IPO vs. Direct Listing - Pros and Cons

Business
USA

TAKEAWAYS          

  • IPO has pros such as increased liquidity, enhanced public image, and cons such as risk involved and disclosure of details.
  • DPO is a way for companies to become publicly traded without a bank-backed Initial Public Offering (IPO).
Pros and Cons of IPO
Summary of Pros and Cons of IPO and DPO

 

  • DPO bears the features of the Free Market System; wherein the laws and forces of supply and demand prevail and has no intervention of the government or other authorities.
  • The major disadvantage of DPO is that it works best only for private companies that are popular, earn substantial revenue, have capital reserves and do not need to raise funds on the public market but wishes to provide liquidity to existing shareholders. 

FINDINGS

Trade in Shares: The Traditional Scenario

  • Shares in a financial market are units used as mutual funds, limited partnerships, and real estate investment trusts. A shareholder owns shares in a company and a share market is the aggregation of buyers and sellers.
  • Trade in the stock market means the transfer of a share or stock or security from a seller to a buyer. It requires an agreement in price. Shares and stocks which are called equities confer an ownership interest in a particular company.
  • Stock exchanges may be a network of computers where trades are made electronically or physical locations where transactions are carried out.  NASDAQ, New York Stock Exchange (NYSE), the Paris Bourse, the London stock exchange (LSE) are typical stock exchanges.
  • Stock market participants may include individual retail investors, institutional investors such as mutual funds, banks, insurance companies, and hedge funds and also publicly traded corporations trading in their own shares.

What is an Initial Public Offering (IPO)?

  • Commonly called “Going public” IPO can be traced back to the 17th century the Dutch Republic, which is often called the birthplace of the world’s first formally listed public company and the first formal stock exchange and market. The Dutch company undertook the world’s first recorded IPO in March 1602. Enabling the company to raise the root sum of 6.5 million guilders.
  • IPO is the process of offering shares of a private corporation to the public in a new stock issuance. it’s a type of public offering in which shares of a company are sold to institutional investors and retail investors. The first sale of securities as stocks in a corporation has to be under the regulations governing the public company.
  • A company planning an IPO will typically need Underwriters. There is a need to choose an exchange in which the shares will be issued and thereafter traded publicly. Investment banks may also arrange the shares to be listed on one or more of the stock exchanges.
  • The requirements of the Securities and Exchange Commission (SEC) calls for a company that is matured enough to face such rigors. SEC regulations and requirements often demand private companies with strong fundamentals and proven profitability potential.

How Does an IPO work?

  • The complexity of the IPO process demands a team of professionals with strong communication, sales, marketing, and financial skills. Various defined steps are necessary for a company to undertake in order to go public through the IPO process. The steps include:
  • Selection of an Investment Bank: The bank becomes the Underwriter, performs services which include looking for and prospecting for investors. The Banks will be strong analyst coverage with well-established sales and distribution abilities. Some of the renowned underwriters include Goldman Sachs, Credit Suisse First Bolton, and Morgan Stanley. 
  • Due Diligence and Regulatory filings: Here the investment bank acts as a broker between the issuing company and the investing public to help the issuing company sell its initial set of shares. The issuing company has to arrange documents showing the firm commitment; best efforts agreement; syndicate of underwriters; engagement letters, clause and Gross spread underwriting discount; letter of intent, underwriting agreement, Registration statement, the prospectus, private filings, and the Red herring document. 
  • Pricing: Issuing company and the underwriter decide an offer price for the share. This happens after the IPO is approved by the SEC, the factors affecting the offering price include the success and failure of the road shows; the company’s goal and the condition of the market economy. 
  • Stabilization: Involves providing an analyst recommendation and creating a market for the stock issued. 
  • Transition to Market Competition: Here the Underwriter acts as an Evaluator and Advisor. The investors at this point move from relying on the mandated disclosures and prospectus to relying on the market forces for information regarding their shares. This period mandates the provision of estimates regarding the earnings and valuation of the issuing company from the underwriter.  

Steps in the IPO Process
Steps in the IPO Process

             

Pros of Initial Public Offerings

  • Opening many financial avenues and access to Capital: IPO is the most realistic and convenient way to secure the continuing growth of the business. It provides access to a measure of capital and boosts investment credibility of the business. 
  • Fair Market price brings liquidity: A public market makes way for a fair price for the shares. This enhances liquidity and provides an opportunity for a quick sale of shares with less transactional costs. 
  • Popularity and Enhanced Public Status:  Listing brings about enhanced media coverage, which increases the company’s visibility and recognition of its products and services. Public profiles support the liquidity of the shares and contribute to the expansion of the business contacts. A large number of institutional and retail investors become shareholders. IPO successful exposure builds confidence in shareholders and achieves a maximum possible value to the business. 
  • Credit Worthiness: Companies listed on a recognized stock exchange become desirable and reliable and obtaining Bank loans become easier. Banking institutions are keen to work with transparent companies. Transparency gives confidence to Banks and other suppliers of credit facilities. 
  • The attraction of top talents of the Nation: During the IPO implantation process, certain internal changes take place including modification of the organization structure, selection of key personnel, delegation of responsibilities, and critical evaluation of the efficiency of the business. These steps attract top skilled personnel willing to relate to popular companies.
  • It is said that IPO is more stable than a DPO because in DPO the underwriters control the opening share price and bear lots of the risks.

