Insights

Direct Listings vs. IPOs: Differences and D&O Liability, Part 1

April 1, 2020

Management Liability/D&O

For the most part, IPOs follow a predictable process and have a predictable level of litigation risk. But there’s a newer, more unconventional way of going public that may be gaining traction: direct listings.

Given that it’s a relatively new process, there is some uncertainty about what we can expect when it comes to litigation against a newly public company that uses the direct listing route.

Only three companies have taken the direct listing route to date: Spotify was the first in 2018, and Slack followed in 2019, both on the NYSE. Watford did a direct listing on the Nasdaq in 2019.

According to NYSE, “Slack and Spotify … ranked among the largest opening trades in the history of the US markets.”

Unfortunately, there has already been litigation. Out of the three direct listings thus far, one-third have been sued, which is to say one company—Slack—was hit with Section 11 litigation.

With many pre-IPO companies considering taking the direct listing route instead of doing a traditional IPO, and the exchanges pushing to open direct listings to more companies, it’s time to take a closer look at this new path to going public.

This article describes some of the nuances of direct listings. In a separate article, I discuss the implications for litigation and D&O insurance.

What Are the Differences Between an IPO and a Direct Listing?

An IPO

To understand what constitutes a direct listing, it’s useful first to recall what the term IPO means.

An IPO, or “initial public offering,” is exactly what it sounds like: it’s the first time a company—or “issuer” in securities law parlance—offers the public the opportunity to purchase securities issued by the company.

This can only be done pursuant to an S-1 registration statement, per US federal securities law. By convention, when the term “IPO” is used, the assumption is that the issuer is issuing new common stock for the public to purchase.

The Shares: Primary and Secondary

The new common stock first issued by a company can be referred to as “primary shares.”

Sometimes existing shareholders will be given the opportunity to sell some of their common stock side-by-side with the company as part of the same S-1 registration statement the company is using for its IPO.

The shares being sold by these “selling shareholders” in the IPO are “secondary shares,” and this part of the IPO is technically a “secondary offering.”

As a reminder, a secondary offering is always the offering of shares by someone other than an issuer. This can be confusing because many people refer to the second public offering of an issuer’s primary shares as a “secondary offering.”

The proper term for an issuer’s second public offering of primary shares, and all offerings of primary shares by an issuer thereafter, is actually “follow-on offering.”

The Investment Banker’s Role

When the term IPO is used, another assumption is that investment bankers are involved. In a typical IPO, investment bankers facilitate the gathering of orders for the IPO from investors, including taking the management team on a “road show” to meet with investors.

This process, known as “building the [order] book,” is what sets the ultimate issuance price for the shares being sold in the IPO. As a technical matter, in most IPOs, a syndicate of investment bankers buys the shares from the issuer at a discount, and then resells the shares to the public.

Lock-Ups

In a typical IPO, investment bankers almost always have existing, pre-IPO holders of company securities promise not to sell their shares until 180 days after the IPO. Known as a “lock-up,” this mechanism makes it easier for the investment bankers to help support the price in the market. It also means that shares held by employees and early investors will not be sold into the public market until after the lock-up expires.

It also means that until the lock-up expires the only shares trading in the market are shares that can be traced back to the original S-1 registration statement.

A Direct Listing

Direct listings differ from traditional IPOs in a number of significant ways. First and foremost, investment bankers do not control the process. They do not take the company on a roadshow, and they do not set the price.

The company may have an investor day for potential investors, but it’s not a road show organized by the investment bankers. In the case of both Spotify and Slack, the investor day was live-streamed, and the investor community was able to ask questions.

The Investment Banker’s Role

Importantly, in a direct listing, investment bankers are not paid the enormous fees they typically earn for the work they do for an IPO.

An investment banker will likely work with the company as an advisor to the company and the relevant exchange to set the “reference price” for the direct listing.

This, frankly, seems to be so that the exchange systems have an initial price to put into the system as much as anything else.

The Shares: Secondary Shares

Unlike in an IPO, in a direct listing, the only shares registered for sale on the registration statement are shares held by folks other than the issuer, which is to say secondary shares. The issuer doesn’t offer any new shares (primary shares) in a direct listing.

As a result, the issuer that registered the shares doesn’t get any proceeds from the direct listing.

Another difference is the process of getting shares in the market. In a direct listing, there is no investment banking syndicate purchasing all the registered shares and then pushing them into the market.

