Spotify did it. Slack did it. Many other late-stage private technology companies are reported to be seriously considering it. Should yours?
If you are a board member of a late-stage, venture-backed company or part of its management team, you likely have heard of the term “direct listing.” Or you may have attended one or all of the slew of recent conferences being hosted by big-name investment banks and others, including tech investor guru Bill Gurley, who recently debated the pros and cons of choosing a direct listing over a traditional IPO.
Before you decide what’s right for your company, here are a few things you need to know about direct listings.
Direct listings vs. IPOs
For people not familiar with the term, a direct listing is an alternative way for a private company to “go public,” but without selling its shares directly to the public and without the traditional underwriting assistance of investment bankers.
In a traditional IPO, a company raises money and creates a public market for its shares by selling newly created stock to investors. In some instances, a select number of pre-IPO investors, usually very large stockholders or management, may also sell a portion of their holdings in the IPO. In an IPO, the company engages investment bankers to help promote, price and sell the stock to investors. The investment bankers are paid a commission for their work that is based on the size of the IPO—usually seven percent for a traditional technology company IPO.
In a direct listing, a company does not sell stock directly to investors and does not receive any new capital. Instead, it facilitates the re-sale of shares held by company insiders such as employees, executives and pre-IPO investors. Investors in a direct listing buy shares directly from these company insiders.
Does this mean that a company doing a direct listing doesn’t need investment banks? Not quite. Companies still engage investment banks to assist with a direct listing and those banks still get paid quite well (to the tune of $35 million in Spotify and $22 million in Slack).
However, the investment banks play a very different role in a direct listing. Unlike a traditional IPO, in a direct listing, investment banks are prohibited under current law from organizing or attending investor meetings and they do not sell stock to investors. Instead, they act purely in an advisory capacity helping a company to position its story to investors, draft its IPO disclosures, educate a company’s insiders on process and strategize on investor outreach and liquidity.
Understanding the current direct listings trend
The concept of a direct listing is actually not a new one. Companies in a variety of industries have used similar structures for years. However, the structure has only recently received a lot of investor and media attention because high-profile technology companies have started to use it to go public. But why have technology companies only recently started to consider direct listings?
The rise of massive pre-IPO fundraising rounds
With an abundance of investor capital, especially from institutional investors that historically hadn’t invested in private technology companies, massive pre-IPO fundraising rounds have become the norm. Slack raised over $400 million in August 2018—just over a year prior to its direct listing. Because of this widespread availability of capital, some technology companies are now able to raise sufficient capital before their actual IPO to either become profitable or put them on a path to profitability.
Criticism of current IPO process
There has been increasing negative sentiment, especially amongst well-known venture capitalists, about certain aspects of the traditional IPO process—namely IPO lock-up agreements and the pricing and allocation process.
IPO lock-up agreements. In a traditional IPO, investment bankers require pre-IPO investors, employees and the company to sign a “lock-up agreement” restricting them from selling or distributing shares for a specified period of time following the IPO—usually 180 days. The bankers put these agreements in place in order to stabilize the stock immediately after the IPO. While the merits of a lock-up agreement can certainly be debated, by the time VCs (and other insiders) are allowed to sell following an IPO, oftentimes the stock price has fallen significantly from its highs (sometimes to below the IPO price) or the post lock-up flood of selling can have an immediate negative impact on the trading price.
In a direct listing, there is no lock-up agreement, which allows for equal access to the offering to all of the company’s pre-IPO investors, including rank-and-file employees and smaller pre-IPO stockholders.
IPO pricing and allocation: In a traditional IPO, shares are often allocated directly by a company (with the assistance of its underwriters) to a small number of large, institutional investors. Traditional IPOs are often underpriced by design to provide large institutional investors the benefit of an immediate 10-15% “pop” in the stock price. Over the last few years, some of these “pops” have become more pronounced. For example, Beyond Meat’s stock soared from $25 to $73 on its first day of trading, a 163% gain. This has fueled a concern, particularly shared amongst the VC community, that investment banks improperly price and allocate shares in an IPO in order to benefit these institutional investors, which are also clients of the same investment banks that are underwriting the IPO. While the merits of this concern can also be debated, in instances where there is a large price discrepancy between the trading price of the stock following the IPO and the price of the IPO, there is often a sense that companies have left money on the table and that pre-IPO investors have suffered unnecessary dilution. If the IPO had been priced “correctly,” the company would have had to sell fewer shares to raise the same amount of proceeds.
Because a company is not selling stock in a direct listing, the trading price after listing is purely market driven and is not “set” by the company and its investment bankers. Moreover, since no new shares are issued in a direct listing, insiders do not suffer any dilution.
The Spotify effect
Before Spotify’s direct listing, technology companies hadn’t used the direct listing structure to go public. Spotify was, in many ways, the perfect test case for a direct listing. It was well known, didn’t need any additional capital and was cash flow positive. In addition, prior to its direct listing, Spotify had entered into a debt instrument that penalized the company so long as it remained private. As a result, it just needed to go public. After clearing some regulatory hurdles, Spotify successfully executed its direct listing in April 2018. After Spotify’s direct listing, Slack (relatively) quickly followed suit. Slack’s direct listing was notable because it represented the first traditional Silicon Valley-based VC-backed company to use the structure. It was also an enterprise software company, albeit one with a consumer cult following.
Is a direct listing right for my company?
