Direct Listing
Direct listing is similar to an IPO, where shareholders sell their shares directly to public investors without underwriting, roadshows, or book-building
When a private company goes public, it will undergo a well-known process in banking - IPO (initial public offering). IPO occurs when a firm sells its shares to public investors for the first time.
These shares become traded on stock exchanges like NASDAQ (US), FTSE 100 (UK), CAC 40 (France), or SSE 50 (China).
Once a share is on the stock exchange, it is traded daily. The demand and supply from buyers and sellers determine its market price. IPO offerings are often market-driven processes—their number increases in the period of economic propensity.
In contrast, in a down market, the initial public offering pipeline shrinks as sellers will get a discounted price imposed by unfavorable market sentiment. Often, companies choose to wait for the stabilization of market trends.
The pattern works for direct listing initiatives. It is not dissimilar from an initial public offering. Selling shares to the market is at the core of each.
Investment banks have ECM departments (Equity Capital Markets) working on IPOs. It is one of many types of transactions they advise on. Equity-linked products, convertible bonds, exchangeable bonds, and rights issues also enter this scope.
A direct listing is a less common guest among all these participants. We will see why further.
Key Takeaways
- An IPO (initial public offering) is when a private company sells shares to public investors for the first time.
- The shares become traded on stock exchanges like NASDAQ, FTSE 100, CAC 40, or SSE 50.
- The demand and supply of buyers and sellers determine the market price of the shares.
- An IPO can be primary (the company issues new shares) or secondary (current shareholders sell their shares).
- A direct listing is similar to an IPO, where shareholders sell their shares directly to public investors without underwriting, roadshows, or book-building.
- Direct listing primarily provides liquidity for existing shareholders and establishes a public market for the company's shares.
- Recent developments allow companies to include a primary component in a direct listing, enabling them to issue new shares and raise capital.
- Differences between an initial public offering and direct listing include the roadshow process, lock-up period, financial outlook communication, underwriting role, and offer price determination process.
- In a direct listing, the share price is determined through an auction mechanism on the listing day, while in an initial public offering, it is determined through a book-building process.
- Direct listing aims to provide a more transparent and market-driven mechanism for determining the initial trading price.
What is Direct Listing?
A direct listing is very similar to an initial public offering. They result in the same thing but use different means. In a direct listing or direct public offering, a company’s shareholders (management, employees, and private investors) sell their shares to public investors.
These shares then become traded on a chosen stock exchange. In this process, a company renounces underwriting, roadshow, and book-building, concepts that are part of every IPO transaction.
The direct public offering doesn’t bring any capital to the company. Instead, the sold shares belong to the current private shareholders, who receive cash.
Even if a direct public offering is a simplified option compared to an initial public offering, companies still must abide by the rules of legislators and stock exchanges. Therefore, pre-launch preparations are quite similar.
A direct listing primarily provides liquidity for existing shareholders and establishes a public market for the company's shares.
However, recent developments have allowed companies to include a primary component in a direct public offering, enabling them to issue new shares and raise capital concurrently with the listing.
This is known as a "primary direct listing" or "direct listing with a capital raise." This option allows the company to generate funds by selling new shares to investors during the direct listing.
The specific regulations and requirements may vary, and companies considering this route should consult with legal and financial advisors to determine the feasibility and implications of a primary direct public offering.
NOTE
It's important to note that a direct listing may only be suitable for some companies. The company must have a strong existing shareholder base, wide recognition, and an established market presence.
Why do companies become public?
The decision to make an initial public offering is contingent on many factors. For example, many IPO companies are owned by private equity or venture capital firms looking to exit an investment. Others can be family-owned businesses that are at their maximum capacity.
Selling of non-core divisions or spin-offs is also on this list. Additionally, the decision to go for an initial public offering is propelled by using IPO proceeds and emotional attachment.
On top of existing investments and getting financing to spend on future growth strategies, it is always prestigious for managers to mark on their resumes that they run a company that successfully went public.
An initial public offering can take two forms:
- Primary
- Secondary
In a secondary initial public offering, current shareholders of a company sell their shares and receive cash. The company doesn’t get anything.
On the contrary, a primary offering happens when a company issues itself new shares. The capital raised flows directly to the company and services its financial needs. An initial public offering can be entirely primary, secondary, or combined.
Summary of principal reasons justifying companies’ IPO choice:
1. Money-making
The most typical reason for doing an IPO is to give owners a cash-out opportunity. In addition, an initial public offering is frequently an appealing alternative because the valuation tends to be higher than if it was an instant sale to a P/E fund or another company.
Furthermore, owners are not obliged to sell 100% of shares. An IPO allows them to sell only a portion of their ownership and remain with a majority stake in the company.
This partial exit is advantageous for sellers because they can participate in a potential upside in the event of the share price appreciation. This upside is infinite to some extent because the share price rise is limitless.
