IPO vs. Direct Listing

Whenever a private company wants to go public, there are essentially two methods that they can follow in order to list shares on a public stock exchange: the company can file for an IPO, which most businesses do, or you can go the Direct Listing route, which is significantly less common. If you followed Spotify’s path to becoming public last year or Slack’s path this year, you might have noticed that both of these disruptive tech companies opted for the Direct Listing route instead of the usual IPO process.

There a couple of reasons why a private company would want to go the Direct Listing route instead of an IPO, but it helps to understand the difference first. With an IPO, a company seeking to go public works with an underwriter, whose main tasks include determining the initial offer price of shares, assisting in identifying regulatory requirements, buying the shares from the company, and then selling those shares to investors with the help of their network. During the IPO process, the company go on a “roadshow” where the CEO and executive team travel to different institutional investors and do their best to create interest in purchasing their stock. This process helps the underwriter, who normally represents an investment bank or group of banks, determine the offering price. If there happens to be a lot of demand, the price goes up; if not, the price tanks. Of course, if a company starts having red flags come up, that can also lower the valuation of the company (e.g. WeWork, anybody?)

When a company opts for the Direct Listing route, they sell shares directly to the public rather than working with an underwriter. No new shares are listed and existing investors and employees can sell shares immediately. By doing this, companies avoid lockup agreements that are included in an IPO, where there is a period of time (usually 6 months) where existing shareholders cannot sell their stock beforehand. Direct Listing is nowhere near as common of a path as an IPO is for a couple of reasons.

First, when a company goes the IPO route, the underwriter guarantees the sale of a number of shares at the price that was initially offered. They also agree to buy excess shares should that situation come up. There is also the right for the underwriter to sell more shares than they initially planned to if the demand for those shares is plenty, which is also known as a greenshoe provision. On the other hand, there are no such guarantees in a Direct Listing and no large investors that can back you during price volatility of your shares.

Still, there are a couple of reasons where it makes more sense for a company do a Direct Listing. If a company doesn’t have the resources of hiring an underwriter and going through the roadshow process, they don’t have to do so. By hiring an underwriter, companies are expected to shell out a fee per share (usually around 2-8% of the share price). That can add up to hundreds of millions if the IPO price is strong. They may also want to avoid the aforementioned lockup period and also may not want to dilute existing shares with the creation of new ones.

It will be interesting to see if more tech companies follow what Spotify and Slack have done. So far, they seem to be the exception with going the Direct Listing route and they have their reasons for doing so. I have a feeling there may be more to come.