All about Direct Listings

For startups seeking to build a sustainable and enduring business, we’ve covered a lot of the strategic financing milestones along the way — from mindsets for startup fundraising to when and how to build a finance function with a CFO to what it takes to do an initial public offering (IPO). There’s also a lot that goes on behind the scenes en route to IPO, including how they’re priced, that may affect company building.

But an emerging trend to now pay attention to is tech companies doing a Direct Listing instead of a traditional IPO as a route to the public markets. Spotify started this last year, and Slack just did it last month. Both of these companies debuted on the New York Stock Exchange (NYSE), and so had all the outward trappings of an IPO, from ringing the bell to a specialist on the floor of the NYSE opening the stock for trading. 

However, in a Direct Listing, no shares are sold by the company itself, and therefore no capital is raised. So why would a company do a Direct Listing? What are other key differences between an IPO and a Direct Listing? And what are the tradeoffs involved in this new approach? Since the Direct Listings process is so new, I try to demystify the topic in this post given my own vantage point immersed in the capital markets (including behind the scenes with Slack, where we’re investors). What are Direct Listings, how do they work, and why do they matter? 

What are the differences between a Direct Listing and an IPO?

The biggest difference between an IPO and a Direct Listing is that there is no “o” — that is, there is no offering from the company selling its stock to public investors. Besides this and a few other substantive differences that I’ll cover, the differences between IPOs and Direct Listings mainly boil down to the order of operations. The activities in both processes are actually rather similar — registration, investor education, trading, and so on — differing mainly in what happens when, and in some cases, how. 

There is also no formal book-building roadshow in a Direct Listing. In a traditional IPO, the company going public literally goes “on the road” with their underwriter (the investment bank) over an intense two-week period for back-to-back, intimate meetings with potential investors. They do this is not just to market their company story, but to enable the management team to build relationships with investors — typically, large institutional investors — and for those investors to then submit orders to purchase shares (“building the book”) at the end of the process.

While the company does go into the IPO roadshow with an initial filing price range that indicates the listing price, it will often adjust that price based on the “market” feedback from these meetings with investors. In a legacy IPO process, this initial filing range is the first price that will be associated with a company going public; the second price is when the company actually sells the stock to institutional investors — the IPO pricing. And the third price — the actual opening price of the stock the day after IPO pricing — will be determined at the exchange where the stock is listed, based on market supply and demand; this is referred to as the trading price

But how does the company arrive at the IPO price in the first place? Back to the book of orders: the company and its underwriters will try to determine from that book the price at which they can sell shares that target the most desirable group of investors for the company. They  — particularly tech companies that want to continue their product innovation — are seeking investors who “get” their company, and who will support them in the markets long term. 

There is a fine art to this entire process, from the art of relationship building to the art of pricing — but it’s basically all about assembling the right mix of investors at the right price (by IPO standards). The goal is to allocate just-enough stock for investors to care about their stake in the company, and get meaningful appreciation right away… yet also still be a buyer of additional shares in the future. Pulling this off involves all kinds of circus hoops, from discounting the IPO pricing and orchestrating the IPO “pop” (an initial bounce in price that superficially indicates a win on the first day of trading), to ensuring the company has lined up future growth in the form of new products, initiatives, or markets (as my partner Jeff Jordan often counsels companies to do in advance of IPO).  

Of course, such planning, investor education, and relationship building matters in a Direct Listing, too — only here the roadshow is replaced by an “Investor Day”, where the company invites investors to learn about them one-to-many, including via a webcast. In this way, Direct Listings can be considered more democratic because everyone has access to the same information all at once.

The company will also meet 1:1 with the largest and most influential investors, accompanied by its capital market advisors. Note, these advisors are still investment banks (for example, Morgan Stanley was an advisor in both Direct Listings completed to date) — but here the banks play a slightly different role than being underwriters (the actual purchasers and resellers) as they are in an IPO. Despite the similar players and activities, though, the investor meetings part of the Direct Listing process is much more limited in scope compared to the schedule for a traditional IPO roadshow. Most notably, there is no solicitation of orders from investors as with the bookbuild process in a traditional IPO, because the company is not selling any shares. 

