What to Know About Direct Listings—From a Banker

From Silicon Valley to Wall Street, tech companies and investors are focused on direct listings—also known as direct public offerings, or DPOs—an alternative to the traditional initial public offering, or IPO, as a way to go public. But what are direct listings? How do they work and why are they suddenly in vogue? Could they become the dominant on-ramp to the public market for private companies?

Morgan Stanley, which advised Spotify, Slack, Palantir and Asana, the four companies to date that have gone public through direct listings, spoke with Colin Stewart, the firm’s Global Head of Technology Equity Capital Markets, to explain direct listings, the tradeoffs vs. IPOs, and why now, more than ever, they’re capturing the attention of high growth companies, Silicon Valley investors and Wall Street.

Colin Stewart: It’s important to start by saying that direct listings and IPOs result in essentially the same thing: A privately held company becomes publicly traded on a stock exchange, shifting its ownership from a small number of private investors to a broader institutional and retail investor base.

But how a company gets there is what makes a direct listing different from a traditional IPO. In a direct listing, or simply “DL” in many circles now, a company lists on an exchange, allowing shares held by private investors, management and employees to publicly trade on the stock market—no new capital is raised through the listing. Select investment banks are financial advisors to the company in this process. In contrast, for an IPO, the company hires investment banks to underwrite the sale of shares that raise capital for either the company and/or private shareholders.

Stewart: Companies should consider going public via direct listing for four primary reasons:

1. To avoid dilution: For those already well-capitalized, the direct listing avoids the issuance of primary shares, and therefore dilution to the company and existing shareholders.
   
   
2. To provide liquidity to all shareholders: A company’s entire shareholder base is available to sell shares on day one, compared to the 180-day lock-up for shareholders in an IPO.
                
3. To conduct a true auction-based price discovery process: Instead of marketing a set number of shares in a fixed price range for an IPO, a direct listing conducts a live auction of undefined size and price on the morning of the listing. Google’s Dutch auction IPO was similar, but it was an auction for price only. Slack and Spotify’s direct listings were true auction processes that were unlimited in supply and price.
   
   
4. To provide access to all buyers: Any investor can buy as many shares as they desire in the market, due to the increased liquidity of direct listings.

IPO Deal Sizes Are Shrinking

Stewart: We’ve noticed several structural trends supporting the direct listing. The most apparent is liquidity disappearing from the IPO process. In the 2000s, nearly 30% of a company on average was sold at IPO, whereas today it’s only 16%.¹ The percentage sold at IPO is even smaller for high-growth software companies at less than 10% (these figures are based on basic share count). Why is this?

1. Companies are going public at later stages when they’re larger and more mature. Twenty years ago, the median age of a company going public was five years old, and today it’s 10 years old.²
   
   
2. Technology companies going public don’t need as much capital as before. The subscription model for software has taken capital expenditure and made it operating expenditure and they don’t need the same level of infrastructure with the advent of public cloud computing technology.
   
   
3. Private markets are more efficient and liquid than ever before. The rise of crossover investors and growth equity firms has made capital readily available.
   
   
4. The average IPO price increase on the first day of trading has grown meaningfully over the last few decades. In the 2000s, the average IPO would trade up 20% on the first day, compared to 37% in 2019. For the highest-growth cohort of technology companies going public in 2019 and 2020, that figure is about 50%.³ Issuers may view a high surge in price on day one as a missed opportunity to have sold shares higher and raised more capital in the IPO.

The direct listing brings liquidity back. All four direct listings to date have had vastly bigger free floats compared to IPOs constrained by lock-ups. The abundance of liquidity allowed public shareholders to build larger positions much more quickly. The four direct listings have not experienced the liquidity-constrained price dynamics that similar IPOs have. A company that chooses a direct listing should be comfortable ceding control on liquidity and pricing to the marketplace.

Stewart: Right now, there’s a sample size of four for direct listings. The next one will be different by definition, with a different story, market cap, financial profile and shareholders. There will be more that follow and the direct listing product will continue to evolve. We’ll see all manner of companies considering the direct listing, not just large-cap or consumer-branded private companies.

We could see companies raising capital privately ahead of a direct listing, like Spotify, Slack and Asana, which each had a fundraising round less than a year before listing, allowing them to be impartial to an IPO or direct listing. We could see public investors becoming more active in buying shares of a private company ahead of its direct listing to establish positions earlier.

A future challenge is that people are still trying to understand the behavior of both sellers and buyers in this process and the effects of unfettered liquidity on trading. Public investors have noticed how highly liquid the two direct listings have been. Therefore, they may be more patient in accumulating positions in the next one. Palantir did include a lockup on approximately three quarters of their shares to allow for more liquidity than a traditional IPO and to manage the increase in free float better in the early days of trading. The factors that have led to diminishing liquidity from the IPO, however, will persist. Direct listings, with or without a partial lockup, will still be the best way to bring liquidity and efficiency back into the process of going public.