Venture capital-backed companies, startups and other companies looking to go public can now, if they meet all listing requirements, conduct their initial public offerings (IPOs) directly on the New York Stock Exchange (NYSE) through what is called a “direct listing”. The adoption of direct listings is a major development in our capital markets as we, unfortunately, continue to see more and more companies go public at prices substantially below the actual stock market price for their equity under the traditional IPO model.
On December 22, 2020, the U.S. Securities & Exchange Commission (SEC) approved the proposed rule change of the NYSE that now allows companies to go public directly on the NYSE and raise money from investors in their IPOs without going through the typical “firm commitment” underwriting process of involving large investment banks and paying hefty fees to those banks. Prior to the SEC´s order, companies utilizing direct listings could not raise money for their businesses through a direct listing, but could only use direct listings as a means for liquidity for existing shareholders. The SEC’s order changes this critical limitation to allow companies to actually raise capital and fund their businesses through a direct listing while also providing an attractive and likely more cost-effective alternative to the traditional IPO process for companies ready to access the public markets.
In this article, we will explain the process that companies have historically gone through when they are going public and conducting their IPOs and the problems that this process creates for these issuers. We will then explain the new NYSE “direct listing” option and show real world examples of how companies that launch their IPOs through the direct listing process versus the traditional IPO route could see substantial financial benefits for themselves and their existing shareholder bases. At the end of this article, we will also explore the type of companies that this direct listing option will likely serve best.
Historical Perspective: The Typical “Firm Commitment” IPO Process
In a traditional IPO underwritten on a firm-commitment basis, an underwriter or a group of underwriters enter into an agreement with the issuer in which they commit to take and pay for a specified number of shares of that company at a negotiated public offering price. The underwriters’ actual purchase price always comes with a discount, or spread, to the public offering price. The underwriters purchase the securities at the agreed upon discount and then flip the securities almost immediately to their network of investors at the full public offering price, resulting in profits to the underwriters based on their spread. For example, in the recent IPO for Airbnb, the underwriters in that deal bought approximately 50 million shares from Airbnb at $66.56 per share and then immediately sold them to their network for $68.00 per share.
The determination of the public offering price in a traditional IPO itself is also not always highly transparent. That price is almost always based on “what is sellable” to the underwriters´ network of institutional clients, not the price for the company’s shares that natural market forces would dictate.
What is the shorthand version of this traditional IPO description? Stated more simply, the company going public and its underwriters negotiate a price for the company’s shares, which the underwriters will buy at a further discount to the negotiated price and then sell shortly thereafter to their network of investors, collecting the spread between the discount price and the sale price in the process, with the underwriters´ network of investors then holding shares of the company often at an undervalued price to the price the shares would have on the open market. At the same time, these underwriters are charging substantial fees to the company going public for facilitating these transactions.
What happens next in a traditional IPO? When the securities begin trading on an exchange following a traditional IPO, the opening price is determined based on orders to buy and sell the securities and may vary significantly from the initial public offering price at which the underwriters´ contacts purchased the shares. Where there is a jump in the price of the shares when trading in those shares commences, which we continue to see more and more in recent IPO transactions, two situations typically result.
First, initial purchasers who purchased shares from underwriters – those who had the benefit of long-standing relationships with the underwriters (not your typical retail investor) – can sell their shares for a quick profit or lock in immediate gains. They, in other words, get all of that upside from the share price jump, not the company actually conducting the IPO.
Second, where there is an immediate jump in the share price on the market from the price in which companies sold their shares to their underwriters and initial purchasers, those companies find themselves in the position of “having left money on the table” by underpricing their shares. The result is these IPO companies having sold more of their company’s equity than they actually needed to to fund their capital needs, diluting the ownership interests of management and existing shareholders more than necessary.