There is a fine art to this entire process, from the art of relationship building to the art of pricing — but it’s basically all about assembling the right mix of investors at the right price

An argument could be made that in these ways, the Direct Listing accomplishes many of the goals of the roadshow and at a “truer” market price for the stock (more on that later). The company doing the Direct Listing also publicly provides prospective investors forward-looking financial guidance — in a form similar to earnings calls and press releases — whereas in a traditional IPO, no forward-looking guidance is issued until after the IPO has been completed (usually at the first quarterly earnings release). This is because in an IPO, the S-1 registration is filed, but not declared effective, until the night of pricing (the day before initial trading); therefore, the company can’t provide advance guidance without violating SEC rules. In a Direct Listing, however, the registration is effective well in advance of trading (10 days prior in the case of Slack), so the company can provide such forward-looking guidance before the stock starts trading. In this way, Direct Listings could also improve a structural issue with current IPO timelines.  

Finally, another substantive difference between a Direct Listing and an IPO is in the lock-up period: In a traditional IPO, existing company shareholders agree to a period, typically 180 days from the date of the IPO pricing, where they are restricted from selling, hedging, or distributing shares. While they are not mandated to do so by the SEC, investment banks usually ask for this because it allows for a set period of time for the company’s shares to trade and establish a track record. Having a set amount of stock (the float) available for trading theoretically provides more predictability, allowing the stock to stabilize a bit before more share volume comes onto the market. On the other hand, the float in a typical IPO is such a small amount — usually ~10% of the company’s total stock — that this artificial restriction also forces distortions for both investors buying large amounts (who have to build up their position gradually and typically have to wait until after the lock-up expires) as well as for others seeking the stock’s true price (not enough volume in the true market of sellers and buyers to determine it). 

One last point: Direct Listings are much cheaper to do than an IPO. Given that the fees involved are far less important than getting to the right outcome, I only point this out since it’s another difference between the two methods. Currently, the IPO underwriting fee is based on a percentage of the proceeds raised by the issuing company: typically ~7%, although some larger high-profile IPOs have gotten underwriting fees as low as ~2%. In a Direct Listing, the fee is a flat advisory fee, and is about half of what the smallest underwriting fee for an IPO would be. 

How do Direct Listings work?

As mentioned, the major activities of Direct Listings and IPOs — from registration to investor education — are not that different, but the nuances of when and how they happen do matter. Since IPOs have been around for centuries and are more broadly familiar, let’s focus on the major phases of doing a Direct Listing.  

Preparation

The preparation process for a Direct Listing is actually very similar to an IPO. Note that by the time the public sees an S-1 from a company going public, it’s already been in process privately for a few months beforehand:

  • The company files an S-1 registration statement with the SEC, typically through a confidential filing. 
  • The SEC will review the S-1 form, share comments, and ask clarifying questions. 
  • In parallel, the company will conduct investor education meetings, and prepare materials for their Investor Day. Forward guidance is not allowed during this period since the S-1 is not yet effective. 
  • There is also a quiet period while the company is in registration, during which all public statements made from the company and by Affiliates (board members and major investors) must follow careful rules — who, what, when — so as not to hype the stock before trading. 
  • After the initial review period, the company will then flip to a public filing (the company decides when), where investors, and the public, will see the amended S-1 registration statement, still in draft form, for the first time.

Before listing

The next phase — beginning about 5 weeks prior to the first day of trading — is where the Direct Listing process begins to diverge from a traditional IPO process:

  • The company will invite investors to their Investor Day, where they will publicly talk about the company and financial results — though still only about historical performance. 
  • The company will also still meet with investors 1:1, as mentioned earlier, to build demand, build relationships with investors, and build trust in management — but not build a book. 
  • The SEC will at some point in this phase declare the S-1 registration statement effective, which will permit the company to publicly announce forward-looking financial guidance. This allows investors to hone in on what price they would be willing to pay for the company’s shares at least 1-2 weeks before the stock goes public. 

