Going Public: IPO vs. Direct Listing

What does going public mean?

Going public refers to when a company sells shares of its stock to the public for the first time, which can be done through an initial public offering (IPO) or direct listing (DL). The process primarily entails entering into a more regulated regime of the capital markets to attract and raise capital from a wider range of investors and provide liquidity for existing shareholders.

Direct Listing: An Overview  

A DL allows a business to enter the public markets without going through the initial public offering process. In a DL, anyone who owns shares in the company can sell them directly to the public. DLs are less expensive than an IPO and provide liquidity for pre-public shareholders. The first DL ever was carried out in 1984 by Ben & Jerry's.

Companies using the DL route have distinct objectives compared to those opting for an IPO. In a DL, the stock owned by employees and/or investors is made available for sale to the public, the company is not required to engage underwriters, and lock-up periods don’t apply.

The absence of an underwriter means the company relies on the market to set the opening stock price (initial share price), which opens the company up to price and volume volatility risks which could result in little to no trading; and hence no market to sell stock into. Therefore, DLs are typically suitable for companies with a strong track record, that are not primarily looking to raise funding, have a strong brand and reputation before going public, and operate on business models that offer easy-to-understand valuation propositions.

Notable Direct Listings

Some of the most high-profile DLs include Spotify, Slack, Palantir Technologies, and Asana. Asana's CEO and co-founder, Dustin Moskovitz, said that going public via a direct listing was an opportunity for Asana to sell stock itself (without an underwriter) and gain validation from larger businesses and investors that it hopes to target in its next phase of growth.

Spotify's Direct Listing

Spotify's DL allowed existing shareholders to sell their shares directly to the public without raising any new funds. Spotify did not rely on underwriters to help assess demand and set a price; it simply listed existing shares directly on the New York Stock Exchange.

During 2017, the value of Spotify was estimated to be between $6.3 billion and $20.9 billion, based on the varying prices at which its shares were sold. In April 2018, Spotify broke records with a $29.5 Billion DL. Spotify's unconventional IPO did not affect its valuation, as the business had already fetched a valuation of up to $22.6 billion in pre-DL rounds of funding.

The Stockholm-based company's DL was the largest on record. Spotify now boasts a market valuation higher than that of Snap Inc., the owner of Snapchat. Spotify's DL was motivated by a strong brand name, lower underwriting fees, liquidity without dilution, valuation precedence, and its convertible debt terms.

These companies, that started out as startups, had outgrown the private financial markets and chosen to go public through the direct listing method instead of the traditional IPO route. In recent years, more companies are considering this option to go public. However, direct listings are still relatively rare compared to traditional IPOs.

Initial Public Offering: An Overview

An Initial Public Offering (IPO) is a traditional method for a company to enter the public markets. The process broadly entails the issuance and sale of a company’s shares to the general public. The concept of the modern IPO originated from the Dutch East India Company's IPO in 1604, the world's first IPO. Saudi Aramco's IPO in 2019 is the biggest initial public offering conducted to date. It raised £25.6bn on the Riyadh Stock Exchange.

Companies typically choose an IPO to raise capital, enhance their public profile, and provide a profitable exit for early-stage investors. The funds raised from the IPO can be instrumental, amongst other reasons, for a company's growth and expansion goals, research and development activities, or paying down existing debt. From a capital raising standpoint, an IPO can be seen as a more feasible alternative to costly private equity or venture capital.

However, IPOs are complex processes riddled with nuanced restrictions that may not apply to a DL, such as the lock-up period, which prohibits early shareholders from selling shares until after a certain amount of time has passed after the IPO. Generally, an IPO is an expensive and lengthy process, especially in comparison to a DL, unless it's a DL with capital raise. The most notable difference between an IPO and a DL is that IPOs require an underwriter. Investment banks, acting as underwriters, play a crucial role in this process, conducting extensive due diligence, marketing the IPO, and shouldering the risk of selling shares. However, engaging an underwriter adds to the time and cost of going public, which, in some cases, may be unnecessary (Spotify - case in point). Nonetheless, having an underwriter and a market maker helps bolster a company’s reputation, facilitates capital raise, and ensures that the post-going public market for a company's stock is liquid, healthy, and fluid.