Consider this example of how a company going public through a traditional IPO can be impacted by this “selling for too low an IPO price” scenario:
XYZ Company wants to launch an IPO to raise $500 million for its business needs. XYZ Company and its underwriters determine that the initial price per share of XYZ Company should be $50 per share, and XYZ agrees to sell 10 million shares, or 10% of its company, at that price to its underwriters and thus their initial purchasers. When trading in the IPO commences on the NYSE, the share price doubles to $100 per share as other eager investors purchase shares in XYZ Company on the exchange. If XYZ Company had sold directly into the public market at the $100 per share price rather than to its underwriters and their purchasers first at the $50 per share price, XYZ Company could have met its capital needs by raising the $500 million while only diluting its existing shareholders by 5% rather than the 10% because of the 2x share pricing in the public market versus the negotiated $50 per share they were sold for. This mispricing resulted in the sale of 5% more of XYZ Company equity than necessary, all while the underwriters and its clients collected or locked in huge profits and tacked on large fees.
In our example, the existing owners in XYZ Company have potentially taken a much greater dilution to their shareholdings than they would have if they had conducted their IPO under the new direct listing rules. We will see other examples of this mispricing alignment when we look at the Airbnb and Doordash IPO examples in detail below. So, how do direct listings fix this misalignment of interests?
Direct Listings: A Solution to the Inequities of the Traditional IPO Process
In an IPO conducted via a direct listing, in contrast, there is no initial sale of company shares to an underwriter or pre-opening sale by the underwriter to initial purchasers. Instead, initial sales of the shares of the company going public are conducted through the NYSE directly, with the share price in the IPO determined instead based on matching buy and sell orders at the time trading commences among all investors interested in the security, not just large, well-connected institutions.
This direct listing process, therefore, combined with its now advantageous ability to raise capital directly for business purposes, has the potential to fix the problem we note above about issuers potentially undervaluing their companies in negotiations with underwriters and initial purchasers because the market itself will control this price determination.
Leveling the Playing Field: Why do the NYSE and SEC want Direct Listings?
The SEC believes that permitting the implementation of direct listings as a means for companies to finance their business needs through an initial public offering is consistent with the SEC´s mission to “ . . . maintain fair, orderly, and efficient markets, and facilitate capital formation.”
Quoting the SEC’s order approving direct listings through the NYSE:
“The SEC believes that direct listings will provide benefits to existing and potential investors in IPO companies relative to traditional firm commitment underwritten offerings. First, because the securities to be issued by the company in connection with a direct listing would be allocated based on matching buy and sell orders at the time trading begins, some investors may be able to purchase securities in a direct listing who might not otherwise receive an initial allocation in a firm commitment underwritten offering because they don´t sit on underwriter preferred investor lists. The proposed rule change therefore has the potential to broaden the scope of investors that are able to purchase securities in an initial public offering, at the initial public offering price, rather than in aftermarket, often-inflated trading.
[D]irect listings will provide an alternative way to price securities offerings that may better reflect prices in the aftermarket, and thus may allow for efficiencies in IPO pricing and allocation. The opening auction in a direct listing provides for a different price discovery method for IPOs which may reduce the spread between the IPO price and subsequent market trades, a potential benefit to existing and potential investors.”
The use of direct listings is not, however, without its critics. Commenters to the SEC´s order permitting NYSE direct listing expressed concerns to the SEC that the lack of traditional underwriter involvement in direct listings generally would increase risks for investors, suggesting that direct listings circumvent the traditional due diligence process and traditional underwriter liability and legal protections for investors present in typical firm commitment IPOs.
Working together with the SEC to address such comments, the NYSE responded directly to this concern, stating and receiving the support of the SEC that:
“[We] do not believe that the absence of underwriters [in direct listings] creates a gap in the regulatory regime that governs offerings of securities to the public. [W]hile involvement of a traditional underwriter is often necessary to the success of an IPO or other public offering, underwriter participation in the public capital raising process is not required (emphasis added) by existing securities laws, and companies regularly access the public markets for capital raising and other purposes without using traditional underwriters [in non-IPO capital raises]. [T]he due diligence process in direct listings is the responsibility of the gatekeepers who participate in the transaction, such as the company’s board of directors, its senior management, and its independent accountants. [A] company pursuing a direct listing [will], actually, go through the same process of publicly filing a registration statement as an underwritten offering with the SEC, and if a company’s business model exhibits weaknesses, they will be exposed to the public prior to listing.”
