Business chat and instant messaging company Slack Technologies Inc. went public on June 20, but not in the way that most businesses go public. Instead of doing an initial public offering (or IPO), Slack executed a direct listing.
Also sometimes referred to as a direct placement or direct public offering (or DPO), a direct listing offers both benefits and potential drawbacks to businesses going public. Slack is the second major technology company to execute a direct listing within the past year or so after the music-streaming service Spotify used a direct listing to go public last April.
The main difference between these two methods of going public is that with a direct listing, the company doesn’t issue any new shares of stock. Instead, existing shares that are held by investors, promoters and employees are sold to the public. Also, no money is raised by the business executing a direct listing and there are no underwriters involved.
How an IPO Works
With an IPO, brand new ownership shares of the company are created, underwritten and sold to the public. An underwriter — usually an investment bank or group of banks — plays a key role in the IPO process by performing a number of different tasks, such as:
- Determining the initial offering price for shares;
- Helping ensure that all regulatory requirements are met;
- Purchasing shares offered for sale; and
- Selling these shares to institutional investors such as broker-dealers, mutual funds, insurance companies and other investment banks.
Another key role of the underwriter is leading what’s referred to as the investment “roadshow.” Here, the underwriter and key executives go on the road to meet with potential institutional investors in order to generate interest in the stock. Importantly, underwriters may also guarantee the sale of a certain number of shares at the initial offering price while agreeing to purchase excess shares.
Pros and Cons of a Direct Listing vs. an IPO
Not surprisingly, investment banks charge a hefty fee for these services, typically ranging from two percent to eight percent per share. In a large IPO, this can add up to hundreds of millions of dollars. So one of the biggest benefits of a direct listing over an IPO is lower cost, since there’s no underwriter in a direct listing.
For companies that want to go public but can’t afford the large underwriting fees, a direct listing may be a viable option. Also, with a direct listing, there is no dilution due to the creation of new shares of stock, and there’s no lockup period. This is the period of time after an IPO — usually 180 days — when existing shareholders (such as pre-IPO investors and employees — can’t sell their stock.
But there’s risk involved in choosing a direct listing instead of an IPO. With no underwriter, there’s no guarantee of the sale of shares or support or promotion for share sales. In addition, there are no large investors to help guard against share price volatility and there is no opportunity for a greenshoe option. A greenshoe option is an underwriting provision in which the underwriter has the right to sell more shares than originally planned if demand for shares at the offering is especially strong.
Of course, with a direct listing, no cash is raised for the company, either.
When a Direct Listing Makes Sense
Considering these pros and cons, there are several scenarios where going public via a direct listing could make sense:
- The business cannot afford or doesn’t want to pay large underwriting fees and is comfortable with the risks of bypassing underwriting.
- The business wants to give long-time employees an opportunity to cash out their ownership shares.
- The business is profitable, has a healthy cash flow and doesn’t need to raise capital in order to continue growing, but wants for its shares to be traded publicly.
For example, in a case study examining the Spotify direct listing published last year by the Harvard Law School Forum on Corporate Governance and Financial Regulation, the authors noted that the company wanted to provide greater liquidity to existing shareholders without raising capital itself, and they also wanted to avoid lockup period restrictions.
In addition, they wanted to allow existing shareholders to sell their shares immediately after the listing, as well as to conduct the listing with maximum transparency while enabling market-driven price discovery. The direct listing enabled Spotify to achieve each of these objectives.
Are Direct Listings Becoming More Common?
With Spotify and Slack Technologies now having gone publish via direct listings, it’s anticipated by some market watchers that direct listings could become more common in the future, especially among tech companies that meet some of the criteria listed above.
Talk to your financial advisor if you have more questions about direct listings and the potential opportunities they may offer you as an investor.