When E*Trade launched the first online trading platform for retail investors back in 1992, it triggered a tsunami of change that is still being felt in the financial services industry today. Investors who were unhappy with full-service brokers now had a choice. If they didn’t feel the need for the analysis, recommendations or expertise offered by a broker, they didn’t have to pay for it. Investors could make their decisions and investments any time, any place, all by themselves — and they could save money doing it.

Nearly 30 years later, it is no surprise that the founders and executive teams of some of the best-known and attractive companies looking to go public expect the same type of flexibility in their IPOs they have had their entire lives in their investment activities. Enter … direct listings.

GOING PUBLIC

There are three primary methods for going public — a standard initial public offering (IPO), merging with a special purpose acquisition company (SPAC) that has previously conducted its own IPO, and a direct listing. Everyone is probably familiar with the standard IPO because it’s how nearly every company on the NYSE and NASDAQ got there. The SPAC IPO is a bit different. It involves forming a shell company whose sole purpose is to raise enough money to buy another company. Investors have no idea who the target company is when they invest in the SPAC. They are essentially writing a “blank check.” Once the SPAC has purchased or merged with its target company, the new company becomes a listed stock.

The direct listing shares many of the advantages of a traditional IPO, such as a listing on the NYSE, but without the high costs. Up until a couple of months ago, the primary difference between the two structures was that IPOs allowed a company to raise additional capital by creating new shares of stock, while a direct listing simply monetized shares already held in private hands. No new shares were created. The idea was not to raise additional capital for the company, but to allow the founders, executives, employees and other private shareholders to sell their own shares and provide liquidity for these early investors. The NYSE attempted to erase this distinction in July when it issued new guidance that allowed direct listings to create new shares and raise new capital, just as more traditional IPOs always have. Implementation of these new guidelines has been put on hold pending a review by the SEC, but it seems likely both categories of public offerings will soon allow the issuance of new shares of stock.

So, if both methods are likely to allow the company going public to raise capital via newly created shares, what are the differences between traditional IPOs and direct listings? The differences are actually very similar to those found when comparing investing online to investing via a broker, with the traditional IPO being akin to the traditional full-service broker, and the direct listing following the path of the do-it-yourself online platform.

The IPO process is typically a months-long process involving a third-party underwriter/valuator. This underwriter analyzes the proposed stock issue, values the shares, commits to purchasing a specific percentage (which the underwriter will typically sell at a discount through its network of investment banks, broker/dealers, mutual funds and insurance companies) and organizes the dog-and-pony shows that build investor and industry interest in the offering. Once the offering goes public on the exchange, a lock-up period kicks in, which prevents company insiders from selling their shares during the next three to six months.

The direct listing process is simpler and more streamlined. There are no underwriters, formal valuations, traveling road shows and usually no lock-up periods. The advising banks do not set the initial price of the shares. Instead, a live auction on the morning of the listing determines the opening price. A third-party matches shares being offered at a certain price by the current shareholders with bids for those shares, and whatever investors have bid for the securities is what they are priced at. In addition, there typically are no institutional investor roadshows nor media tours to drum up interest. Instead, the companies that have gone this route have held virtual meetings to explain the offering.

Each method has its advantages and disadvantages. Those who stand behind the traditional IPO like to point out that having a third-party underwriter/valuator provides investors with a sense of security that the equity is worth what the company says it is. If there were any shenanigans afoot, the underwriter will presumably catch them. The underwriter also reduces some of the risk for the company by buying a specific number of shares at an agreed upon price before the markets open, guaranteeing the company a minimal amount of capital raised.

The primary advantage for a direct listing is the main disadvantage for an IPO — cost. All of those professional services cost money, typically from 3 percent to 7 percent of the price of each share. This can add up to hundreds of millions of dollars per IPO.

