By: EIC Student
Raising capital is a challenge for almost every entrepreneur during his or her business’s lifecycle. The capital required, or even simply desired, to grow a business may exceed what individual private investors are willing or able to give. Constantly finding new private investors can drain a company of time and resources. A popular remedy for this dilemma is for an entrepreneur to take the company “public,” aka to sell its stock to public investors in the open market. There are a number of advantages to going public: the financial benefit of immediate capital, ease in raising capital later, increased public awareness of the company and its brand, and even the potential for an exit down the road.
The typical route for going public is an Initial Public Offering (IPO). However, there is another method that has reemerged in light of a recent rule change with the NYSE: the direct listing process (DLP).
WHAT IS AN IPO
An IPO is the most common option for companies looking to go public. In an IPO, companies work with a number of intermediaries to facilitate the process of meeting the regulatory requirements to be listed on an exchange (like on the NYSE or NASDAQ). One of those intermediaries are underwriters. In an IPO, underwriters assist in meeting statutory and market requirements, and in preventing financial harm to the company. Underwriters’ work culminates in setting the initial offering price. Underwriters also buy the shares from the company first and then sell to investors via their pre-existing distribution networks that are comprised of investment banks, brokers, dealers, and mutual funds. These connections to distribution networks help underwriters to set realistic IPO prices and ensure that company stock is bought by long-term holders. Additionally, underwriters can provide for a guarantee of sale to their clients, adding a level of security for the company going public. The downside of an IPO is that underwriters and other intermediaries (e.g. investment bankers, etc.) charge a fee for their work. Usually this is between 2% and 8% of the capital raised via the IPO. While underwriters will take care of the process and formalities, it comes at a cost that can be burdensome to entrepreneurs who are searching for funds to begin with.
WHAT IS DLP
In addition to an IPO, companies can go public through a DLP. In a DLP, a business, rather than using a number of third parties to run the process, will sell shares directly to the public. No new shares are issued; only existing shares can be sold. This prevents dilution to existing stocks and gets rid of additional steps the company would have to take. A DLP also does not have a “lock-up period,” or a time when stockholders are restricted from selling their own shares in the market due to contractual terms.
This begs the question – how does a company make any money from an DLP? The short answer is: they don’t. One financial benefit of the DLP is that it gives shareholders a way to make money immediately on their own. It gives the investors of a company the ability to sell stocks as soon as the company is listed and do it on a larger, transparent, regulated market. Individual shareholders can make money. But, the longer answer that demonstrates the benefit to the company’s finances is the ability for the company to later grow, authorize, and issue shares with less hassle. Existing as a public company facilitates raising capital and obtaining financing in the future; a public company can conduct a second offering to raise capital, and the access to capital markets provides a better route to future funding sources.
DLP is also appealing to small businesses looking to enter the public market because of the low cost attached to a DLP; there is no underwriter fee and no broker fee. If a company has low funds to begin with, spending the extra money on an IPO and all the fanfare attached may seem unnecessary.
However, there are downsides to using a DLP. The first, as previously mentioned, is that the company does not raise capital immediately. Additionally, unlike in an IPO, there is no guarantee for the sale of stock and this risk only increases with the absence of promotions or safe long-term investors. Further hurting the company’s prospects is the inability for greenshoe options. A greenshoe option is a clause contained in the underwriting agreement that allows underwriters to purchase company shares at the offering price so that if public demand for the shares exceeds expectations and the stock trades at a higher price, the brokers are permitted to sell more shares. Once the additional shares are sold in the market, the broker can buy them back and stabilize fluctuating share prices. This is a key benefit to having the intermediary resources available in an IPO; the networks that make IPOs appealing are absent from a DLP. Lastly, if the company is in need of immediate financing, a DLP is less appealing.
THE LEGAL REQUIREMENTS
To file for a direct listing with the NYSE, a company must file with the SEC a registration statement that it has declared “effective” and that covers the resale of some or all of the outstanding shares of its restricted stock. For a U.S. issuer, this can be done on a Form S-1, the same form used to register for a traditional IPO. Additionally, when filing for a direct listing, a company can choose to register under the Securities Exchange Act of 1934 using Form 10 (or Form 20-F(R) for foreign private issuers).
This form is subject to review and comment by the SEC and also requires a number of disclosures about the company akin to those of a IPO registration statement which includes information regarding the company’s management and finances. The direct listing is not effective until it has received SEC approval. Additionally, the NYSE has qualitative criteria and quantitative criteria that must be satisfied in order to be listed; these still hold when applying for a DLP.
RESURGANCE OF THE DLP: SPOTIFY
Spotify is a music streaming site and app available for free to consumers. It has 159 million users, 71 million of whom are paying subscribers of Spotify Premium. Though a private company, Spotify announced its intentions to go public via a DLP, a particularly rate move, and it officially went public on April 3rd. As a larger tech company, the traditional move would have been an IPO in the vein of Facebook’s 2012 IPO or Snapchat’s 2017 IPO.
During its 2018 Investor Day presentation, Spotify went into further detail as to why it is departing from the typical route. First, Spotify noted the ability to list without selling shares. Spotify is without debt since it converted debt into equity for investors. Currently, it has approximately $1.3 billion in cash and securities, and is turning out a net profit. The company has no need to immediately issue large quantities of new shares. Second, Spotify noted the democratic nature of the liquidity aspect within the context of a DLP; employees and investors can sell at any time and are not stuck in a lock-up period. Third, bankers will not be getting preferred access; everyone has the opportunity to purchase shares at the same time. Fourth, Spotify noted the ability for all people to have the same information about the company. Lastly, Spotify believes in market-driven price discovery (i.e. allowing for the public to determine what the company is worth rather than select financiers).
While Spotify’s stated reasoning romanticizes the market place as capable of regulating fair value for its stock, the choice to avoid an IPO is still risky for the company. At its core, Spotify is a music app. Music prices and catalogues are similar across the industry. Without the benefits of publicity and fanfare that come with an IPO, it was unclear how Spotify would do. However, the DLP date has passed and there are concrete numbers to be considered. Spotify’s DLP was successful; Spotify yielded a public market value of about $26.5 billion (above its private market value) and had a first day closing price of $149.01, higher than the reference price set by the NYSE based on the data available from previous private market trades. Though, by the morning of April 4th Spotify shares had dropped as much as 8.5%, opening at $140, this should still be seen as a success from the perspective of private companies looking to go public, but perhaps a potential threat to traditional Wall Street mainstays.