The SEC’s order doubled down on the counterargument to these commenters in support of the NYSE:
“In almost all cases, companies going public through a direct listing will need to engage financial advisors with experience navigating the process. Thus, the financial advisors to issuers in direct listings have incentives to engage in robust due diligence, given their reputational interests and potential liability, including as statutory underwriters under the broad definition of that term under our securities laws. Moreover, even absent the involvement of a statutory underwriter, investors would not be precluded from pursuing any claims they may have under the Securities Act for false or misleading offering documents, nor would the absence of a statutory underwriter affect the amount of damages investors may be entitled to recover. In addition, issuers, officers, directors, and accountants, with their attendant liability, play important roles in assuring that disclosures provided to investors are materially accurate and complete. The Commission therefore does not view a firm commitment underwriting as necessary to provide adequate investor protection in the context of a registered offering. Indeed, exchange-listed companies often engage in offerings that do not involve a firm commitment underwriting.
The Airbnb and Doordash IPOs
Airbnb
Airbnb went public in December 2020 through a traditional IPO process, looking to raise approximately $3.5 billion through the offering. In its IPO, Airbnb committed to sell approximately 50 million shares of its common stock in the offering, or approximately 8.6% of its post-issuance total common equity, at a price per share to the initial purchasers in the offering of $68 per share, and with a $1.44 per share discount to that price for its underwriters. When trading of Airbnb´s stock began, the price of its shares exploded, opening at $146 per share in initial trading, or 2.15x the price per share that Airbnb had just sold its shares for to its underwriters and their clients.
The net result for everyone in the transaction: The underwriters in the transaction, Morgan Stanley, Goldman Sachs, and the remainder of its syndicate collected approximately $10 million in deal fees and leveraged its share discount for an approximately $74 million profit. The initial purchasers in the deal more than doubled the value of their shares immediately upon the commencement of trading in Airbnb shares on the Nasdaq. Airbnb, while it got the $3.5 billion that it needed to fund its business needs, arguably sold more than 2x the percentage ownership in the company than it needed to to raise those funds, substantially diluting the ownership interests of its founders and existing shareholders. If Airbnb had been able to go the direct listing route for its IPO, and the opening trading price per share held constant at $146 per share, Airbnb could have instead raised its needed $3.5 billion by selling only approximately 24 million shares, or just 4.2% of its company instead of 8.6%, all without the substantial fees and discounts mentioned above.
Doordash
Doordash also launched its initial public offering in December 2020, entering the market at an initial offering price of $102 per share and closing on its first day of trading, after an 86% increase from its initial offering price, at almost $190 per share. The public market valued Doordash at $60.4 billion based on the $190 trading price, whereas the private market of institutional investors that bought the company´s shares at $102 per share in just the hours before the company began trading only valued the company at $32.4 billion. Doordash, like Airbnb, is a company that, although it hit its funding goal of raising the $3.3 billion it needed for its business, gave up almost twice the amount of equity in the business than it needed to had it gone the direct listing route for its IPO and sold its equity to the public at the $190 per share price instead of the $102 per share price that its advisors recommended.
We see, again, with Doordash a similar theme as we did with the Airbnb IPO when we compare the results of the transaction for those involved: Goldman Sachs, J.P. Morgan and the remainder of their syndicate leveraged their share discount for an immediate $80.8 million in profit. The initial purchasers in the deal nearly doubled the value of their shares before the end of the first day of trading in Doordash shares on the NYSE. If Doordash had been able to go the direct listing route, and the trading price per share held constant at $190 per share, Doordash could have instead raised its $3.3 billion by selling only approximately 17.4 million shares, or just about 6% of its company, rather than 10.4% that it did sell.
Are the Airbnb and Doordash IPOs anomalies? In other words, is our discussion of the huge differential between the price that institutional investors buy into these IPOs and the price that is actually available to retail investors when the shares begin trading only present in stocks like Airbnb and Doordash that have a “coolness” factor and have become household names before launching their IPOs? Recent statistics tell us that in more than a majority of IPOs, the answer to this question is no.