Trading

  • During this final phase, current shareholders in the company will also begin to determine at what price they would be willing to sell their stock — remember, the company itself is not the one issuing stock for sale. In any market, there must be shares for new investors to buy — liquidity — which is only made possible by existing shareholders selling. The company will already have turned off any trading of company shares in the secondary markets by this time. 
  • The day before trading begins, the stock exchange — in consultation with the company’s financial advisor — will declare a reference price. This price is the closest analog to the initial filing range in a legacy IPO process, but is really just a guidepost that informs the public of recent private trading activity. In the case of Spotify, the reference price was the last private secondary trades. With Slack, it was closely informed by the volume-weighted average price (VWAP) of the recent secondary trading activity, but was not the exact VWAP. Unlike in an IPO, where the initial filing range will at least initially be closer to opening price, the reference price in a Direct Listing does not actually serve a material purpose in this process. (The unspoken truth may even be that a reference price is set in a Direct Listing to satisfy the legacy IPO machinery that reinforces the public’s obsession with pops and prices going up on a stock opening day.) 
  • Early in the morning on the first day of trading, an auction commences — first indicating size of demand, and then at what price as supply and demand starts to build. Buyers and sellers will adjust their orders for several hours as the market begins to hone in on the equilibrium price. In the case of Slack, it took about 2.5 hours after the open of the broader market to commence trading, which was faster than most participants expected;  supply and demand built at a higher level of volume fast enough that the market maker (the person designated on the exchange) chose to open the stock sooner. 

There is a similar trading dynamic to determine prices in legacy IPOs, but the volume of shares trading there are restricted because only new shares are sold to new investors for the first 180 days (with some shares intentionally placed with investors who will sell for a quick profit, and smaller allocations given to investors who wanted more). Compared to this, there is a truer view into supply and demand in a Direct Listing.

Volume is key to finding the true market price with a Direct Listing  

Lastly, a step that is not required — but one that I recommend as helpful — is for the company going public to open a market for private secondary trading activity well before any Direct Listing (at least six months prior, but ideally longer). While most private companies have full restrictions on private secondary trading, the company can still maintain control through a share-transfer approval process. The point of doing this is to not only diversify the cap table a bit, but to help establish some initial price discovery prior to the Direct Listing so it’s not total guesswork. 

Then why couldn’t secondary markets accomplish some of the same goals of a Direct Listing, since they give early investors and employees liquidity (and with no additional dilution for ongoing investors)? Secondary exchanges don’t offer true market price discovery as Direct Listings do: They are more of a marketplace, matching one buyer to one seller, than they are a true public market with robust supply and demand, matching many buyers and many sellers. This volume is key to finding the true market price with a Direct Listing.  

Common misconceptions about, and the case for, more Direct Listings

While Direct Listings are still a new phenomenon with only a class of two completed so far, they could become a trend. The legacy IPO process is also ripe for innovation: The very first IPO technically happened over 400 years ago, and the rules for current IPOs were established nearly a century ago. But technology has changed since; for instance, Google did a “dutch auction” in its 2004 initial public offering, where the online clearing price set the IPO price. More recently, other innovations such as the Long-Term Stock Exchange (LTSE) (the first stock exchange headquartered in Silicon Valley) are aimed at aligning company building and market interests around the long term. The LTSE was just approved by the SEC last month [full disclosure: we’re investors]. 

The bottom line is that the timeline, order of operations, and mechanisms of going public need to change, which is where Direct Listings come in. They’re also a natural evolution given other shifts in the capital formation process over the past decade. Before, a company on the path to the public markets would raise a Series A, then a Series B followed by a Series C… and then IPO. Total capital raised back then was also modest by today’s standards, and the early investors were mostly only venture firms. Today, however, a company might raise several hundred million to billions of dollars across 5-7 rounds of funding — and not only from venture capital firms, but also from hedge funds, mutual funds, and sovereign wealth funds. 

With all this capital available in the private markets, companies no longer need to rely on the public markets to raise capital (we once dubbed this phenomenon “quasi-IPOs” for this reason). And, they can still build relationships with long-term public investors, which is something I counsel companies to do sooner anyway. Since the decision to be public today is often driven by considerations outside of capital needs or investors, Direct Listings offer a more evolved route to the public markets. Below, I address some common misconceptions about both IPOs and Direct Listings to help make the case for more of the latter. 

Myth #1: Price appreciation is the measure of a successful listing 

One of the greatest myths of modern IPOs — aided and abetted by the media coverage of them — is that price appreciation is the measure of a successful listing, let alone of a successful business. This is not only untrue of the Direct Listing, it’s also a myth about the traditional IPO. 

