What Is a Direct Listing? | Direct Listing vs IPO

September 27, 2021 14:43 UTC

Recently, companies such as Wise, Roblox and Coinbase have chosen to go public via a ‘direct listing’ instead of the more traditional Initial Public Offering (IPO). But what is a direct listing? And what are the differences between a direct listing vs IPO? In this article, we will answer these questions and much more!

What Is an IPO?

Before we answer the question of ‘what is a direct listing?’ it is worth reminding ourselves what an IPO is.

In an IPO, a company creates new shares to offer to the public market in order to raise capital. These new shares are underwritten by an investment bank - who publicise the IPO, help sell the shares to institutional investors, decide the initial share price and help navigate the various regulatory requirements.

Of course, the underwriter does not provide this service out of the kindness of their heart and charge a fee which can range anywhere between 3% and 7% of the total amount of money raised from the IPO. This is no small amount and for a large IPO the investment bank can end up walking away with tens or even hundreds of millions.

What Is a Direct Listing?

So what is a direct listing? Unlike an IPO - in a direct listing, or direct public offering (DPO), no new shares are created. Instead, the company’s existing shares are listed on the stock exchange and existing shareholders can begin selling their shares directly to the public.

In a direct listing, the company going public is not required to hire underwriters; but, instead, will retain the services of financial advisors to help with the listing process.

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Direct Listing vs IPO

We should now be familiar with the basic concepts of what an IPO and direct listing are. Both paths lead to the public market, but they differ significantly in how they get there.

Let’s take a look at some of the key differences between a direct listing vs IPO and explore why a company might choose one over the other.

Raising Capital

One of the main, if not the main, differences between a direct listing vs IPO is that, as part of the IPO process, the company creates new shares to sell to the public. This is done to raise capital, which can then be used to fund a particular new project or simply in order to help the company grow. These new shares have the knock-on effect of diluting existing shares, in other words, reducing their value.

In a direct listing, on the other hand, new shares are not created, because the company in question does not need to raise capital. Instead, once the company has been listed, existing shares are sold. But if no capital is raised, why bother going public in the first place?

Going public provides other benefits to a company besides simply raising capital. For one, it provides existing shareholders with greater liquidity, allowing them to sell their shares on the public market. Furthermore, going public increases public awareness for the company and their product, perhaps leading to an increase in market share. There is also a certain level of prestige associated with becoming a listed company.

Cost

When reading through our basic definitions of a direct listing vs IPO, the first thing that will have occurred to most is that, without the expense of underwriters, going public via a direct listing incurs far smaller fees.

Going public via an IPO is the traditional way for your company to list on an exchange and go public. However, it seems that recently, more companies are beginning to challenge the status quo. Why should a company dilute their shares and lose out on tens or hundreds of millions in underwriter fees if they do not need to raise additional capital?

Initial Share Price

As part of the IPO process, the underwriter values the company and sets the initial price which shares will be sold for to institutional investors.

In this process, underwriters are frequently accused of systematically under-pricing the shares. They have two motivations to do this. First, so that their clients, the institutional investors, can benefit from an IPO “pop” during the initial trading session – something we frequently read about in stories about IPOs. Second, the cheaper the shares are, the lower the risk that they will have to step in and buy any unsold shares, something their role as underwriter requires them to do.

In contrast, with a direct listing, the initial share price is purely based on market supply and demand. As there are no new shares being created, the supply depends entirely on whether existing shareholders wish to sell their shares; if none of them do, then no transactions will occur. This tends to lead to more volatility in the early trading sessions.

Lock-Up Period

Usually, when a company goes public via an IPO, there is a “lock-up period” following the initial listing. During this period, which typically lasts between 90 and 180 days, existing shareholders are not able to sell their shares in the market.

The lock-up period prevents the market becoming oversupplied, which might lead to the share price falling. Furthermore, a lock-up period also provides potential investors with the reassurance that the company is confident in itself and is not merely going public so shareholders can cash in on their holdings.

Conversely, due to the fact that no new shares are issued and the only shares being sold are sold by existing shareholders, a direct listing does not have a lock-up period.

Which is Better: Direct Listing or IPO?

The clear benefit to a company of going public with a direct listing is the reduced cost involved in doing so. Companies can not only save themselves millions in underwriter fees, but also remove the risk of leaving additional money on the table due to their shares “popping” in the initial trading session.

However, with this reduced cost, companies do lose some of the benefits of an IPO. First and foremost, they miss out on raising capital for reinvestment in the business; although, there is nothing stopping the company raising money by issuing new shares further down the line once the company is already public.

Moreover, although they charge high fees, investment banks do provide the company with a lot of support during the IPO process. Particularly valuable are the investor roadshows which are used by the underwriters in order to drum up investor interest and public anticipation for the upcoming IPO.

Consequently, whilst there are financial advantages to a direct listing, it will not be suitable for every company. A company considering a direct listing will need to be well-funded and confident that there is already enough interest in their business amongst potential investors. For example, recent companies which have gone public using the direct listing process – such as Slack and Spotify - already had strong and recognisable brands as private companies.

Final Thoughts

In conclusion, therefore, direct listing and IPOs both have their advantages and disadvantages. Which process is “better” will depend largely on the profile of the company in question and what they are aiming to achieve from going public.

Although, with several big name companies going public via direct listings recently, do not be surprised if you start to see more companies following suit in the future.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks

Roberto Rivero
Roberto Rivero Financial Writer, Admirals, London

Roberto spent 11 years designing trading and decision-making systems for traders and fund managers and a further 13 years at S&P, working with professional investors. He has a BSc in Economics and an MBA and has been an active investor since the mid-1990s