are listed, anyone can purchase them, so control of shareholders is immediately lost. This can cause worries regarding a lack of long-term investors, as the company is unable to allocate shares to them. Although this is a valid risk, if enough investor engagement has been completed (see later), this shouldn’t be a problem, as they will buy in the public market.
Pricing a stock is tricky: no two companies are the same, and all valuation methods require many assumptions into the future. Common valuation techniques are Discounted Cash Flow (DCF), Trade Comparables, and Transaction Comparables. Therefore, there may be discrepancies on the pricing from internal and external forces. The company wants a high valuation, to allow shareholders high returns. Investors want a low valuation, so they can get a large(r) stake without putting as much capital in. Finding a middle ground is difficult.
The price of an IPO can only be deemed as “right” after some time has passed. A correctly valued stock will increase in price 15-27 per cent in the aftermarket (the market trading shares post offering). Many companies do not achieve this - increasing, decreasing or flatlining post-IPO. As such, although the valuation techniques will have been rigorously checked, the market can value the stock differently than expected by the underwriter(s).
In a Direct Listing, market forces decide the price. If demand is low for the stock the price will decrease, whilst if demand is high the price will be pushed up. The price is also dependent on supply (the number of sellers). With a Direct Listing there is no confirmation of number of stocks being traded. Anyone holding a stock can sell. Therefore, predicting aftermarket performance can be difficult, especially if large stakeholders sell last-minute.
Pre-Public Offering Investors
Share dilution occurs when a company releases new shares (for example in an IPO). This causes current shares to decrease in value as their ownership stake decreases, but the company valuation remains the same. This does not happen in a Direct Listing, as no new shares are released, only current shares are released onto the market. Remaining shareholders investments are not devalued.
IPOs give great exposure to the company about to go public. The underwriters utilise their expansive investor network, to ensure that all companies (even those who may be more under the radar), are shown off to potential investors. Direct Listings do not allow for this in its traditional sense. Investor engagement can be completed, but for lesser-known companies connecting with investors, this may be an unreachable hurdle.
IPOs are very expensive for the company: banks typically take two-to-seven percent of capital raised as their fees. In a Direct Listing, companies will often consult investment banks but won’t use them as an underwriter. For this reason, fees are considerably reduced. However, with the reduced fees also comes reduced exposure to investors. For lesser-known companies, the contacts an investment bank brings are irreplaceable.
Direct Listings do not allow for the company to raise any extra capital. Only existing shares (owned by existing shareholders) can be released onto the market. To combat this, companies can perform a private placement to raise capital before the Direct Listing. The timeframe may be increased by doing this, due to two transactions occurring, so this may be a drawback for some.
Direct Listings are the old way for a company to become public, listing shares without (much) help from financial institutions or aftermarket stabilisation. They are reliant on the market valuing their company as they believe it should be valued. Precedents of Direct Listings include Spotify and Slack. Both companies did not need to raise capital and were already known worldwide, hence why a Direct Listing was chosen and was successful.
For smaller companies with less brand-recognition, Direct Listings are yet to be confirmed as a viable option due to the lack of capital raised and investor engagement. These companies look towards going public as a way of obtaining new equity financing, and the investment bankers, as experts in potentially niche markets (e.g. natural resources/renewable energy).
IPOs will not be going anywhere anytime soon: the formula of investor contacts, aftermarket market stabilisation, and equity capital raising has been refined over the years to make IPOs what they are today. Direct Listings are a viable alternative for recognisable companies who do not need a capital injection, however the uncertainty and risks associated with them may put companies off. The majority of companies require new capital when they go public, and this is one of the main motivations for doing so. As such, Direct Listings (at least without a private placement) aren’t thought seriously about.
Before Covid-19, “at least 5” Direct Listings were in the pipeline for this year, according to Goldman Sachs’ Will Connolly, on Exchanges with Goldman Sachs. Some Direct Listings have gone ahead, for example Palantir’s in September 2020. Whether all the Direct Listings in the pipeline at the time of Will Connolly speaking have gone ahead, we will never know. With Covid-19 increasing volatility in markets, they could have been deemed extremely risky for this year. However, the unstable markets are not deterring all. It was reported by the Financial Times on October 2nd, 2020, that Roblox are considering completing a Direct Listing in early 2021. Keep an eye on the news for more Direct Listings in the future. With more flexibility and uncertainty than IPOs, it will be exciting to see how they are structured in the future, and whether the market values them as expected.