Cons of the IPO Process

  • IPO exposes the share price of the company to the public. Stock market fluctuations in certain circumstances may influence the market price and liquidity of the shares to drop.
  • The IPO process brings on a wide range of disclosure requirement and regular financial reporting of scope and quality in excess. These tunes up financial investment in the process brings on more responsibilities, and more time investment.
  • The sensitivity of the market causes the activities of the directors and top management to be regulated to avoid disclosures that might affect the market price stability.
  • In addition, an IPO is generally a risky investment because one does not know how much demand will exist for the stock after its initial offering, the risk comes from the uncertainty about the stock resale value.

Initial Public Offering Examples

Case study 1: Facebook’s IPO 

  • A typical example of an IPO that incurred investor risk and raised the necessary capital for the company is the IPO of Facebook in 2012. 
  • The buzz around the then-innovative company had raised investor’s expectations. At that time that Zuckerberg decided to go public. Facebook had already 500 private shareholders and more than 800 million users on a monthly basis. 
  • Due to the hype around the offering, the initial price per share of $28 rose to $35 per share, and Zuckerberg increased the number of shares outstanding by 25%, thereby offering 7.74 million shares to the public and reaching a market cap of $104 billion
  • The offering had technical problems that prevented more people from placing orders. Although the share price initially rose, it basically struggled to remain around the offering price of $38, and the Underwriters were forced to buy back the shares to technically support the price. However, the following day, the stock declined and kept on falling for 2 months to $20, thereby incurring nearly $40 billion losses for investors. 
  • Facebook IPO was the largest initial offering in the history of US exchange market as it raised $16 billion.      

Case study 2: Uber IPO

  • Uber was founded in 2009 by Travis Kalanick and Garrett Camp as UberCab. After Kalanick's resignation as CEO in 2017, Dara Khosrowshahi took his place. Ronald Sugar was named chairman in August 2018. Kalanick remains on the firm's board of directors.
  • Operations and Services:  Uber serves hundreds of cities in dozens of countries including the U.S. and Canada as well as other cities around the globe in Central and South America, Africa, Asia, Australia, New Zealand, and the E.U. Depending on your location Uber may be your only taxi alternative option. In the U.S. the service list over 300 cities from Las Vegas, Chicago, and New York to Fargo, Pensacola, and Kalamazoo.
  • Going Public and Market Share: Uber filed paperwork for its documents for IPO on Dec. 6, 2018. After delays, the company filed final documents to be listed on the New York Stock Exchange (NYSE) using the ticker symbol UBER. According to CNBC, the offering is expected to be one of the largest of 2019. The multinational ride-hailing company was valued at $120 billion by Wall Street banks and reported $11.27 billion in 2018 revenue.

 

What is a Direct Public Offering?

  • The Direct Public Offering (DPO) became available to small businesses in 1976 but became popular in 1989 when the rules were simplified. In 1992 SEC established its small businesses initiatives program. The program broke the limitations that reduced the participation of small companies to raise capital by selling their stock. 
  • The development of the internet energized all avenues. The promise that all companies can sell their stock directly via the internet did arrive! DPOs developed in a period of exuberant market expansion. 
  • Will Keyton identified the Direct Public Offering (DPO) as a “direct placement”. He pointed out that in this market structure that all middle persons are eliminated. These may include the investment Banks, broker-dealers and the underwriters. 
  • His definition focused on emphasized the goal of raising capital and the elimination of intermediaries. It can be observed that Free trading and independence was of utmost importance to him. Wikipedia defines DPO as a method by which a business can offer an investment opportunity directly to the public. It stresses that DPOs qualify for an exemption from the federal registration requirements. 
  • A company can sell its shares directly to anyone! All financials are in agreement that DPO is a direct listing; a financial tool; it's a way for companies to become publicly traded without a bank-backed Initial Public Offering (IPO). 
  • In DPOs, the general public and existing investors can cash out at any time without “the lock-up” period of traditional IPOs. They are an alternative to IPOs in which companies do not work with an Investment Bank to underwrite the issuing stock.  
  • Companies can avoid many costs of “going public” through an Initial Public Offering due to many of the registration and reporting requirements of the Securities and Exchange Commission (SEC) are deleted. Company’s employees and investors can convert ownership into a stock that is then listed on a stock exchange. Raising new outside capital like an IPO is avoided. 