While a direct listing offers many benefits, the structure does not make sense for every company. Below is a list of key benefits and drawbacks:
Benefits
Equal access to all buyers and sellers: In a direct listing, company insiders are not constrained from selling or distributing their pre-IPO shares by a lock-up agreement. They can sell their shares whenever and for whatever amount they want. Moreover, unlike in a traditional IPO, the shares in a direct listing are not allocated by the company to a small number of institutional investors. Instead, investors of all shapes and sizes can participate at the same time. In addition, instead of the research analyst process in a traditional IPO, companies in a direct listing have been unable to share detailed forward-looking projections with these research analysts. Instead, in a direct listing, companies have issued public-company-style guidance that is available to all investors. Moreover, since the investment banks are not able to set-up and attend investor meetings, companies that have pursued a direct listing have opted out of the traditional IPO roadshow, which consists of a one-to-two-week series of one-on-one meetings between the company’s management team and the large institutional investors buying in the IPO. Spotify and Slack, for example, chose to educate their potential investors by holding an “Investor Day” via live streaming, opening access to a broader base of investors.
Market-based price discovery: In a traditional IPO, the price for a company’s stock is determined based on demand from a small number of large institutional investors for a limited supply of a company’s shares (often only representing 10-20 percent of the entire company). This scarcity in supply results in a stock price following an IPO that isn’t necessarily reflective of what a purchaser of the stock would pay for the shares if more shares were available in the open market. This explains the stock price decline that companies often experience in advance of the lock-up expiration. In theory, a direct listing allows for true market-based discovery since all of a company’s shares are available for sale and purchase on the first day of trading.
Lower investment banking fees: Due to the more limited role that investment banks play in a direct listing, the fees in a direct listing are generally lower than if the company were to do a traditional IPO. To get a sense: Spotify did its direct listing at a $29 billion market capitalization and paid $35 million in advisory fees; Snap went public at a $24 billion market capitalization and paid $85 million in underwriting fees.
Similar to an IPO process with a bit less IPO-related documentation and process: A company doing a direct listing still selects investment bankers, holds an organizational meeting, prepares an S-1 registration statement, goes through the same lengthy SEC review and comment process, and has the same liability exposure. Despite all these similarities in the process, there are a few things that are streamlined in a direct listing—mainly related to underwriting documentation and regulatory filings.
Drawbacks
A direct listing is NOT (currently) a capital-raising event: Companies doing a direct listing aren’t currently raising capital. Even with massive pre-IPO fundraising rounds, many technology companies still need to raise additional capital in their IPO. Not being able to raise capital in a direct listing probably forecloses this structure for many technology companies, especially those that are not yet profitable or that do not have a clear path to profitability. The good news is that this will likely change soon! The NYSE recently proposed a significant rule change that will allow for a company to raise capital and do a direct listing at the same time.
No research analyst education process: In a traditional IPO, companies spend significant time with their investment bank research analysts that will cover the company and its stock following the IPO. Ensuring that these research analysts have a clear understanding of a company’s business is critical as the research that these analysts publish can have a significant impact on a company’s stock price. Unfortunately, due to regulatory restrictions that limit what can be shared with research analysts outside of a traditional IPO, the investment banks have not yet gotten comfortable with allowing their research analysts to participate in a direct listing. As a result, companies that do a direct listing are deprived of the valuable exercise of spending time educating the research analysts covering their stock.
Need to create a liquid market for your shares on the first day of trading: There is a lot of uncertainty in a direct listing because it is unclear who will sell and buy shares on the first day of trading. In a traditional IPO, you know who the buyers are and the bankers have a good sense of the trading patterns of your IPO investors in the after-market. In a direct listing, that certainty goes out the door and the market for your shares will be limited by the number of shares that your insiders choose to sell on the open market. An illiquid market on the first day of trading could result in negative consequences for the stock price. Accordingly, companies need to spend a lot more time educating their insiders, including employees, about the direct listing process and how to sell shares, if they so choose, immediately after the stock begins trading. Also, some of the company’s founders and venture capitalists will likely need to sell on the first day of trading to create an active and liquid market for the shares.
Lots of heavy lifting by management to educate investors: Because the investment bankers in a direct listing are not involved in setting up and attending investor meetings and with no traditional roadshow and research analyst modeling process, the onus falls on the company’s management team to take control of, and run, the investor education process. Companies that do not have a management team that is experienced with navigating the complex public offering landscape may be better served by a traditional IPO, in which the investment bankers are able to assist with the investor education process.
What should my company do to prepare a direct listing?
Here are a few steps you can take to prepare for a successful direct listing:
- Review your financing and organizational documents: Most financing and organizational documents for venture-backed companies are structured in such a way that the preferred stock terms only terminate on an underwritten IPO. Before you do a direct listing, these documents need to be modified to preserve flexibility to do a direct listing.
- Consider a fundraising round before your direct listing: If your company still needs additional capital, you should consider doing an equity financing between six and 12 months ahead of the direct listing. The financing should be sufficient in size to carry the company through profitability.
- Investor and research analyst education: With no underwriting support from investment bankers and no formal research analyst education and modeling process, it is critical for management to be heavily involved in investor and analyst education and to own the process. Companies should consider hiring a strong investors relation person.
- Educate your existing investors and employees: It is very important to spend a lot of time educating existing investors and employees about the direct listing process. The company should seek to gain a good understanding of selling interest from existing investors. This education should come early in the direct listing process—much earlier than what you would see in a traditional IPO.
Considering a direct listing? Read more about it here.