Example
Apple’s share price was $22 on December 12, 1980, when it went public. Considering subsequent stock splits, its adjusted share price becomes $0.1. I would welcome the opportunity to buy Apple’s shares at this price today.
2. Fund growth
IPO is viewed as a source of financing. Therefore, a company can use these proceeds to enhance its business activity. It can be external growth (mergers & acquisitions) or investing in new products, markets, equipment, and technologies.
3. Entry to investment markets
As shares are traded on the public market, they are a liquid asset class. Liquidity of shares is favorable for follow-on offerings, allowing to raise additional funds compared to private markets more easily.
Several debt instruments like hybrid and convertible bonds become available to companies because they are linked to equity.
4. Capital structure improvement
Highly leveraged companies can opt for an initial public offering to repay existing debt and display more safe debt-related ratios. As a result, it reduces their riskiness and, thus, the cost of debt.
As you know, M&A transactions are paid in shares. Therefore, shares of publicly listed companies are a good and liquid currency.
NOTE
IPO proceeds are also debt enhancers. By raising $1 of additional equity, banks can commit to bringing $0.5 to the table.
6. Talent management
Public companies can pay their employees not only in cash but also in shares. As a result, stock-based compensation can sometimes be a significant portion of a compensation package.
This form of incentive is meant to retain key talent within a company and make them contribute to its success in the long run.
7. Heritage and Reputation
Becoming public creates a feeling of stability and permanence. This is particularly significant for companies founded by individuals or family-owned, as they value their legacy.
Going public through an initial public offering is an important event that attracts attention and increases the company's visibility. In addition, it helps establish and strengthen the company's image.
Direct Listing vs. Initial Public Offerings (IPO)
Although a direct public offering results in the same as an initial public offering, some fundamental differences between them lie in the process and investment bankers' roles.
1. Roadshow
In an initial public offering, underwriters need to market the company going public. Roadshow means that a string of meetings is made to entice the interest of buy-side investors. In addition, underwriters want to ensure there will be a demand for the stock.
In a direct listing, the company doesn’t need to market itself. Thus, the typical IPO-type roadshow step is skipped. Although, a company can conduct some presentations targeting investors at its discretion.
Example
Slack streamed its pitch to all prospective investors on the brink of its direct listing.
2. Lock-up period
In every initial public offering, you can find a lock-up constraint prohibiting current stakeholders from selling their shares for a typical 180-day period. This is because they are viewed as insiders and have access to private information, allowing them to use it only for their benefit.
In a direct listing, there is no lock-up period. This benefits existing shareholders as they can sell their shares on day one. It is especially worthwhile because they can take advantage of early price upsides stemming from the stock-related frenzy.
3. Financial Outlook
Companies rolling out a direct listing may communicate their financial estimates before listing. However, in a traditional initial public offering, no forward-looking guidance is not made before an IPO.
4. Underwriting
Investment banks have a different role in a direct listing. They are not hired as underwriters but as financial advisors.
They are paid a predetermined fee to help a company with marketing materials (marketing story, public communications), authorities' documentation, and simplifying the launch of trading.
They can also follow the company’s stock afterward (equity research). All fees that a company incurs are immediately expensed. Consequently, a company needs to have sufficient cash to bear these charges.
In an initial public offering, the after-IPO proceeds to finance all fees, and a company doesn’t need to advance any capital.
NOTE
A direct listing is always less costly than an initial public offering. Underwriting fees are a very lucrative source of revenue for investment banks. For example, UBER had to pay $106.2 million to underwriters deducting it from the initial offering of $8.1 billion.
5. Offer price determination process
In an initial public offering, a book-building process is mandatory. During this process, investment banks and underwriters solicit indications of interest from potential investors to determine the price and quantity of shares to be issued.
The information is compiled in a "book" and helps set the final IPO price. Book building allows the company to gauge investor interest and optimize the pricing and allocation of shares in the offering.
In a direct listing, the book-building process is bypassed. Instead of book building, the price at which the shares start trading is determined through an auction mechanism on the day of the listing.
NOTE
Offer price determination process involves collecting buy and sell orders from various market participants and matching them to determine the opening price.
6. Indicative price
In an initial public offering, the underwriter establishes the reference price. It is an opening share price on the exchange.
Conversely, an indicative price for direct listing is determined on the night before the actual trading day. Then, brokers collect buy and sell orders from all investors to find an optimal price.
The direct listing approach aims to provide a more transparent and market-driven mechanism for determining the initial trading price.
Example
The New York Stock Exchange (NYSE) uses the "Direct Floor Listing Auction" mechanism to establish the reference price in a direct listing.
This process involves collecting buy and sell orders from various market participants to determine the opening price.
The Direct Floor Listing Auction aims to find an equilibrium price that reflects supply and demand dynamics and allows for a fair and orderly market for the shares. Once trading begins, the market forces of supply and demand will determine the actual trading price.
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