Over time, IPOs became a popular method for companies to raise capital by selling shares to the general public. However, the number of IPOs issued has never been constant. It has and continues to vary with the level of innovation and economic conditions across different sectors. During the dotcom boom, the tech industry saw a surge in IPOs that ballooned into the dotcom bubble and crashed two years later in 2001. Similarly, following the 2008 financial crisis, IPOs came to a standstill and new listings were scarce for several years.

In 2020, $83 billion was raised across 203 IPOs in the US, excluding SPACs. According to available data, the number of IPOs and the amount of capital raised in IPOs in 2022 have been significantly lower than in 2021. In 2021, a total of 397 IPOs raised $142.4 billion, making it the busiest year by deal count since 2000 and the biggest year for proceeds ever. [1] However, in the first half of 2022, only 92 companies went public and raised all of just $7 billion, which is the lowest amount of IPO proceeds since 1990 [2]. According to EY, there was a 44% reduction in the number of global IPOs during the January-September 2022 period.

Direct Listing vs IPO

Going Public? Things to Know and Factors to Consider.

Historical Results Beget Future Performance

As companies contemplate the pivotal decision of pursuing an IPO or DL, a thorough evaluation of their historical performance and present financial well-being is paramount. The rigorous scrutiny during the going public process underscores the necessity of a strong financial foundation and a proven track record. A company's financial success hinges on a history of positive earnings and revenue growth, a well-informed and deliberated plan for meeting future goals and objectives, and a team that inspires certainty of execution.

Industry experts like PwC emphasize that successful public offerings often demonstrate the capacity to maintain robust sales and earnings growth trends. EY's Guide to Going Public echoes the same sentiment by stressing the importance of articulating a compelling equity story that can be supported by a distinguished track record of growth and shareholder value creation.

Underwriter’s Role in Going Public? How does an Investment Bank raise capital for an IPO?

Underwriters, or investment banks, play a significant role in the success of a company's going public strategy (a DL does not require an underwriter unless the company is raising capital through an offering of its shares). Underwriters manage and sell the offering of shares on behalf of the company. Their primary task involves working closely with the company to establish the offering price by taking into account factors such as the company's financial performance, industry trends, and market conditions. In smaller IPOs, the offering price can be determined by a book-runner, which is the main underwriting investment bank that leads and directs the IPO process. Underwriter's careful analysis of a company can be critical to the success of an IPO or a DL with capital raise, but not so much in the case of a DL.

In some cases, the underwriter collaborates with other banks to form a syndicate, which helps in underwriting the offering, and marketing and selling the offering to potential investors. This marketing process may involve organizing roadshows where the company's management team can meet with prospective investors to present and discuss the offering.

Post-going public, an underwriter may continue to be involved with the company in various capacities, including providing support through analyst recommendations, after-market stabilization, and creating a market for the issued stock. For example, if there are unfulfilled trade orders due to demand and supply imbalances, the underwriter may purchase shares at or below the offering price to maintain market stability.    

The success of an IPO (or a DL with capital raise) largely depends on the underwriter's ability to manage and sell the IPO effectively, especially for companies that do not have a substantial historical indicator of their valuation.

Can a company raise capital through Direct Listing?

Yes, now issuers can raise capital through a DL, provided the direct listing is done on NYSE or Nasdaq. However, the enhanced Direct Listing with Capital Raise (DLCR) Nasdaq standard requires an underwriter for DLs.

A DLCR on Nasdaq or NYSE is substantially similar, with one notable exception: NYSE does not require an underwriter for DLs under the DLCR standard.

On May 19, 2021, the SEC approved a proposed Nasdaq rule change to allow for capital raising concurrently with a DL on the Nasdaq Global Select Market. This means that companies can now sell shares in the opening auction on the first day of trading and raise capital. The SEC also approved a proposal by NYSE on August 26, 2020, to permit private companies to raise funding through a DLCR on NYSE.

On December 2, 2022, the SEC issued a notice of filing of Amendment No. 3 to modify certain pricing limitations for companies listing through a DLCR - in case of a DL with a capital raise, for the opening auction, the price of the security may not be lower than the lowest price of the price range established by the company in its registration statement. The amendment allows companies to set the opening price for their shares based on market factors, such as demand, rather than being constrained by a predetermined price range.

