There are various reasons why a company may decide to list on a public exchange but, most commonly, it's a means of raising capital to grow the business further. A stock exchange listing can also provide an important opportunity for early investors and shareholders to cash in some profits while allowing the general public to invest in the company for the first time.
The most popular way for a company to go public is via an Initial Public Offering (IPO), with the alternative option being a Direct Listing. However, it seems the tide may be changing, as some venture capitalists are now starting to favour and recommend direct listings over IPOs. In this article, we will explain the differences between a direct listing and an initial public offering, and why VCs are beginning to have a preference.
What is an Initial Public Offering (IPO)?
The IPO process involves the creation of new shares, which are underwritten and then sold to the public. Companies interested in having an IPO will usually have a private valuation of at least $1 billion, but those with smaller valuations can still qualify.
An underwriter is an intermediary that works closely with the company during the IPO process and charges a commission for its services. The underwriter will help the company meet the regulatory requirements, decide the initial offer price for the shares, and sell the shares to its network of brokers, mutual funds, investment banks and other potential investors.
Both company executives and the underwriter will present to institutional investors prior to the IPO. This helps to generate interest in share sales and enables the underwriter to set a reasonable initial offer price. The underwriter's fee, often ranging between 3 per cent and 7 per cent per share, consumes a notable chunk of the capital raised. However, the underwriter will usually guarantee that a certain number of shares are sold at the initial offer price, providing a safety net for the company.
What is Direct Listing?
The direct listing process, also known as a direct public offering (DPO) or direct placement, does not involve the services of an underwriter or the creation of any new shares. This can be better suited for companies that don't have the funds to pay for an underwriter or don't want to dilute their existing shares.
Instead, the company and existing investors sell their shares directly to the public without hiring any intermediaries. While it serves as a much cheaper alternative to the IPO process, it lacks the guarantee of share sales, regulatory assistance and access to institutional investors that an underwriter can provide.
Nonetheless, a direct listing is typically faster and creates a more level playing field than an IPO. That's because the shares listed will be available to everyone, rather than just at the underwriters select brokerages who may impose restrictions on who can participate.
DPO vs IPO: which do venture capitalists prefer?
Despite the popularity of IPOs, some venture capitalists are now advising start-ups to go for direct listing instead. The venture capitalists claim that direct listings on stock exchanges provide a better alternative to IPOs.
VCs believe that the underwriters, which in most cases are investment banks, price shares deliberately low so they can surge on the first day of trading. The surge benefits the institutional clients who buy at the low initial offer price and then flip their shares when the price goes up.
This underpricing of shares via IPOs means that companies receive less capital and early investors such as VCs see diminished returns. Research shows that in the past decade, VC-backed IPOs underwritten by Goldman Sachs had, on average, a 33.8 per cent first-day gain. Some VCs now believe it's hard to justify giving away millions of dollars in one day. This means in the battle of direct listings vs IPOs, we could start to see a new champion emerging.