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A Deep Dive on Direct Listings

I’ve been thinking…What is a Direct Listing?

There are four principal methods for a private company’s shares to trade in the public markets: (1) sell shares to the public through a direct listing process, (2) sell shares to the public by undergoing an initial public offering, (3) be acquired by a Special Purpose Acquisition Company (SPAC), and (4) enter into a so-called reverse merger transaction with an already public company.  This blog deals with direct listings.

Background

Some basic definitions are going to be helpful for this blog.  A direct listing is a formal process whereby a company facilitates the sale to new investors of registered shares of the company held by existing investors.  Such a sale of outstanding shares is also commonly called a secondary offering.  In a secondary offering, the company does not sell newly created shares and, therefore, does not raise capital for itself.  In contrast, when a company sells newly created registered shares into the market, this is called a primary offering.  In a primary offering, the company raises capital for itself.  An initial public offering, or IPO, refers to the first time a company issues newly created registered shares to a syndicate of underwriters, who in turn sell the same shares to investors.  All subsequent offerings of newly created shares are called follow on offerings.

There are many similarities between the direct listing process and an IPO.  The end result of each process is the creation of a public company with registered shares that are freely traded in the market.  However, becoming a public company also brings with it a host of responsibilities, including being subject to ongoing SEC regulations.

This blog is being written on the heels of the SEC’s approval on August 26, 2020 of the NYSE’s June 2020 amended direct listing application, which fundamentally changed the nature of the existing direct listing procedures by creating a listing procedure that allows for a concurrent capital raise.  On August 31, 2020, the SEC stayed the effectiveness of the rule change to allow for the indicated challenge to the rule from the Council of Institutional Investors.

Spotify’s 2018 Direct Listing

The story starts with Spotify’s direct listing on April 3, 2018.  Before the SEC’s August 2020 action, the SEC had approved the NYSE’s June 2017 proposed changes to its listing rules to allow for direct listings, presumably to accommodate Spotify’s intentions.  In April 2018, Spotify conducted its landmark direct listing of some 55 million shares.  These shares were owned by employees along with non-employees holding shares for under one year and represented some 31% of Spotify’s total shares.

Goldman Sachs, Morgan Stanley and Allen & Company acted as financial advisors to Spotify in connection with the direct listing application. Morgan Stanley was also retained as an independent valuation agent to opine that the registered shares available in the direct listing had a public market value of over $250 million, the minimum amount that the NYSE’s rule deemed necessary to assure sufficient liquidity.  Citadel Securities was selected as the designated market maker (DMM) in Spotify’s direct listing.  Absent an IPO, the NASDAQ requires a DMM to have a financial advisor in part to provide specific advice on setting a non-binding reference price for the registered shares.  Spotify appointed Morgan Stanley to also act as a financial advisor to Citadel.

SEC’s August 2020 Approval of NYSE’s Proposal

In the August 2020 SEC action, the NYSE’s amended application referred to the direct listing procedure described above as the Selling Shareholder Direct Floor Listing.  In addition, the NYSE also proposed a new type of direct listing, called the Primary Direct Floor Listing.  As the name of new listing implies, this type of direct listing allows a qualifying company to create and register new shares that are sold new investors, thus raising capital for the company.  In my opinion, the current qualification rules for a primary direct floor listing are strict, and the SEC’s approval allowed no grace period.  It remains to be seen how many private companies will pursue this new alternative.

For a company seeking to list its shares publicly, the Board of Directors can choose between the following mutually exclusive options: (1) an IPO; (2) a selling shareholder direct floor listing, and (3) a selling shareholder direct floor listing combined with a primary direct floor listing.  From the Board’s point of view, choosing amongst these alternatives may hinge on the company’s need to raise funds at the time, since all three alternatives provide liquidity to the existing shareholders of the registered shares.  Another important consideration of the Board is the cost of each alternative.   In my experience, costs of the two direct listing alternatives are a fraction of those of an IPO.