Instead, the registered selling shareholders can choose to sell their shares or not. Retail and institutional buyers have to contact their broker and place an order to get shares.

Lock-Ups

Yet another big difference is that there is no lock-up. This means that there may be sellers of company stock in the public market other than those whose shares were registered on the S-1 registration statement.

Specifically, employees and others who have met the requirements of Rule 144 will be eligible to sell their shares in the market, too.

As a result, there may be shares in the market that cannot be traced back to the registration statement—a very important difference from an IPO that is relevant when it comes to litigation.

IPODirect Listing
PRIMARY SHARES

Yes

No*

SECONDARY SHARES

Maybe

Yes

COMPANY RECEIVES PROCEEDS

Yes

No

BANKERS CONTROL PROCESS AND HOST ROAD SHOW

Yes

No

BANKERS SET ISSUANCE PRICE

Yes

No

BANKERS BUY THE REGISTERED SHARES AND THEN RESELL THEM IN THE MARKET

Yes

No

180 DAY LOCK-UP

Yes

No

*The NYSE has proposed to the SEC that this be allowed.

Who Should Do a Direct Listing?

Given that no proceeds of a direct listing go to the issuer, only issuers who do not need capital should consider doing a direct listing.

Having said that, there is a lot of talk about companies doing a large private round of financing right before a direct listing. Indeed, a lot of IPO companies do this as well.

One concern for a direct listing is having enough sellers. As a reminder, the selling shareholders listed in the S-1 registration statement of a direct listing can sell their shares in the open market, but they do not have to do so.

The more sellers there are, of course, the more likely someone is to sell their shares. A stock that has an inadequate number of sellers is a stock that will be highly volatile, something that tends to scare away buyers.

Why Do a Direct Listing?

Given that a company doing a direct listing is going to incur a lot of expense and trouble to become publicly traded, and also isn’t getting any proceeds from the transaction, why do it?

First, direct listings bring with them all the benefits of being a public company. This includes:

  • Being able to more easily access capital markets in the future
  • Being able to provide employees with equity that they can more easily convert to cash if they would like to do so
  • Having the stature of being a publicly traded company

Second, the market determines the value of shares on the first day of trading. Many applaud direct listings as a way to offer a truer, market-driven price versus the traditional way prices are set in an IPO. (For more, this article on the Harvard Law School blog gives a good overview on direct listings.)

Thus, the real question might be this: Why avoid taking the traditional IPO path?

There are a number of reasons why companies may choose this unconventional path. For instance, insiders say that Spotify had specific goals that the IPO route just didn’t support, including:

  • Offering greater liquidity for its existing shareholders without raising capital and without the restrictions of lock-up agreements
  • Providing unfettered access to all buyers and sellers of shares, allowing the company’s existing shareholders the ability to sell shares immediately after listing at market prices
  • Conducting its listing process with maximum transparency and enabling market-driven price discovery

An interview on this topic with Spotify CEO Daniel Ek can be found here.

There’s another reason that venture capitalist investors in pre-IPO companies have not been shy about mentioning: the costs. Direct listings effectively cut out the costly middlemen—the investment bankers—in the IPO process. This can be a lot of money.

As mentioned earlier, investment bankers will still earn fees as advisors, but those fees are far less than what they earn when they underwrite an IPO.

Finally, there is a great hope that direct listings will be less susceptible to the unfortunate litigation environment IPO companies now find themselves in.

This would be very positive, particularly coming on the heels of the recent Delaware Supreme Court decision affirming the validity of federal forum provisions in Sciabacucchi.

A Push for More Direct Listings

As highlighted earlier, both NYSE and Nasdaq offer direct listings. In order to make direct listings a more accessible option for more companies, in November 2019, NYSE proposed a change that would allow companies to raise capital via a direct listing, and lessen the requirement on existing shareholders.

As it stands today, direct listings cannot raise capital and must have 400 round lot holders (holders who own 100 or more shares) prior to listing.

With NYSE’s proposed rule change, a company would be able to sell newly issued shares to raise capital on its behalf and would have a grace period before it needed to have the required number of round lot holders.

The Securities and Exchange Commission rejected the proposed rule.

In December 2019, NYSE amended the proposal and resubmitted it for SEC approval. As of this writing, the SEC has not yet provided a response.

Given that direct listings may be growing in popularity, it’s important to understand the potential risks to directors and officers in a direct listing. I’ll cover these topics in next week’s post when I discuss the litigation risks of direct listings.

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