The statistics regarding all IPOs conducted in 2020 show us that almost 79% of all 2020 IPOs, many of which were of companies far less known than Airbnb and Doordash, performed level with or positive to their initial offering prices on their first day of trading. Direct listings do not guarantee companies that they will be able to sell a smaller portion of their company in their IPOS and still raise the money they need for their business than they would in a traditional IPO, but with an almost 80% chance of equal or better performance, assuming 2020 statistics hold relatively consistent in future years, a direct listing is certainly an option that soon-to-be-public companies should be evaluating.
Companies Taking Note
Companies entering the market through an IPO are taking note of this misalignment between price per share sold to institutions and what their shares would likely trade for in the public market. In December 2020, Roblox Corp., a company in the video gaming space, decided, for example, to pull its traditional IPO, and disclosed its plans to pursue instead a direct listing in February 2021 because “Roblox officials were concerned about leaving money on the table should the videogame platform have a big first-day pop,” according to people familiar with the matter. Roblox is not alone in taking this moment to pause and consider whether conducting their IPO through a direct listing would be a more prudent alternative than the traditional IPO we have described.
Which Companies are Eligible for a Direct Listing?
As with the case of a traditional IPO, companies going public through a direct listing must still meet the listing requirements of the exchange. At the time of writing this article, Nasdaq is still considering adding a direct listing option for companies interested in conducting their IPOs through the exchange. The NYSE requirements for listing, which we expect NASDAQ will eventually closely mirror, are summarized below. We include these listing requirements in this article so that companies can understand, at least from a regulatory timing perspective, when they may be in a position to actually pursue their own direct listing.
Aggregate Market Capitalization
Companies must have a market capitalization, calculated by multiplying price per share by the number of outstanding shares, meeting the NYSE requirements.
In the case of direct listings, the NYSE has proposed that it will deem a company to have met the market capitalization requirement if the company will sell at least $100 million in market value of its shares on the first day of trading on the exchange. As an alternative, where a company is conducting a direct listing and will sell less than $100 million of its shares in the direct listing, the NYSE will determine that such company has met its market cap requirement if the aggregate market value of the shares of the company that the company will sell on day one and its other shares publicly held are valued at at least a combined $250 million.
Number of Shareholders
According to the NYSE, those companies pursuing a direct listing will still need to prove that they will have at least 400 shareholders in the security, a prerequisite to listing so that the NYSE can get comfortable that an adequate market for the shares will exist.
Number of Shares and Price
At the time of listing, direct listing companies will need to have at least 1.1 million shares outstanding, again to create a viable market. Each share will need to have a price per share of at least $4.00 at the time of initial listing, so low-volume, “penny” stocks and other low-priced offerings will not qualify.
Conclusion
The NYSE, and we expect soon NASDAQ as well, in conjunction with the SEC, seem to be signaling to companies that are exploring the idea of going public, through the advent of this direct listing concept and other recent rule changes, that they want to make going public a more attractive alternative to staying private.
We expect measures related to IPO attractiveness to continue to be implemented as exchanges and the SEC look to narrow the gap between registered and non-registered securities offerings. In 2019, registered offerings accounted for $1.2 trillion (30.8%) of new capital, compared to an estimated $2.7 trillion (69.2 percent) that the SEC estimates was raised through exempt offerings. Creating more transparency in the market and bringing more companies into the public arena will always be objectives of the exchanges and the SEC.
Companies interested in launching their IPOs should be mindful of the options available to them, such as direct listings, as they decide what is best for the founders who built their companies and the shareholder base that supported them from their journey from just an idea to an IPO.
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*This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author(s) and not necessarily those of our clients.
Resources:
https://www.sec.gov/rules/other/2020/34-90768.pdf
https://www.nytimes.com/2020/12/09/technology/doordash-ipo-stock.html
https://marker.medium.com/why-the-day-one-ipo-pop-is-overhyped-85fbab29103b
https://www.wsj.com/articles/record-ipo-surge-set-to-roll-on-in-2021-11609324381