On the cost analysis, the IPO and both of the direct listing alternatives still require the engagement of experienced legal counsel to guide the company through the transition from a private company to a public company, including a reasonable legal due diligence investigation.   However, when compared to the customary role of underwriters in an IPO, the nature and extent of the involvement of financial advisors in the two direct listing alternatives is far less extensive.

The IPO Process

The actual mechanics of a typical IPO are dramatically different than the comparable mechanics of the two direct listing alternatives.  For example, an IPO is marked by the sale of newly created registered shares to the investment banks serving as a syndicate of underwriters of the IPO.  The underwriters immediately allocate and resell those same shares to the set of investors largely pre-selected by the issuer and the underwriting syndicate.  The price per share received by the issuer is subject to negotiations at the very end of an elaborate price discovery process, called book building, that culminates in the acceptance by the buyer of the price per share proposed by the syndicate head of the underwriters.  Once the price per share is finalized, the preliminary S-1 registration statement and prospectus, which contains a range of expected share prices, is replaced with the final S-1, which is filed with the SEC.  The IPO is launched for trading the morning after the SEC declares the final S-1 “effective.”

The typical IPO has the new investors paying some 7% more per share than the issuer receives.  This 7% represents the entire compensation amount that the syndicate of investment banks involved earns for orchestrating the IPO.  Importantly, the 7% fee is structured as a success fee: it is paid on the closing of the IPO…no closing, no fee.

Underwriters invariably perform a reasonable due diligence investigation of material information on the company and reasonably rely on the results of this investigation to form a reasonable basis to believe in the accuracy and completeness of material disclosures in the Form S-1 and the Prospectus, which are among the offering documents required by the SEC for an IPO.

Other underwriter services provided are, among other things, (i) arranging for so-called teach-ins by the research analyst of the lead investment bank to an audience of sales executives from the lead underwriter to present the  research analyst’s opinion on the company, including a detailed financial model; (ii) arranging for the company executives to present the draft road show slides to an audience of sales executives from the lead underwriter covering in part the company’s history and strengths but not actual financial projections; (iii) conducting the road show, which is an orchestrated event showcasing the company and its executive management in meetings (physical and virtual) with invited prospective investors; the road show takes place in the so-called quiet period, which prohibits the company from discussing projected financial results; (iv) beginning the process of book building by tallying the so-called indications of interest from road show investors at various prices and quantities; (v) negotiating the over-allotment option (called the green shoe), which is used for share price stabilization, if necessary, immediately after the opening of share trading); (vi) committing to making a market in the company’s shares; (vii) negotiating the lock-up of the shares of insiders and other investors owning large numbers of shares for up to six months in order to modulate the supply of shares available for sale; and (viii) conducting bring-down due diligence just before final pricing meeting to be assured that there are no recent developments that materially affect the accuracy and completeness of the offering documents.

Direct Listings Procedures

In orchestrating the two types of direct listings, investment bankers act as advisors and invariably perform a reasonable due diligence investigation of material information on the company and reasonably rely of the results of this investigation to form a reasonable basis to believe in the accuracy and completeness of disclosures in, among other things, the Form S-1, the required SEC offering document for each of the direct listing alternatives.

Direct Floor Listing

In a selling shareholder direct floor listing, the company facilitates the sale to new investors of its outstanding registered shares held by existing investors willing to offer their shares in the direct listing.   The actual mechanics are quite different from those of an IPO discussed above.  For one thing, in an IPO the initial share price is known by both the issuer and IPO investors and listed in the final S-1 filed with SEC, which replaces the preliminary S-1 containing an estimated filing range of share prices.  The initial share price in an IPO is determined through the book building process discussed above, and this is a price per share received by the issuer (less the underwriter fee of 7%).   The initial share price is not to be confused with the share trading price.  Share trading prices for shares issued in an IPO are determined once secondary trading starts between investors and are subject to the laws of supply and demand.  The NYSE employs the so-called specialist system to determine the opening trading share price and to handle day-to-day trading.