Market Sentiments and Conditions: Make or Break

Market conditions play a significant role in the success of an IPO or a direct listing. Favorable market conditions are generally characterized by positive investor sentiment, uptick in stock market performance, lower inflation, the end of an interest rate hike regime, easing of geopolitical tensions, and little to no global economic disruptions (as recently noted with COVID).

Lower inflation and the cessation of interest rate hikes are other key factors that contribute to a conducive environment for IPOs. With stable or reduced interest rates, the cost of borrowing decreases, which makes investments in equities attractive for investors. This, in turn, can lead to increased demand for shares of newly listed companies. Going public in a market characterized as such would help a company not only secure a higher IPO valuation but also raise a significant amount of capital.

Navigating Complex Legal and Regulatory Requirements

Companies going public or operating as public entities must navigate complex legal and regulatory requirements. Private companies entering the public sphere become subject to three federal securities laws, each with distinct requirements: the Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes-Oxley Act of 2002.

The process of going public necessitates collaboration amongst various professionals on preparation of filings with regulatory agencies such as FINRA, the Securities and Exchange Commission (SEC), and stock exchanges. The same is required post-going public to ensure compliance with regulations and standards applicable to publicly traded or otherwise reporting issuers.

If a business opts for a registered public offering, the Securities Act mandates filing a registration statement with the SEC before offering the securities for sale. The company cannot sell these securities until the SEC staff declares the registration statement "effective." Similarly, despite having an effective registration statement, a company cannot trade on a stock exchange without meeting exchange-specific standards.

Regulations and standards are a labyrinth of nuanced rules and regulations for companies exploring going public - eligibility standards, financial standards, corporate governance standards, business practices standards, and reporting standards - to name a few. Picking the right direction and charting the path to going public requires a careful inspection and selection of the regulations and exemptions that would produce the best going public outcomes.

For example, four primary regulations govern the preparation and filing of Form S-1: Regulation C, Regulation S-K, Regulation S-X, and Regulation M-A. Companies must adhere to one of these regulations to ensure a compliant and successful public offering.

Similarly, once a company becomes public, its governance structures undergo significant changes, such as additions to officers and directors, formation of audit, compensation and special committees, rigorous investor relations policies, and periodic financial reporting.

Navigating the transition from private to public necessitates a thorough understanding of your going public goals, a detailed analysis of the legal and regulatory landscape, and a corporate infrastructure that can withstand the scrutiny, scale, and regulations of the public markets.

Why opt for a Direct Offering?

A DL is generally a suitable solution for companies that have a business model that is easy to understand, have a proven track record, are well-known brands, and have a strong historical indicator of their valuation (preferably through the latest round of capital raise). These factors can bolster investor confidence and facilitate the price discovery process without the need for traditional IPO mechanisms.

A direct offering eliminates the need for underwriters which results in substantial cost savings on advisor fees. In a DL, the pre-public shareholders can sell their shares without the lock-up restrictions commonly imposed in traditional IPOs. This helps provide immediate liquidity and allows market forces to determine the stock price more organically.

DLs do not involve the issuance of new shares, nor do they include a greenshoe clause, which allows underwriters to sell additional shares in an IPO to stabilize the stock price. By avoiding such provisions, the stakeholders of a company can maintain greater control over its stock price and minimize potential dilution. Furthermore, direct listings often create a more equitable environment for retail investors, as underwriters do not prioritize institutional investors during the allocation of shares.

How is a Direct Offering Priced?

While underwriters are not required for any DL without capital raise, financial advisors work alongside the exchange to set a reference price for day one. Using the reference pricing as a starting point, the initial pricing is established through a price discovery process that takes place during the opening auction. Buy and sell orders are matched to determine the opening price. Choosing the right reference pricing is critical to preventing volatility when trading opens.  NYSE states that the DLs on their platform have traded with superior market quality - lower volatility and tighter spreads - on Day 1 compared to IPOs.

