The initial public offering (IPO) process and the direct public offering process allow companies to go public and sell shares. Direct listings have grown in popularity following a recent rule change by the SEC. Companies can now raise new capital while selling shares through direct listings.
A direct listing is cheaper than a traditional initial public offering. The big difference is that the direct process doesn’t use intermediaries. A company does not work with an investment bank, broker-dealer or underwriter. This means lower fees and regulations. But what are the benefits? How do they work? Could they become the new standard for going public?
Traditional IPO vs. Direct Listing
Why go public? Going public opens a company up to new investors. This helps it to raise funds. But it isn’t that simple. Going public takes time, and the process can be expensive. A company can IPO through a traditional process, direct listing or a SPAC.
The Role of the Underwriter
Traditional Initial Public Offering Process
A company issues new stock shares during an initial public offering. Companies going public for the first time face more regulations. Many companies will hire an underwriter to manage the process.
An investment bank usually underwrites an IPO. They serve as an intermediary between the company and investors. They help determine the initial offer price of a stock and buy shares from the issuing company.
One important piece of the process is the IPO roadshow. This is a sales pitch to build interest before going public. And the IPO roadshow usually takes one to two weeks.
The investment bank helps to tell the company’s story. They try to find what price investors are willing to pay and how many shares they want. The company and underwriter are then able to determine how many shares to sell at what price.
An underwriter is an added safety net because they sign an agreement to buy and sell shares. And every underwriting agreement is different. An investment bank can decide how much risk it wants to take on.
There Are Three Types of Underwriting Agreements…
- Bought Deal – The underwriter agrees to buy the entire IPO issue. The underwriter will have to resell all shares to make money. The underwriter bears all risk of selling the stock.
- Best-Effort Deal – This is an agreement from an underwriter to make its “best efforts” to sell the issue to the public. The underwriter does not buy any shares.
- All-or-None Agreement – This is the least common agreement. The company and underwriter agree to cancel the IPO if not all shares sell.
Direct Listing Process
A direct listing allows a private company to sell shares to the public without underwriters. It is exactly how it sounds: direct…
This process skips the bank-backing steps of a traditional initial public offering. Existing stock owned by employees and investors is listed on the exchange. The public is then able to buy those shares.
Direct listings are ideal for established companies with a loyal client base. This is because people are already familiar with the brand. They don’t need the added exposure that comes with the traditional IPO process.
Small companies opt for direct listings because they’re a quicker, less expensive way to go public. A company may not have the financial resources to afford an underwriter. Some companies also prefer direct listings to avoid diluting existing ownership or a lockup period.
Traditional IPO Pros and Cons
Traditional IPOs have been the standard for going public. They can bring in a lot of new capital and boost a company’s progress. They can also increase exposure to potential customers.
Although, the big downside to this process is time and cost. The traditional IPO process can take six months to a year. The SEC requires several contracts between the underwriter and the company.
Underwriting is usually the most expensive part of the IPO process. Hiring an underwriter can cost around 5% of the offering. That can easily result in millions or tens of millions in fees per IPO.
Direct Listing Pros and Cons
Direct listings allow a company to raise money going public without the hassle and cost of a traditional IPO. But waiving the safety net of an underwriter can be risky. Going public without an underwriter can put a company at higher share price risk. Banks can help with building interest for an IPO.
Private shares are listed on a public stock exchange without the help from an underwriter. There is no guarantee of selling shares at a certain price.
Supply and demand determine the share price. No transactions will occur if there is no market demand. With a direct listing, a company has to build interest from the investor community on its own.
Companies still use traditional IPOs for the added safety. But more companies are leaning toward direct listings. They’re faster and cheaper alternatives. The success of Spotify and Slack Technologies direct listings have gained media attention. And analysts predict direct listings will become more common for going public.
Although, SPAC IPOs are also gaining momentum. To learn more about that process, check out that link.
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