The US equity market has recently seen “Direct Listings” by Spotify and Slack in preference to a traditional Initial Public Offering. AirBnB has announced it will consider this option, and other US tech companies are rumoured to be considering the same route in 2020.
Direct Listings, known more commonly as Introductions in the UK, which have been around for decades as a route to market. From The Deal Team’s execution point of view, the documentation and listing preparation is similar to an IPO but without a sale of existing or new shares to a new shareholder base. They have typically been used across a number of markets by companies, small and large, with an existing diverse shareholding structure where there is no obvious need for raising capital, and where shareholders or management have a desire for liquidity – just like for Spotify and Slack.
The US market has seen Direct Listings before, so it’s not new technology. It was however used almost exclusively by very small issuers, and companies emerging from bankruptcy. Barry McCarthy, CFO of Spotify, is credited by the US tech sector for challenging the preconception that an IPO was the only way to come to market for a tech company like Spotify, which didn’t need to raise capital (he also coined the title of this article). What is driving this trend in the US, what are the pros and cons, and is it a passing trend or genuinely a potential impending structural change to market practice? There has been increasing press coverage on this tying it to the poor recent IPO track record, followed by initiatives in the US to promote the use of Direct Listings and even question how they can raise primary capital.
Could the Direct Listing – and potential equivalents in other markets – replace an IPO? Many of the benefits of being a listed company are common whether the traditional IPO route or a Direct Listing are taken – including shareholder liquidity, employee incentivisation, acquisition currency, profile. There are however some important differences to consider, which we break down in six ways:
Educating public investors
Advocates of IPOs say that the offering process allows the investment case to be proactively marketed to a long-term supportive shareholder base, by an incentivised and educated banking and research community – therefore encouraging a healthy aftermarket, particularly if there is a perceived overhang of shares waiting to be sold.
In the Spotify Direct Listing, it was argued that the brand and business model was well understood, and this awareness of the business meant it had no need to use the traditional IPO roadshow and investment bank activity to promote itself to investors. It’s fair to say that Spotify’s shares outperformed significantly in the months post their listing. It’s also true, however that they held a full investor day and issued earnings guidance, similar to a mature company’s investor relations work. Advocates of Direct Listings maintain that active private issuers (such as large tech companies with diverse private shareholder bases) will usually already have conducted extensive non-deal roadshows and private capital markets activity, helping to raise their profile.
Because of this nature of large private tech companies, it appears that executing a Direct Listing many not be so easily available for issuers without such a private market track record of investor engagement, or a more concentrated shareholder base. One will impact the likely public market interest, the other the number of shares available to sell, whether for regulatory reasons or lack of desire to sell at an unknown price. By way of comparison, practitioners usually estimate that “orphan” listed stocks wishing to reset their investor relations effort need to engage in a sustained two-year IR campaign to see material improvements in liquidity, research coverage, and shareholder base.
Slack’s under-performance since its Direct Listing has been attributed to a weaker outlook, with increasing competition from Microsoft, growing uncertainty over a route to profitability, potential disclosure lawsuits and a federal investigation breaches of securities laws. Seemingly no direct references to the route by which it came to market.
Firstly, issuers and selling shareholders have noted about the value transfer given the IPO “discount” or first day premium – the same thing viewed from a different perspective – that is seen as a sign of a successful IPO.
The Direct Listing is seen by its advocates as a way to avoid this IPO pop. A previous tech issuer, Google, tried to disrupt the IPO market in 2004 with a Dutch auction (the list of orders is allocated from the highest bid down, with the price being set at the clearing price where 100% of the shares are sold) which however did also include the bookrunners in the allocation decisions, diluting the automatic process of the auction.
A Direct Listing allocates shares at the clearing price for the pre-open auction on the first day of trading. The question of whether this is a better valuation discovery process is outside our scope (we do not advise on valuations), however fans of Direct Listings believe that this avoids an explicit value transfer on the first day of trading, and it facilitates secondary market liquidity. From an execution aspect, we would point out that the precise mechanism of this discovery process will depend on the existing mechanics for pre-open market maker auctions, the number of shares available for sale, and the demand on the day. Anecdotally, we are told that both Spotify and Slack had at least 10% of their outstanding shares traded in the initial auction.
We’d also point out that regulatory free float considerations could have an impact. The US tends to have much lower free floats at IPO, around 10%. This compares to Europe and much of the rest of the world, where a 25% float is seen as desirable or required by regulation. This higher free float requirement may well be more difficult to execute under a Direct Listing, potentially endangering the entire listing.
Raising primary capital
A second argument is that IPOs have historically been favoured over Direct Listings because they can be used to raise capital. However, with private funding now much more abundant for larger, later stage companies this argument may be less strong for some issuers. There has also been recent debate whether a Direct Listing could be combined with a fund raising, by allowing the company to sell primary shares in the pre-open auction. This would however raise the question of “selling shares at any price” and create uncertainty over the company’s balance sheet status until after the Direct Listing.
Historically, certainly in the UK, demergers such as Standard Life and Zeneca (which are similar in many aspects to Direct Listings), have successfully been combined with rights issues.
With the trend of disruptive companies staying private for longer and then even in an IPO context retaining control through superior voting rights, governance rights in US tech IPOs have become a focus for stock market investors. The push back on founders’ rights and governance is seen as one major factor in recent IPO performance, compounded by the index providers’ exclusion of shares with split voting rights. It may be that Direct Listings would facilitate these companies to come to market regardless of market conditions and sentiment towards any poor governance structures. However, as the market will be allowed to determine the value of the company both in the initial market maker clearing auction and in the long run, governance may continue to be a factor in the investment decision.
Lowering market risk
A fifth argument in favour of direct listings is market conditions. An IPO is a huge financial commitment but potentially more importantly a huge distraction for management. The live period of an IPO can take up to two weeks in the US, and longer elsewhere, subjecting the entire process to market volatility. Relying on market conditions is therefore a risk and a potential cost for IPO candidates. A Direct Listing is in theory less reliant on a sustained positive level or moderate volatility of the stock market. This could be of benefit where venture capital shareholders have negotiated penalties to investee companies who do not achieve liquidity for shareholders within a specified time period, and find themselves up against the deadline. For example, Spotify had dilutive ratcheting penalties from VC investors. AirBnB is believed to be moving towards its Direct Listing, in part due to its decision a decade ago to grant stock options with a 10 year maturity to motivate and retain employees.
As regards process and management of a Direct Listing the process from a company perspective is unlikely to differ materially. A Direct Listing application/registration statement will cover 95% of the same disclosure requirements as an IPO Prospectus. Having the right team and deal execution capabilities will be at least as important for a Direct Listing.
To date, the examples of a Direct Listing being preferable to an IPO are limited to rather special cases.
Some of the specific features of an IPO such as ability to fundraise, investor education, ability to stabilise, and day-one liquidity are likely to continue being important parts of the decision between the two options. Some US practitioners expect that the Direct Listing will open up the to-date “standard” IPO price discovery process and evolve into a spectrum of offering types tailored to the issuer. In markets outside the US, it would not be surprising to find some issuers with the extensive private market presence of Spotify or Slack, to look at a Direct Listing-type option.
For any transaction, whether an IPO, or a Direct Listing, The Deal Team keeps the destination in mind throughout the transaction execution. These are important transactions, certainly – which are however only a single stage in the company’s journey. Our view is that the destination is what matters, and we work with advisors to execute their recommendations on which option would meet the company’s and shareholders’ needs best. Instead of what sometimes, might seem like chasing disruption simply for disruption’s sake.
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