A major difference between a traditional IPO and a direct listing was removed last week with the SEC’s approval on August 26 of a new NYSE rule. The new rule will enable companies to sell newly issued shares (“primary direct listing”) into the opening auction on the first day of trading, raising fresh capital as part of a direct listing, while continuing to permit existing stockholders to sell their shares (“secondary direct listing”). Prior to the rule change, companies were unable to issue new shares as part of the direct listing process, which limited the utility of a direct listing for companies that wanted or needed to raise capital as part of their initial listing. With the rule change, more companies will consider whether to go public via a direct listing in lieu of a traditional IPO.
Also last week, Nasdaq filed a similar (though not identical) rule change proposal with the SEC that would allow companies to issue shares in connection with a direct listing on Nasdaq.
The new NYSE rule sets out the following requirements for a primary direct listing:
- The company must disclose in its registration statement the number of shares the company intends to sell in the direct listing and a price range within which it intends to do so. This information must be disclosed in the registration statement before it is declared effective. This is a key difference from a secondary direct listing where this disclosure is not applicable.
- The company must place limit order instructions where the limit order price is equal to the lower end of the price range, and the quantity of shares is the number of shares, in each case disclosed by the company in its effective registration statement. This limit order must be executed in full in the opening auction, otherwise the direct listing fails, and the shares will not begin trading. The company cannot easily modify its limit order instructions without obtaining SEC clearance. This differs from a traditional IPO process, where a company can upsize or downsize the offering (both as to the number of shares and the price) within applicable safe harbor limits without seeking SEC clearance.
- The company must satisfy aggregate market value criteria either by (a) selling at least $100 million in market value of shares in the opening auction on the first day of trading or (b) meeting an aggregate market value test. This test is met if the aggregate market value of shares to be sold by the company in the opening auction and the shares that are held by persons other than directors, officers and 10% holders immediately prior to the listing is at least $250 million, with such market value calculated by using the lower end of the price range disclosed in the company’s effective registration statement.
- The company must satisfy all other NYSE numerical listing requirements, including the requirement to have at least 400 shareholders of round lots and 1.1 million publicly-held shares outstanding at the time of initial listing, and to have a price per share of at least $4.00 at the time of initial listing.
With this change, is there any reason for a company to consider a traditional IPO?
Direct listings offer many benefits:
- Capital raising and liquidity: Under the new NYSE rule, the company will have the ability to raise fresh capital, while allowing selling stockholders to sell their shares as part of the listing. Existing stockholders should have immediate access to liquidity assuming no lock-up agreements. Indeed, in connection with secondary direct listings completed to date, stockholders have not typically signed lockups and therefore have been free to sell their shares immediately following the listing.
- No IPO “pop”: Because the opening price for the shares is based on market-based pricing, there is less chance of an IPO “pop” (i.e., less chance of money being left on the table) in the way there often is in a traditional IPO. Critics of this phenomenon argue that traditional IPO pricing disadvantages the company and existing investors in favor of a key group of IPO investors. At the same time, in a primary direct listing, the company must provide limit order instructions offering to sell all primary shares into the opening auction at the lower end of the price range set forth in its effective registration statement. This will require companies to carefully consider how they set the price range in order to avoid a failed listing.
- Guidance: In a traditional IPO, the company does not provide financial guidance to potential investors. Instead, the company spends a significant amount of time with the set of research analysts affiliated with the underwriters to educate them about the company, its financial model and forecast. This education then informs the analyst financial models shared with the underwriters’ sales forces and institutional clients at the time of the IPO, as well as the research reports these analysts publish about the company following the IPO. But not all analysts are able to participate in this education process and therefore do not have access to this information. In contrast, in a direct listing, the company typically holds an investor day at which it provides detailed information to the public about its business, financial model and forecast. This enables the company to provide public company-style guidance prior to the offering, which allows the company to widely disseminate its views on guidance about its future prospects and results.
- No underwriting commissions. Because there are no underwriters, the company does not pay underwriting commissions on the shares that it sells in the primary direct listing. However, the company must nonetheless pay the fees of the financial advisors that assist it in preparing for its direct listing.
Nevertheless, traditional IPOs will still be a very attractive route for many companies:
- Capital raising and liquidity: One of the benefits of a traditional IPO has always been the ability for companies to raise capital. And while existing investors have historically been required to sign lock ups, there are already examples of lock-up periods in traditional IPOs dropping below the historically standard 180 days, with investors instead released from the trading restrictions on a staggered schedule, according to certain price targets or based on the amount of time elapsed since the IPO if certain conditions are met.
- Flexible pricing mechanism: A traditional IPO is conducted as a firm commitment underwriting, which means that the company negotiates the IPO price with the underwriters based on the order book developed during the roadshow and the underwriters are contractually bound to purchase the shares at that price. As part of this process, and in contrast to the strict limitations in a primary direct listing, companies have broad flexibility to price the IPO outside the price range and change the number of shares offered, subject to the limitations of the applicable safe harbors, without seeking SEC clearance.
- Investor allocations: As part of the pricing process, the company, together with the underwriters, reviews the order book for its IPO and can make decisions about which investors receive an initial allocation of shares. In this way, the company can curate the group of initial public investors and ensure that its initial investor base comprises stable, long-term investors. This contrasts with a direct listing, in which the securities sold are allocated based on matching buy and sell orders, and the company has no ability to influence the allocation of the shares to particular investors, which may cause some institutional investors to stay on the sidelines on listing day.
- Marketing: In a traditional IPO, underwriters participate in extensive marketing efforts together with the company, including testing the waters meetings, a lengthy roadshow, marshaling a sales force to sell the stock, and engaging with research analysts. However, unlike in a direct listing, there is no practical ability for the company to offer guidance and, as a result, expectations about the company’s future prospects and results are left to the determination of the research analysts and the investors. In addition, this high level of publicity also allows the company to raise its corporate profile, often providing an unparalleled branding opportunity.
The new NYSE rules bring the traditional IPO and direct listing processes much closer together as both now permit capital raising and investor liquidity. However, some key differences remain such as no lock up period imposed on existing shareholders, better pricing transparency and an ability to provide guidance as part of a direct listing. While these benefits are compelling, the traditional IPO continues to offer the ability for underwriters to engage extensively in marketing activities with and on behalf of the company and an ability to curate a more stable shareholder base. Also, in a traditional IPO, companies may price outside of the range set forth in their prospectus. In a direct listing, if the limit order for the full number of shares the company expects to sell cannot be sold at the price at the lower end of the price range, the direct listing fails, and the shares do not begin trading.
We have put together an extensive memo describing the process for conducting a primary or secondary direct listing, and the numerous considerations that a company will need to weigh in determining which going public option is most suited to its goals. For a copy of this memo, please email us. In addition, no discussion of going public options in 2020 is complete without considering the increasing popularity of Special Purpose Acquisition Companies (“SPACs”). We remind readers of our memo detailing the 20 key considerations for private companies evaluating whether to be acquired by a SPAC, available here.