What Are Direct Listings, How Do They Work, and Why Do They Matter?
Why would a company do a direct listing? What are the key differences between an IPO and a direct listing? And what are the tradeoffs involved in this new approach? In the discussion that follows, Joe Grundfest, W.A. Franke Professor of Law and Business, answers these questions, and more, about direct listings.
What is a direct listing and how does it compare to the traditional IPO process?
In the traditional IPO, there are really two price setting mechanisms that occur within a few hours of each other. First, the underwriter tries to estimate the price at which the security will trade in an active secondary market, and based on that estimate sells the securities at the “IPO price,” typically to a group of institutional or high net worth investors. Your average retail investor typically can’t get into an IPO at the IPO price. Then, a few hours later, the stock starts trading on the Nasdaq market or on the NY Stock Exchange. There, it’s an entirely different group of buyers and sellers that establish an equilibrium price, and that secondary market trading price can diverge significantly from the IPO price.
In contrast, in a direct listing the underwriters never set an IPO price and never sell to a select group of purchasers. Instead, trading begins on the secondary market with any purchaser able to submit a price at which they are willing to buy the shares. The underwriters don’t sell at a price they determine to a select group of purchasers. The market sets the price at the very first instance.
Is the traditional IPO process broken?
Some market participants think it’s working just fine, others think there’s room for improvement, and others think that the process is profoundly broken. The major cause of the debate is a phenomenon known as the “IPO pop” – the tendency for the price of some issuer’s shares to increase significantly above the IPO price on the first day of trading. To the strongest critics of the system, “the pop” is evidence that underwriters are failing to get the best price for issuers. Their concern is not only that the issuers are leaving money on the table because they could have sold their stock at a higher price. They also fear that underwriters underprice because it generates profits for the underwriters’ clients who get to purchase shares at the cheap IPO price, and that the clients return the favor to the underwriter by directing more business to the firms that get them into these hot deals.
Do all offerings result in price pops?
No. Many offerings trade at prices reasonably close to the offering price, and many scholars explain that a modest amount of underpricing is likely necessary in order to provide purchasers with an incentive to take the risk of purchasing stock in a brand-new issuer where the value of its shares hasn’t been established in an active, open secondary market.
Do stock prices ever sink below the offering price?
Yes, they do. That phenomenon is called “breaking bid” and several recent high profile IPOs have broken bid. Uber, Peloton and SmileDirect are examples of three offerings in which the purchasers at the IPO price lost money from the get go.
Are direct listings a real alternative to the traditional IPO?
That’s a topic of debate. Many market professionals believe that the larger issuers who are well known to the investment and retail communities are the issuers most likely to be able to succeed in a direct offering because they don’t need professional underwriters to help drum up demand for their shares. Many market professionals also believe that the direct offering market will evolve by first beginning with the largest, best known new IPOs and then move down market to more obscure issuers as the market gains confidence with the operation of the direct offering process.
Who is the right candidate for a direct listing (and who is not)?
At the outset, the best candidates are likely well-known firms with transparent business models that don’t need underwriters to drum up consistent demand for their shares.
What are some of the challenges facing the direct listing model, and how can the SEC and investors overcome those challenges?
The SEC’s rules in this space are calibrated for the traditional IPO process and need to be tweaked in many different ways to accommodate direct offerings in which the company itself will be selling stock. We know that the SEC has already approved the direct offering process when the shares that come to market are owned by stockholders such as venture capitalists, and are not issued directly by the company itself. There are many different disclosure and process issues that have to be resolved when the company is selling its own stock in a direct offering, and there is every indication that the Commission and its staff are hard at work helping the market figure out how to navigate through these complex details so as to facilitate direct offerings in which the company also sells some of its stock.
Do you think that we will see more direct offerings in the near future?
I am very hopeful. Whether and when they happen depends on the interplay of market conditions with the SEC’s ability to tweak the rulebook so as to facilitate direct offerings in which issuers sell their own shares. There’s every reason to believe that the Commission will help get the market to a point where direct offerings become a viable alternative to the traditional IPO for a large number of issuers.