By Megan O’Brien, finance and business editor
⏰ 8-minute read

In short:

  • Direct listings have become a topic of startup discussion after big-name companies like Slack and Spotify completed them, and other major companies are reportedly considering them in 2020.
  • The subject reemerged in earnest last week, when the SEC reportedly began an investigation into Slack and other companies’ recent stock market openings.
  • We break down the direct listing’s difference from an IPO, benefits, drawbacks and prognosis for the future, along with what that means for startups heading into 2020.

Traditionally, the question for growing companies has been whether they want to stay private or go public. However, trends in the past few years have dictated an additional consideration: “Should I go public via IPO or direct listing?”

And last week, headlines once again sparked chatter around IPOs and their newfangled cousin the direct listing, which we explain in detail below. The Wall Street Journal reported that the Securities and Exchange Commission had launched an inquiry into several IPOs and direct listings handled in the past five years by two global market makers: Citadel Securities and GTS.

The exact reasoning for the probe is currently unknown, but some speculate it was instigated by the opening of Slack’s direct offering in June 2019. Allegedly, some floor brokers felt that the initial indications given by Citadel were too low (thus not showing a true view of supply and demand) and alerted the NYSE’s regulatory office.

However, the Journal noted, “It couldn’t be learned who the investigation may be targeting and what types of misconduct the SEC may suspect. It is possible the investigation won’t lead to any allegation of wrongdoing — public or private.”

As the probe continues to play out, several important questions come to mind: What exactly is a direct listing? Why are we hearing about them now? And how will this manner of going public continue to evolve?

What exactly is a direct listing, and how is it different from an IPO?

In an IPO, new shares of a company are created, underwritten by one or more investment banks and sold to the public in order to raise capital for a company. A direct listing (also known as a direct public offering, DPO or direct placement) is bringing a private company to public investors without an underwritten public offering or issuance of new shares. Instead, those who are already shareholders, like current employees and private investors, can cash out their shares (if they wish) by selling them directly on the public exchange.

IPO
Direct Listing (DPO)
New shares are created
 No new shares created
New shares are underwritten/sold by an intermediary. Private investors or employees who hold shares can sell them directly on the public exchange
Multiple options to support the share price (stabilization agents and greenshoe provisions) No safety net or support provisions
Stakeholders can't sell their shares for an average of 180 days No lockup -- anyone holding shares can sell them immediately
More expensive option due to intermediary commissions and roadshow Lower cost due to lack of underwriter fees and roadshow
Underwriter decides stock price Stock price is dependent on market demand
Primary purpose is to raise capital by selling new stock to investors Not permitted to raise capital during the process*

* The New York Stock Exchange is currently appealing this with the Securities and Exchange Commission.

Roadshow: a series of sales pitch presentations to potential investors that can last up to several weeks

Underwriter: usually an investment bank that assumes a company’s financial risk during an IPO and sells shares to the public

Greenshoe: an IPO clause that allows underwriters to stabilize the company’s stock price if it gets low by selling more shares to stakeholders

Lockup: the approximately 180-day period after an IPO, during which company insiders aren’t allowed to sell their shares

The benefits of direct listings

A direct listing can present many benefits to companies. On average, underwriter fees of an IPO equal 4-7% of gross proceeds, while DPOs don’t incur such costs. In its IPO, Uber paid $106 million to its underwriters while Spotify gave $32 million to its financial advisers during the course of its direct listing. (Note: Like IPOs, stock exchanges require that direct listing candidates engage an experienced financial advisor.)

The direct listing route also ensures that, since no new stock is created, existing shareholders won’t experience dilution.

Lastly, unlike IPOs, direct listings do not face the lockup agreement implemented by the SEC. Thus, instead of waiting 180 days (on average), company insiders like employees, their friends and family and venture capitalists can sell their shares in the company immediately following the listing.

The drawbacks

Listing directly also has its share of drawbacks, primarily when it comes to capital influx and the risk of volatility.

“Typically, going public offers a great opportunity to raise money for the business, so companies miss out on that chance when they do a direct listing,” Scott Coyle, CEO of the investment platform ClickIPO, told Benzinga earlier this year.

In an IPO, the company creates new stock to sell to investors through the primary markets, which thereby raises capital for the company. However, a direct offering only allows for the company to facilitate the “resale” of shares held by company insiders straight to investors.