In a selling shareholder direct floor listing, the laws of supply and demand apply from the get-go. There is no preliminary filing range of share prices contained in the preliminary S-1 filed with the SEC as there is in the IPO case, and there is also no initial share price filed the SEC as there is in the IPO case.  The share trading prices will be determined by the actual supply and demand of registered shares.  The initial supply consists of the number of registered shares that existing investors are willing to commit to the opening auction. The initial demand consists of the number of registered shares that new investors are willing to bid for at various share prices.  The auction is run by the DMM, whose business it is to match opening buy and sell orders and set the equilibrium share trading price to start trading.  The day before trading begins, the DMM, in conjunction with a financial advisor who is appointed by the company, will declare what is known as an indication reference price, which serves only as a guidepost in the price discovery process.

Investment bankers play no role in the share trading between investors and, accordingly, earn no sales commissions.  Investment banks are compensated as advisors in a direct listing, with a fixed fee payable whether or not the transaction goes forward.  Besides performing the reasonable due diligence investigation discussed above, other typical investment banking advisory services include helping company executives with (i) positioning the company’s story to new investors; (ii) drafting accurate and complete S-1 disclosures; (iii) educating company insiders and other advisors on the direct listing process; (iv) outreach to prospective investors, including orchestrating the so-called investor day, which is somewhat analogous to an IPO road show presentation; and (v) managing share trading liquidity.  Although fact specific, investment advisory fees for direct listings have been just 30%-40% of comparable IPO underwriting fees.

A valid criticism of the IPO process, and a raison d’etre for the interest in direct listings, is that certain IPOs have been dramatically underpriced, resulting in the issuer having left money on the table for the capital raise and the pre-IPO investors suffering unnecessary ownership dilution.  For example, if the initial share price is set as $10 and the first trade on opening is done at $15, then the share trading price is said to have “popped” 50%. The issuer company receives no benefit from this pop in share trading price.  The sole beneficiary is the investor that had been allocated shares in the IPO at $10.

The NYSE’s June 2020 application sought to design a new direct listing alternative that allowed not only for companies to raise capital without the underpricing risk inherent in IPOs but also for the elimination of the required insider lock ups in order to modulate the supply of shares available for sale.  The SEC’s August 2020 action to approve the NYSE’s recommendation allowed the capital markets to launch a second alternative to IPOs, one designed to be faster, cheaper and more friendly to pre-IPO investors.   The new alternative combines the existing procedures for the selling shareholder direct floor listing discussed above with the new procedures for what is called a primary direct floor listing, which are discussed below.

Combined Direct Listing

In a combined selling shareholder direct floor listing with the primary direct floor listing, the company not only facilitates the sale to new investors of its registered shares held by existing investors that are willing to sell in the direct listing, but also the company creates and registers new shares and holds an auction to sell the new shares to new investors.  The actual mechanics of a primary direct floor listing are (i) assuring that there are 400 round lot holders; (ii) determining the exact number of shares to be registered for sale, providing that there are a minimum of 1.1 million publicly held shares outstanding; (iii) setting a reasonable share price range that is above $4.00 per share; and (iv) assuring that the registered shares offered meet the stipulated minimum threshold of public market value deemed to assure adequate liquidity for trading by either (a) selling a minimum of $100 million in registered shares in the opening auction, or (b) assuring the registered shares outstanding have a minimum public market value of $250 million.

Investment bankers earn no sales commissions in the primary sale of registered shares to new investors, but their role as advisors to company executives in smoothly navigating the capital raise can be crucial.  Recall that when the SEC declares the IPO’s final S-1 effective, share trading begins the next day.  In contrast, when the SEC declares the S-1 for the primary direct floor listing effective, for technical reasons there is much more than a one-day gap between the start of trading.  When the SEC declares an S-1 effective, the quiet period ends, and therefore the prohibition on the company disclosing financial projections also lapses.  This longer time gap (perhaps up to 7 to 10 days) can be filled with additional outreach to prospective investors, including sharing company financial projections.

In my opinion, very few private companies meet the current listing qualifications for a primary direct floor listing, so it’s not clear at this time how many companies will be able to use this capital raising alternative to an IPO.