Big IPO pops may get a lot of attention, but they show that the IPO was mispriced. In the case of a Direct Listing, the most important measure of successful trading is volume — it is more indicative of a true equilibrium in pricing, when many buyers and many sellers came together to transact at a discrete price. Remember, the total amount of float being offered and trading inside of the lock-up in a traditional IPO is typically very small, which limits the ability for many buyers and many sellers to come together to truly determine a market-clearing price. 

Of course, this means one way a Direct Listing can go wrong is if there is not enough volume. Lessons were learned in the very first Direct Listing, where the stock was opened on thin volume and ended up opening near the high and closing near the low of the day. But in Slack’s case, 45.5M shares traded hands on the opening trade — among the largest in NYSE history (for reference, top spots in that class of IPO opening trade volume were for Facebook and Alibaba). It was a true measure of price discovery, because a very large volume of buyers and sellers met at that price. 

One of the greatest myths of modern IPOs — aided and abetted by the media coverage of them — is that price appreciation is the measure of a successful listing, let alone of a successful business

Myth #2: New listings need to price at a discount to attract new investors

IPOs currently rely on hand-picking investors, including understanding past behavior of investor relationships to determine that selection. They also price at an overly discounted price to give investors quick gains. In a Direct Listing, however, all investors enter at the market-clearing equilibrium price — which by definition selects for the most aligned investors for a given company. Great companies will attract good investors, but great companies at the right price will attract great investors. In many ways, a Direct Listing is a much more egalitarian process, and a better way for companies and investors to begin a long-term relationship than through the transactional nature of building a book. 

Institutional investors themselves are also evolving today, spending a significant amount of time (often with dedicated staff) finding and building relationships with — and investing in — promising companies while they are still private. Previously, companies going public would usually only meet with major investors for the very first time during an IPO roadshow; now, it would be more unusual for such a company to not have already met these companies. 

The whole reason the IPO roadshow existed before is that large mutual funds and hedge funds were unapproachable and remote, requiring investment banks to intermediate the roadshow. The banks themselves have also had a role on both sides of the table in traditional IPOs, because their customers were both the company going through the IPO process, as well as the investors buying into each deal (i.e., repeat customers that they have to satisfy). To be clear, investment banks bring tremendous value to companies going public — but their role shifts from underwriter to a more aligned advisor during a Direct Listing. In the case of Slack, Morgan Stanley’s learnings from Spotify was key to their guiding towards the desired equilibrium, leading to a robust opening and flawless execution. 

Myth #3: The IPO is a financing event

Given the phenomenon of companies having stayed private longer, IPOs today are less a financing event and more about making sure the business is “working”, robust, and enduring. Investors now like to see companies entering the public markets with already-strong balance sheets, with a path to profitability and with cash on hand. 

As for the financing aspect of IPOs, companies are going public below a market clearing price and sized to required public market liquidity (~10%) vs. sized to the company’s needs. Take the recent example of Zoom’s IPO [note, we are not investors, nor is this investment advice] — 

  • The float, or total amount of available stock in the IPO, was: 8% of current shares outstanding (~21M shares)
  • The IPO price was: $36 per share
  • The shares began trading at $65 per share
  • Today, the current market value is: ~$85-90 per share

Because the company and selling shareholders raised about $700M total (roughly half of shares sold were secondary), the company — like many others before it forced to do so by the current framework of underpricing IPOs — left a difference of ~$1.2B on the table given the value of those shares today. 

How different would this have been if they (and other companies) debuted in the public markets at equilibrium price, as with a Direct Listing?

The decision to be public today is often driven by considerations outside of capital needs or investors, Direct Listings offer a more evolved route to the public markets

Myth #4: Companies that need to raise capital can’t do a Direct Listing 

Since an IPO event today doesn’t have to be about fundraising, what about companies that do need to raise capital and want to do a Direct Listing? 

I’d argue that companies can do the following: Rather than using an IPO to raise money at an artificially discounted price, and giving away more of the company than you actually need to (e.g., the typical ~10%) — why not just raise that capital as a private company (at say, 2-3% dilution)? And then start the Direct Listing process at an appropriate time (and following rules for Affiliates). By decoupling the capital raise and the public listing, the company can better calibrate selling the right amount of shares — without discounting too much — and at the right market price.  