In addition to paying out a significant amount of money in fees, Jay Ritter, the Cordell Eminent Scholar in the Warrington College of Business at the University of Florida, has found that investment banks tend to be too conservative in their initial pricing. This means that the pre-sales to the underwriter’s network price the shares too low. According to Ritter’s research, IPOs leave a significant amount of money on the table due to these underpriced shares. For example, in 2019, the average IPO closed 23.5 percent higher than its offer price at the end of the first day of trading. If the shares had been priced correctly, i.e., priced at the beginning what they were at the end, IPOs that year would have realized an additional $6.93 billion in aggregate. That’s real money. So far in 2020, the trend has continued, with the IPO market in aggregate being underpriced by 40 percent, leaving more than $24 billion on the table. Admittedly, this is a strange year, but the underwriters are being paid to account for that strangeness and know the market.

Direct listings have very few of the costs involved in a traditional IPO. In addition, pricing is set by a free-market auction on the first day of trading rather than by an investment bank the night before. This means the company not only saves on fees, it has a better chance of capturing true market value from the get-go. This all makes the direct listing process attractive to high-profile companies like Spotify, Slack, Asana and Palantir, which are well-known but might not have a lot of capital to use for IPO fees. A direct listing for technology companies is also more on brand than going the traditional route because their whole raison d’etre is to be disruptive.

Companies that have gone public through this process so far have fit a specific profile. Because no underwriters are selling the stocks or drumming up interest, the company itself has to be attractive enough to make a splash without all the standard IPO support services. They need to have a strong brand identity and an easy-to-understand business model. Investors like to invest in companies they already know about, understand and preferably use. So far, this has favored high-profile tech companies, but there is no reason other industries cannot jump into direct listings if they have the market share to do so.

NYSE EMBRACES DIRECT LISTINGS

This past summer, the NYSE expanded the direct listing option by allowing companies to use the process to issue new shares. Previously, companies could only use the direct listing route to let existing investors sell shares; now a company can let existing investors sell their shares while simultaneously selling newly issued shares to the public.

This would have seemed like a reasonable expansion, yet not everyone was happy. Just as people in the financial services industry were concerned that retail investors would get in over their heads if they were allowed to invest directly without a broker involved, groups are also concerned that investors will be hurt by investing in offerings that have not been vetted by the traditional IPO process. After the NYSE announced the new regulations in July, the Council of Institutional Investors (CII), a group of pension funds and other money managers, asked the SEC to reconsider its approval and reject the plan. The trade group warned that investors would have fewer legal protections and could be at a higher risk because of the potential for insufficient offering size and liquidity. The CII believes the way the stock shares are registered would make it difficult for an investor to sue if there was malfeasance of some kind. The group requested the SEC block the new regulations. At this time, implementation of the new regulations has been halted while the SEC considers the CII’s request.

Although the CII might have a point when it comes to the registration of these shares making it harder to sue, it would seem that their other concerns are overblown.

“To date, the companies using them have disclosed as much as would be disclosed in a traditional IPO,” says Ritter. “And after listing, all of the SEC requirements for public reporting companies apply, whether the company listed via a SPAC merger, a traditional IPO or a direct listing.”

In addition, all companies planning a direct listing, with or without a capital raise, are required to file a prospectus with the SEC. This is also required of companies planning IPOs. Further, once a company has completed its direct listing, it will have to make all SEC-required ongoing public company disclosures, including annual reports and proxy filings. In other words, the standards for the different offering routes remain the same and should provide the same protections for investors.

WHERE DO WE GO FROM HERE?

Direct listings have gotten a lot of interest this year. We’ve seen the NYSE attempt to expand direct listing benefits, as well as the buzz around Palantir’s and Asana’s direct listing IPOs and word that others, such as Airbnb, are on the horizon. But change doesn’t come quickly to the financial services industry. It’s been 30 years since investors acquired the ability to invest directly. You would have thought that listing directly would have followed sooner than it has. However, just as the industry was hesitant to allow retail investors the ability to trade online, many in the industry are still hesitant about allowing companies to place their own public offering. But there is no putting that horse back in the barn. Direct listings are here to stay. And it is likely that over the next couple of years we will see changes that make them even easier for companies to complete. It is easy to envision a time when direct listing is the process of choice for firms looking to go public. That time is not now, but give it 30 years or so. It’s coming.

Sheila Hopkins is a freelance writer in Auburn, Ala.