Direct listings are an IPO alternative that allows companies to sell shares to the public and bypass the underwriting process. Here are some things investors should know.
Is it time to put a little more “public” into the old-school IPO? Advocates of the NYSE’s new “direct listing” would probably say so. In December, the Securities and Exchange Commission (SEC) approved direct listings on the NYSE, establishing an IPO alternative through which companies can bypass the traditional underwriting process and sell shares directly to the public. Is this a good deal for investors? Let’s take a step back and see what direct listings are all about.
The NYSE direct listing represents a “disruptive response” to growing interest in alternative mechanisms for taking a company public. According to Alex Coffey, senior specialist, Trader Group at TD Ameritrade, exchanges “are looking to evolve and provide more opportunities for companies to raise capital.”
“Direct listings also raise certain risks for companies and investors,” Coffey added. Any investors considering buying shares in a direct listing would be wise to do some homework first. Here are a few basics on direct listings.
In a traditional IPO, a company hires a bank or banks as “underwriters” who scrutinize the financial health of a business and try to gauge a fair price when the shares are sold to the public for the first time. Company leaders may also conduct a “road show” to pitch their business to potential investors. Often, management receives—or has an opportunity to buy—new shares of the company before the IPO. The entire pre-IPO process can take several months.
“A direct listing condenses that exercise and also allows the company to avoid paying underwriters’ fees,” Coffey explained. All the company’s newly issued shares must be sold in an opening auction, at one price and at one time, with price determined by supply and demand.
“It’s aimed at reducing red tape, cutting out middlemen, and simplifying the process for companies seeking to sell shares to the public,” Coffey said, referring to the rationale behind a direct listing.
Before the SEC’s approval in December, direct listings were allowed but limited to a company’s existing shares, meaning the company couldn’t use a direct listing to raise new capital. In 2018, music streaming company Spotify Technology (SPOT) did such a direct listing. Palantir Technologies (PLTR) and Slack Technologies (WORK) also had direct listings in the past couple of years under the previous rule structure.
“A direct listing may help smooth out some of the bungee-cord-like price swings often seen in traditional IPOs,” Coffey noted.
In the traditional IPO process, “you’ll often see vast mispricing, and a stock will move substantially higher or lower on the first day it’s public,” Coffey added. “In a direct listing, a company could increase its chances of going public at a price that’s more in line with where the public market has been pricing it. By cutting out middlemen, the hope is you’d eliminate or reduce the potential for drastic mis-pricing.”
For individual investors, direct listings “level the playing field” in theory, providing them an equal opportunity against big institutional investors to snap up new shares.
“A direct listing allows everyday investors to get ‘in the room’ with a company’s management for new share offerings,” Coffey said. “Companies can go straight to the public and strike a deal.”
Underwriters play an important role in the IPO process, conducting “due diligence” on a company’s finances that presumably would identify questionable accounting practices or other red flags investors should know before they consider buying shares.
“In a direct listing, investors effectively assume the responsibility of an underwriter,” Coffey said. “The ‘gatekeeping’ structure isn’t there to potentially prevent fraudulent companies from going public. That means investors should thoroughly research any direct listing and conduct their own due diligence.”
Not everyone at the SEC was on board with the new direct listing rule. Underwriters “provide an important independent check” in the IPO vetting process, according to SEC commissioners Allison Herren Lee and Caroline Crenshaw in a December 23 statement.
“If underwriters are removed from the equation, investors will lose a key protection: a gatekeeper incented to ensure that the disclosures around these opportunities are accurate and not misleading,” Herren Lee and Crenshaw explained in their statement. (SEC commissioners passed the new direct listing rule by a 3:2 vote.)
“Investors should approach a direct listing with a similar “buyer beware” mentality they’d apply to a traditional IPO or other investment opportunity,” Coffey mentioned. Many of the same questions are worth asking: Is the company profitable? Is it growing? Who are its competitors? Does management know what it’s doing?
With anything new in the markets, “there may be hiccups,” Coffey concluded. “There could be some added risk before the direct listing becomes fully established. As always, thorough research matters, and getting educated in how direct listings work is going to be paramount, because it’s new for everyone.”