Let’s say a hypothetical company valued at $10 billion needs to raise an additional $300M to have enough cushion to operate comfortably for the next few years. Pursuing a legacy IPO would require ~10% dilution, and at a steep discount — rather than 2-3% dilution at a more modest discount, and from crossover investors that would hold through a Direct Listing. 

If further financing is needed in the future, the company now has access to the public capital markets as a seasoned issuer, which is one of the primary benefits of being public anyway. If Slack had gone public in a traditional IPO, it would have had to sell ~10% of the company to meet liquidity needs (as is market standard), even though they had $800M on their balance sheet, and would have suffered unnecessary dilution to do so. Instead, by doing a Direct Listing, Slack sold 0 shares with no dilution. Yet after a period of time as a public company, Slack will be recognized as a seasoned issuer that can freely choose when to finance if necessary and on their terms (i.e., not forced to sell above a particular amount to achieve a liquidity threshold).

Myth #5: Public Investors don’t like Direct Listings 

I heard this sentiment many times over the course of the last several months, and when I asked why, I heard two common responses: that there is no price appreciation “built in” into a Direct Listing; and that without a lock-up, it is impossible to predict selling pressure. I believe both of these claims are overstated; here’s why: 

The discounted pricing of an IPO is not a feature, but a bug. As mentioned, there’s very little merit to the pop as the company is undervaluing its shares and leaving real money on the table. Frankly, the discounted pricing is also relatively inconsequential to the institutional investors that companies going public want as their ideal shareholders. Since the actual float in a typical IPO is too small of an allocation to be a “full position” for very large mutual funds with multibillion dollar holdings, it’s only when more shares come on the market through releasing the lock-up (the overhang) that these investors can build a larger and more substantial position with more liquidity. Direct Listings fix this timing mismatch. 

The lock-up doesn’t really offer as much predictability as one may think. Any benefit  gained from a known float is lost through the volatility that a limited float exacerbates. Without the 180-day lock-up period in a Direct Listing, current shareholders (including employees) can sell shares; new investors can build full positions; and the illiquidity of an artificially constrained small float is removed. Ideally, if the price is right, there will be enough stock sold so that there is not high volatility and continued selling pressure — the very predictability company builders and investors want. 

The discounted pricing of an IPO is not a feature, but a bug

Myth #6: Only “well-known” brands can pursue a Direct Listing

This may be true for the very first Direct Listing ever (Spotify, a mainstream audio service), and even for the second (Slack, a widely used SaaS product in both consumer and enterprise) — but how about the fifth, or tenth? As Direct Listings become more popular, the need for brand recognition will dissipate. 

The job of buyers in both a traditional IPO and a Direct Listing is to get to know the companies coming to market long before they actually do (see myth #2 above). So even if the company is not a popular consumer-facing or even consumer-like brand, it will still be well-known among the investment community at least. 

What about retail or individual investors, you might ask? First, remember that retail allocations — the number of shares that are directed towards individual investors — typically make up only ~10% of all IPO allocations, and often less. They are not a necessary source of demand for the most successful IPOs. That said, a benefit of the Direct Listing is that retail shareholders have the exact same access to Direct Listings (much like they did for dutch auctions like Google’s IPO) as does the most sophisticated investment institution. Given the prolific coverage of tech companies by media today, and the amount of sheer information available out there in general, if a company is good enough to be a public company, investors — of all kinds — will find it. 

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Of course, there are many things that still need to be worked out in a Direct Listing — from better visibility into supply and demand to other mechanisms to build a book in a more automated and efficient manner. It’s still early days yet, and the SEC rules may evolve here to accommodate more innovation too. 

But Direct Listings are a natural evolution of broader corresponding shifts we’ve been seeing over the past decade — from the evolution of and increased activity of private markets to the more mature nature of companies going public to other macro trends. As such, they should be given due consideration as a mechanism for going public if the goal is not just to raise more capital but to build a long-term business. The firm has been around for centuries, and the current rules for IPOs for decades; as technology and companies and markets evolve, it’s time for more innovation.

 

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