How Does A Direct Listing Work?

  • There are three stages of a DPO process. They are as follows:
  • Preparation: Within as little as few months activities are put in place. These activities include ensuring that the issuing company is in good shape, making sure that previous financiers complied with applied securities law. A clean and updated financials is advised. The decision on what security to sell; preparation of the document that describes the issuer and the offering; Preparation of legal documents for the offering and others. 
  • Compliance Filling: A compilation of prepared documents comprising of offering documents; specimen security; formation documents; attorney opinion and other financials. These are submitted in a package of compliance materials to the securities regulators in every state where the offering is to be made. 
  • Selling the Offering: Approvals from the regulators should stimulate quick sales to the public. Having met all imposed regulating rules and demands. Generally, one year may be required to raise the funds. Applications can be renewed yearly and funds raised as long as desired. 

Pros of Direct Public Offerings (DPO)

  • DPO booster in this generation has been the internet. In fact, an estimated 200 small companies went public latter half of the 1990s via the internet either by offering stock online directly through their own websites or by listing with one of several online DPO forums. Benefits include:
  • Companies have much more control over the entire process as a DPO is directly handled by the company and its DPO advisors; the need for underwriting is canceled. So a DPO is not subject to market conditions.
  • There is no need for brokerage services; there is no need to purchase or use expensive outlets. Options such as Newspapers and Magazines, social media platforms, public meetings, and others can be used.
  • Affordable options are called up and some risks avoided as observed.

Cons of the DPO Process

  • DPO skips the underwriting process which means that issuers have more risk if the offering does not go well, but issuers may balance this risk by obtaining a higher share price.
  • The stock sold through DPO goes to a limited number of investors who tend to have a long term orientation; there is often less pressure on the company’s management to deliver short term results.
  • The amount of money that a company can raise through DPO within any period may be limited. 
  • DPO works best only for private companies that are popular, earn substantial revenue, have capital reserves and do not need to raise funds on the public market but wishes to provide liquidity to existing shareholders. 

Direct Public Offering Examples

 Case Study 1: Spotify’s DPO 

  • Spotify Technology S.A went public on April 2018 through a direct listing of its shares on the New York Stock Exchange. These objectives of Spotify going public did not necessarily align well with a traditional IPO process. After some years of successful operations; Spotify in time decided to achieve these objectives. They include: 
  • Offer greater liquidity for its existing shareholders without raising capital itself and without the restrictions imposed by standard lock-up agreements. 
  • Provide unfettered access to all buyers and sellers of its shares, allowing Spotify existing shareholders the ability to sell their shares immediately after listing at market prices. 
  • Conduct its listing process with maximum transparency and enable price discovery.
  • When Spotify went public, it became one of the largest tech companies to do so in recent years. The company opened at $165.90 per share and closed at a price of $149.01 per share. This was 10.2% below the opening price and 12.9% above the reference price. 
  • Spotify had 71 million paying subscribers and more than 15.9 million monthly active listeners positioning the service far ahead of its closest competitor Apple music with just 36 million subscribers. The company reported nearly $5 billion in revenue for 2017.

Case Study 2: Slack’s DPO

  • Slack Technologies, the provider of a cloud-based workplace messaging app, launched its product in 2013 and planned to list its shares on the New York Stock Exchange through a direct listing. Slack Technologies, the provider of a cloud-based workplace messaging app, launched its product in 2013 and preferred to list its shares on the New York Stock Exchange through a direct listing.
  • After Spotify’s direct listing, many said the approach could be used by other startups, given the lack of share dilution and required lockup restrictions.
  • Slack, the workplace messaging software popular in tech and media circles became the second largest tech company to use the direct listing rather than an initial public offering.
  • 136 million shares of Slack were traded and the stock price remained stable through the first day of trading. Opening at $38.50 and ending the day at $38.70. Slack valued at about $7 billion, made a market cap of almost $20 billion.
  • Slack set its reference price at $26 a share, though they are expected to open significantly higher than that.
  • But Spotify’s stock SPOT, hasn’t exactly been well received since the company made its public debut, with shares up only 4% from their reference price at the time of the offering, and down 17% from their opening price. Meanwhile, the S&P 500 index SPX, has gained 10% since Spotify went public. 

CONCLUSION

  • DPO works best for private companies that are popular, earn substantial revenue, have capital reserves and do not need to raise funds on the public market but wishes to provide liquidity to existing shareholders as in the Spotify and Slack cases.
  • IPO is more stable than a DPO .
  • The ideal DPO bear features of a free market system in which prices are determined by the open market and by the consumers or buyers. In a free market, the laws and forces of supply and demand prevail.
  • The free market is free from any intervention by a government or other authority and from all forms of economic privileges, monopolies, and artificial scarcities. The free market system with its independence from bureaucratic restrictions and other numerous benefits may be the potent attraction of companies to the DPO  option.

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