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The difference between IPOs and Direct Listings

Direct Listings are still a nascent phenomenon, but the recent listings of Spotify and Slack could pave the path to a new way of going public.

By Tomer Diari 9.18.19 Investor Thoughts

2019 might be a record year for IPOs, but as Wall Street bankers sweep up millions in IPO-related fees, tech companies are beginning to question the validity of a business practice that stood unchallenged for decades. Direct Listings are still a nascent phenomenon, but the recent listings of Spotify and Slack could pave the path to a new way of going public. Are we about to say goodbye to IPOs and hello to Direct Listings? Here are the differences between the two methods and what any newly-minted founder should know.

Going public?

As a company reaches a large enough scale, it can start entertaining the idea of becoming a publicly-traded company. Many factors weigh in on the decision, but pros and cons aside, going public is a natural step in the journey towards becoming a large independent company. As a rule of thumb, successful software companies often go public after hitting the $100M annual recurring revenue (ARR) mark and only a few companies that surpass a multi-billion dollar valuation choose to remain private, usually for a good reason.

The most common method of going public is through an Initial Public Offering (IPO), but while it’s often thought-of as a liquidity event (AKA an exit), an IPO is actually a fundraising mechanism. Simply put, an IPO enables a company to raise capital from institutional public investors while registering in a stock exchange. The process is facilitated by an investment bank that acts as the underwriter and helps solicit interest from potential investors. The main issue? It’s expensive. Very expensive.

Hidden fees

In order to secure interest and compensate the institutional public investors for the risk of backing the newest company on the exchange, the underwriter often prices the IPO at a 10%-20% discount compared to the actual anticipated valuation of the company, leading to a satisfying 10%-20% pop as trade begins and the stock price rebounds. Moreover, the underwriter also takes a cut of all raised capital in a form of commission, often in the range of 2%–8%. A company raising $100M in an IPO priced at $1Bn can expect to pay ~$20M* in hidden fees. Yeah, IPOs are a lucrative business.

*(By the way, a 15% discount on the IPO price implies $15M worth-of-stock. a 5% commission by the underwriter adds additional $5M in cash.)

Lock-up periods

Moreover, existing shareholders such as founders, employees and early investors are often subject to a lock-up period following an IPO, usually in the range of 180 days. While the lock up period serves an important role in protecting the company from a sudden mass-sell of stock, it also limits public investors from building a large position (as 80% of the company might be locked up), limits liquidity-seeking investors from collecting their proceeds and distributing them elsewhere and defers actual public trading by additional 180 days. Surely there’s a better way.

Direct listing

A less-common and much more straightforward method for going public is simply registering the company directly on a stock exchange in a process called Direct Listing. As Spotify and Slack already proved, a company using direct listing could still enjoy a successful registration on an exchange (and even get its famous picture opening trade at the NYSE) while overcoming the shortfalls of an IPO. No underwriting. No capital raise. No hidden fees. No lockup periods.

  • Want to also raise capital? Just go through a traditional private financing before going public. You can also solicit traditional public investors.
  • Need advice throughout the process? You should still hire investment bankers as advisors, even if they don’t act as the underwriters.
  • Afraid of going public without a lock-up period? Ensure that the price per share reflects the actual value of the company.

Parting thoughts

IPOs are deeply entrenched in the mindset of investors and investment banks have little incentive to suggest alternative approaches to going public, but once again Silicon Valley does what it excels at — challenging existing norms and finding new and more efficient ways of conducting business. Direct listings are not the best fit for every single company, but as more high-profile tech companies choose to go public, it is becoming an increasingly favorable method. It’s too early to tell whether the first few examples are early indicators of a new trend or simply outliers, but I expect Direct Listings to become much more popular over the next few years. Only time will tell.

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