What is a Direct Listing?
A direct listing is a process by which a company can go public by selling existing shares instead of offering new ones. Companies that choose to go public using the direct listing method usually have different goals than those that use an initial public offering (IPO).
Quick Summary Points
- A direct listing is a process for a company to become public without going through the initial public offering process.
- The process makes existing stock owned by employees and/or investors available for the public to buy and does not require underwriters or a lock-up period.
- Direct listing increases liquidity for existing shareholders and is usually cheaper than an IPO.
Direct Listing vs. Initial Public Offerings (IPO)
The major difference between a direct listing and an IPO is that one sells existing stocks while the other issues new stock shares. In a direct listing, employees and investors sell their existing stocks to the public. In an IPO, a company sells part of the company by issuing new stocks. The goal of companies that become public through a direct listing is not focused on raising additional capital, which is why new shares are not necessary.
The second difference is that in a direct listing there are no underwriters. Underwriters work for investment banks to help sell stocks of a company that is going public. They make large purchases which adds value to companies as those shares are taken off their hands. However, the shares are typically sold at a discount to their true value.
The process of using underwriters and selling at a discount increases the time and cost for a company that is issuing new shares. The practice of investment banks buying stocks and then selling the stock themselves is not as common now. Instead, the investment banks will use their network to help market the stocks and drive sales.
Lastly, the direct listing process also does not have the “lock-up” period that applies to IPOs. In traditional IPOs, though not always required, companies have lock-up periods in which existing shareholders are not allowed to sell their shares in the public market. It prevents an overly large supply in the market that would decrease the price of the stock.
In direct listings, existing shareholders can sell their shares right when the company goes public. Since no new shares are issued, transactions will only occur if existing shareholders sell their shares.
Benefits and Drawbacks of a Direct Listing
There are several benefits of a direct listing that attract companies to the process. First, by going public the company provides liquidity for existing shareholders by allowing them to freely sell their shares in the public market. Secondly, the cost of the process is much lower than the cost of an IPO. Direct listing helps companies avoid hefty fees paid to investment banks. It also helps them avoid the indirect cost of selling the stocks at a discount.
Since direct listing does not use investment banks to underwrite the stocks, there is often more initial volatility. The availability of stock depends on current employees and investors. If on the day of the listing, no employees or investors want to sell their shares, then no transactions will occur. The stock price is purely dependent on market demand.
Unlike an IPO in which the share price is negotiated beforehand, in a direct listing the price of the stock depends solely on supply and demand. This increases volatility, as the range in which the stock is traded is less predictable.
Why Do Companies Choose Direct Listing?
Companies that use direct listing have different goals than those that choose an IPO. In an IPO, companies are trying to raise capital for expansion or funding. On the other hand, companies that use a direct listing are not necessarily seeking capital. Instead, they are looking for the other benefits of being a public company, such as increased liquidity for existing shareholders.
Companies that want to go public through this process should also fit a certain profile. Since no underwriters are selling the stocks, the company itself has to be attractive enough for the market. The rough outline of companies that should use this method includes those that: (1) are consumer-facing with a strong brand identity; (2) have easy to understand business models; (3) are not in need of substantial additional capital.
Two notable companies that have gone public through direct listings are Spotify and Slack. Both companies already had strong reputations before going public. They were widely used, and it was easy to understand how the company makes money. These two things combined increase the number of people who are interested in investing in the company. It is because investors are more inclined to invest in companies that they have heard of before and understand.
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