On December 2, 2022, the SEC approved companies opting for DLCRs to sell shares on the Nasdaq in the opening auction at a price that falls outside of the range specified in their registration statement. This price can be up to 20% lower or 80% higher than the price stated in their registration statement.

The Time to Market and the Planning Ahead

In an IPO process, a company undergoes significant due diligence from the underwriters as they are responsible for pricing the stock and can be held liable for misleading information in the company’s prospectus. This part of the process adds to investor confidence but is both time-consuming and costly.

The DL eliminates the underwriter's due diligence process, which makes it faster and less complex than an IPO.

IS a PROSPECTUS REQUIRED for direct listing?

Both an IPO and a direct listing require a company to file a prospectus with the Securities and Exchange Commission(SEC). Preparing for, filing the prospectus, and awaiting final approval from the SEC is a long, arduous, and cumbersome process. You need to plan ahead by hiring the right team of legal, financial, and accounting experts to manage cost, time, and outcomes, effectively.

what goes into a prospectus?

The prospectus contains detailed information about the company's business, financial condition, and management, which enables prospective investors to make decisions informed by a thorough understanding of the company's operations, strategies, and risks. It generally includes information such as the company's history, organizational structure, financial statements, and descriptions of products or services. Furthermore, it outlines the management's discussion and analysis (MD&A) of the financial condition and results of operations, detailing factors that may have influenced the company's financial performance.

why does the sec require a proSpectus?

The SEC closely reviews the prospectus to ensure compliance with securities laws and regulations. This review process is designed to protect investors by guaranteeing that the company discloses all material information that could impact their investment decision. The SEC may provide comments or request revisions to the prospectus to guarantee its clarity, accuracy, and completeness.  

Creating Liquidity for Investors

The stock market operates like any other market: on the basis of demand and supply, and the price the two meet at to create a transaction. Similarly, the listing and trading of a company’s stock create a market of sellers offering stock for sale. The buyer’s side of the market has to be created. Generally, to fulfill this function in an IPO or DLCR, the underwriter performs the role of a market maker post-IPO to fulfill this function.

Prior to filing for the IPO, an unaffiliated market maker has to be engaged to perform this role. Companies going public through the direct listing route also face the same market-making problem and should, preferably, engage one. Additionally, companies should research liquidity technology options made available for their business' direct listing by NYSE and Nasdaq in their analysis.

What are Market Makers? How do they help create liquidity?

A market maker is a financial institution or brokerage firm that actively quotes both buy and sell prices for a security, ensuring liquidity and enabling smooth trading in the market.

A market maker stands ready to buy or sell shares at publicly quoted prices, which enhances transaction efficiency and minimizes price volatility to create liquidity for shareholders and investors. The additional liquidity also helps maintain the price at a level consistent with the offering price while ensuring it promotes fair and orderly trading.

An underwriter's in-depth knowledge and understanding of the issuing company and a vested interest in the stock's performance make it an ideal market maker.

Market Making through Passive Trading

Market makers can also act as liquidity providers through passive trading whereby market makers post buy and sell orders (bid and ask prices) for a security, without actively seeking to execute trades but maintain a presence in the market by only offering to buy or sell a security at publicly quoted prices. Generally, this is an option used by companies looking to either save on cost or do not have an underwriter i.e. they are using the DL route to going public.

Unaffiliated Market Makers

An unaffiliated market maker is a market maker that operates independently from the exchange where the company’s shares are listed. Unlike an affiliated market maker, which is usually a brokerage firm that has a contractual relationship with the exchange, an unaffiliated market maker can trade on any exchange where the security is listed.

Unaffiliated market makers are important for maintaining liquidity and promoting price efficiency, as they can trade on multiple exchanges and compete with other market makers to provide the best bid and ask prices for a security. Market makers may use proprietary trading strategies to generate profits from the bid-ask spread or earn commissions from executing trades on behalf of other investors.

In some cases, unaffiliated market makers may also act as intermediaries between institutional investors, such as mutual funds or pension funds, and the exchange by facilitating large trades or providing liquidity during periods of market stress. Their ability to operate independently from the exchange and trade on multiple venues can make them an important tool for creating liquidity in a company’s financial ecosystem.