A DPO is also more susceptible because it lacks the financial safety net provided to IPOs, most notably the “stabilization agent” and “greenshoe” provisions . After the IPO, an underwriter can be asked to purchase stock when the price of the newly issued shares falters or is shaky in trading, thereby acting as a “stabilization agent.” IPOs can also be bolstered by a “greenshoe” option (also known as an overallotment). This option allows the underwriter to sell more shares to the investors than planned if demand from the public is higher than expected and shares are trading above the offering price. Thus, companies can raise more capital.

Direct listings, or DPOs, lack the financial safety net that companies have when they choose an IPO.

Why all the talk about direct offerings lately?

In the past, direct listings have been utilized for small companies in industries like food and biotech. This approach allowed for budget-conscious, small companies to avoid the expenses incurred by an IPO. However, that has been changing in recent years with major companies Spotify and Slack opting to enter the public markets through a direct listing in 2018 and 2019, respectively. Both companies cited cost and time savings as well as the lack of share dilution and opportunity for liquidity amongst existing shareholders as rationale for the direct listing move.

Greg Rodgers, a partner at law firm Latham & Watkins who worked on the Slack and Spotify deals, predicted that there would be at least five direct listings in 2020. Already, Airbnb and GitLab are rumored to be pursuing the direct listing option this year, as well as Asana and DoorDash.

This could very well be due to a change in attitude regarding IPOs in the last year. In October 2019, venture capitalist Bill Gurley gathered CEOs, CFOs, venture capitalists and fund managers for an event labelled “Direct Listings: A Simpler and Superior Alternative to the IPO.”

In his opinion, “the IPO process has devolved” and “has become a game of just hand-allocating shares to the same 10-15 firms” as major institutional investors like Morgan Stanley and Goldman Sachs again dominated the 2019 IPO bookrunner ranking. He concluded that IPOs have not been “in our companies’ best interest,” especially when considering Wall Street fees and the struggle of bankers to price IPOs.

Perhaps in response to this growing sentiment, direct listings again made headlines late last year when the NYSE filed a proposal with the SEC to allow for companies going public through a direct listing to raise capital at the same time.

And then the SEC opened its inquiry into Slack’s and other DPOs last week. With the probe still in its early stages, it is difficult to say whether it will have an effect on the hype surrounding direct listings. It is likely that companies considering direct listings will postpone plans until more details emerge. However, as it stands now, it seems more likely that this marks an inflection, not ending, point for direct listings.

Spotify made news when it went public via DPO earlier this year.

More on the DPO capital-raising rules:

As presently structured by Section 102.01B of the NYSE’s Listed Company Manual, companies can pursue a “Selling Shareholder Direct Floor Listing,” which allows for current shareholders to monetize their shares. (This is classified as a “secondary market” since investors are buying and selling stocks and bonds amongst themselves.) However, the NYSE is seeking an option for a “Primary Direct Floor Listing,” which would permit companies to pursue primary offerings (i.e. new shares are sold directly by the company) without having to go through the traditional IPO process.

While ultimately rejected by the SEC in December, the NYSE isn't giving up on getting its proposal passed … at least it wasn’t at last check, before news of the SEC probe.

Direct listing success factors

As evidenced by the current SEC investigation and the NYSE proposal, direct listings as a product are in flux and may not be the best fit for all companies. As it stands, a company’s suitability for a direct listing largely depends on the following:

  • Goals: A direct listing tends to be a good fit for companies that want greater liquidity for their existing shareholders, equal access/visibility to all buyers and sellers and to avoid the traditional lockup period. It also proves to be quicker and less expensive than a traditional IPO.
  • Company strength: Going public via direct listing is most conducive to companies that already have strong brand recognition, a comprehensible and transparent business plan, a large and diverse set of shareholders and global scalability. For example, the huge reputation of Spotify earned its DPO analyst coverage and hype, whereas a lesser known company would not receive the same needed exposure for success.
  • Capital: Perhaps the most important component, an abundance of capital, allots companies the option to pursue a direct listing. For companies already rich with private capital, the inability to raise money in a direct listing is less impactful.

In cases where a company differs from these composition and goal traits, the pursuance of an IPO may be a better tactic. Watch our sister site, the Brainyard, for details on that.

The bottom line

High-profile IPO flops in 2019 illustrated that market conditions were rendering IPOs both unpredictable and complex. The “cheap money era” has seen private markets flourish while the time to IPOs has been longer and deal sizes smaller. While an IPO will still likely be the common path for companies looking to go public, direct listings are evolving – and that could have a significant impact on your startup’s goals as it grows forward in 2020.