Role of an Exchange: 3 Reasons Why a Company Might Choose a Direct Listing Instead of an IPO
While direct listings are not a new concept for companies looking to go public, this alternative path is growing in popularity this year. As we aim to demystify direct listings, we analyze three reasons why a company might choose to go public through a direct listing instead of the traditional initial public offering (IPO).
Communicate Directly with Retail Shareholders
In a traditional IPO, the underwriters facilitate a roadshow for a couple of weeks before the company lists on an exchange in order to generate investor interest in the company. During this process, some institutional investors will commit to buying a large amount (or tranche) of shares, but individual retail investors, typically, do not participate in this process directly.
In contrast, a company going public through a direct listing does not conduct a traditional roadshow facilitated by an underwriter but may communicate with shareholders through a public webcast, online message boards or one-on-one meetings. This latitude allows the company conducting a direct listing to tell its story directly to all investors, including retail investors. This puts institutional and retail investors on a similar footing in learning about and investing in the newly listed public company.
Price Discovery
The roadshow also helps the underwriters to determine the price that investors are willing to pay for the company’s shares. For instance, Investor A may indicate that they will buy 100,000 shares at $30, and Investor B may offer to buy 50,000 at $28. The underwriter will analyze these indications from investors and determine the optimal price for the shares. Following the initial pricing of the offering, the company files a prospectus that includes this price with the U.S. Securities and Exchange Commission, and the shares begin trading the next day. However, the shares do not start trading at this price—rather, the listing exchange will match buy orders (indicating investor demand) with sell orders (indicating investor supply), either through an electronic matching engine or designated market makers on a trading floor. This process will determine the price at which the shares begin trading. As a result, the company’s shares that priced at $28 per share the night before may begin trading the next day at $35.
Meanwhile, direct listings do not involve an underwriter at all. The listing exchange, in consultation with the lead bank, determines the “reference price,” which is used to help educate market participants about the potential value of the company’s securities. The reference price may be based, in part, on the company’s valuation. On the first day of trading, a similar process is used to match buy and sell orders on the morning of trading. As a result, a company with a reference price of $28 may open at $30 or $26, but it is important to understand that no shares are sold at the reference price.
Some companies and industry vets believe the pricing model of the traditional IPO process may be inefficient because it may create an “IPO pop” on the first day of trading. The traditional IPO example above may generate a headline like “Company A jumps 25% on the first day of trading.” To some, it looks like the company’s first day of trading was a success. To others, it may seem like the company left money on the table and could have set its offering price 25% higher, generating more money for existing investors, employees and the company’s founders.
Direct listings aim to eliminate the IPO pop. If a company comes to the public market via a direct listing, the market becomes the metaphorical underwriter by setting the price for the newly traded public company. Many have described direct listings as a truer model of supply and demand compared to a traditional IPO, which is why direct listings are often viewed as a more democratized process.
Role of the Banks
Underwriters for an IPO may require “lock-up” periods for existing investors for a certain amount of time to prevent shareholders from flooding the market with the company’s shares once it starts trading, which could cause the company’s stock to nosedive. For their services, underwriters historically charge up to 7% of the IPO proceeds in underwriting fees. Notably, underwriters can be held liable under securities laws if the prospectus provided to investors contains misleading or untrue information.
As mentioned above, direct listings do not involve an underwriter at all. Instead, a bank acts as a financial advisor to the company throughout the process. Financial advisors provide due diligence, additional transparency and other reasonable levels of assurances to help the company comply with regulatory requirements. However, the banks do not act to stabilize the company’s share price post-trading, as underwriters typically would in a traditional IPO, which could result in more volatility. While financial advisors also charge fees for their services, they generally are less than traditional underwriting commissions. Some have expressed concerns that financial advisors may not be subject to the same liability as underwriters under securities laws, but this issue is currently being resolved in courts.
With direct listings, traditional IPOs and special purpose acquisition companies (SPACs), companies looking to go public have to consider all of these options to determine what is most suitable for the firm and its stakeholders. As each path to the public market uses a unique process, it is critical that investors understand each of these paths before investing and seeking the advice of a professional advisor is suggested.
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