The role of Market Makers in a Direct Offering

In a direct listing, market makers play a vital role in ensuring the smooth and orderly trading of newly listed shares. Unlike an IPO, generally direct listings (without capital raise) do not involve underwriters, which means that the issuing company does not issue any new shares.

In this scenario, market makers are responsible for facilitating price discovery, matching buy and sell orders, and providing liquidity to the market. They work closely with the stock exchange to gather indications of interest from investors and establish an appropriate opening price range for the shares. On the first day of trading, the designated market maker or a similar entity is responsible for matching buy and sell orders and ensuring that the initial trades occur at a fair and orderly price.

After trading begins, market makers continue to provide liquidity by consistently quoting buy and sell prices, minimizing price volatility, and promoting smooth trading. The market makers' involvement in direct listings ensures stock trades are fulfilled efficiently in a stable market.

Alternate Solutions to Creating Liquidity

Creating liquidity in a direct listing without an underwriter or market maker can be challenging, but there are several strategies companies can adopt.

• During an IPO, companies have access to Testing-the-waters meetings and roadshows with investors. Companies opting for DLs will have an Investor Day to answer investor queries and concerns. In either case, for a successful roadshow or an Investor Day, companies must assemble a qualified investor relations team with clear and comprehensive investor relations mandates and policies, and prepare securities law compliant presentation materials that prove its historical financial performance and certainty of execution of future prospects.
• Since an underwriter is not involved in a standard DL, it is crucial that the business exhibits transparency in financial reporting to foster confidence in investors and encourage trading activity. Additionally, selecting a reputable stock exchange with rigorous regulatory standards (higher disclosure standards instill investor confidence) and premium resources for issuers (tech-enabled market making strategies), such as the NYSE or Nasdaq, can facilitate liquidity.
• Encouraging employees to participate in the direct listing by selling a portion of their vested stock options and actively engaging with institutional investors, such as mutual funds and hedge funds, can bring additional trading volume to the market. This participation can improve liquidity.
• Lastly, companies should closely monitor the post-DL trading activity to preempt liquidity shortages and proactively make strategic decisions accordingly. For example, share buybacks or secondary offerings can help ease liquidity constraints.

Lock-Up Periods

Lock-up agreements are not required under federal securities law for going public. However, underwriters will typically require company insiders to sign lockup agreements to prevent sell-side pressure on the stock in the initial months. These restrictions limit the ability of shareholders to sell their shares for a certain period of time, typically 180 days.

Companies that opt for direct listings without capital raise or DLCR on the NYSE benefit from no lock-up restrictions since an underwriter is not required.

Companies that choose the Direct Listing with Capital Raise route with Nasdaq may be subject to lock-up restrictions. Despite this constraint, the lockup period in DLCRs is typically shorter than that in IPOs.  

Managing Stakeholders

The complexity of the going public process stems from the sheer types and amount of stakeholders with an even greater number of varying expectations, responsibilities, and obligations - board of directors, underwriter, market maker, management, employees, legal and financial advisors, investors (previous and prospective), regulatory bodies, and auditors.

Opting for going public through a method that does not involve an underwriter helps reduce the complexity but is it worth it? You would be restricted to a direct listing without any capital raise unless you limit yourself just to the NYSE.

The key takeaway is to fully understand the going public process before you set out on this path. It requires immaculate planning and a high degree of emotional and experiential intelligence to navigate this process to successful completion. It is key to ensure that all stakeholders are on-board with your plans for the future and the strategy forward.

How CIEL Can Help

Before you set out on this path, we can help you fully understand the going public process, the options you have, how you can create the best possible outcomes, and how to avoid unexpected surprises - before you set out on this path.

Going public and maintaining your reporting requirements as a public company can be complex. Our Strategy & Corporate Finance experts help companies navigate the complex landscape of U.S. capital markets - from drafting and filing a registration statement, to setting up corporate governance practices, to ensuring you meet all regulations and standards for a public company.

About CIEL

We help businesses achieve more with less - and build enduring relationships by delivering long-term sustainable growth. CIEL specializes in Mergers & Acquisitions, Strategy & Corporate Finance, Investor Relations, Accounting Management & Advisory, and Design & Marketing. Contact us today to learn how we can help your organization achieve its goals.

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