Direct Listings: An Alternative to IPOs?

The traditional financing ecosystem has been disrupted in recent years, as more companies choose to remain private longer and no longer view an initial public offering as a necessary or desired ultimate liquidity event.

More sources of private capital have become available, especially to promising technology companies. These new financing sources, which include institutional investors, including sovereign wealth funds, family offices, and hedge, private equity, and cross-over funds, are willing to invest at attractive valuations.

As a result, many private companies have attained valuations of over $1 billion. Some of these companies are skeptical of the advantages of becoming a U.S. public company. Some may believe that the regulatory reporting burdens are too significant, or that public scrutiny and focus on short-term earnings should not be allowed to influence their business strategies. Others may find the litigious environment too off-putting.

Instead of pursuing IPOs, many favor M&A exits. Even for those companies that do choose to pursue IPOs, their motivations are often different than those of their predecessors.  In the past, for many companies, the principal motivation for an IPO was the “offering,” or capital-raising element.

Private capital wasn’t as plentiful or may not have been available on attractive terms. Now, most issuers have attained higher valuations by the time of their IPOs and are much more mature. So, if capital-raising no longer motivates companies to undertake IPOs, will a new approach to “publicness” take hold? Direct listings are an alternative that’s garnered a lot of attention lately.

A U.S. or foreign-domiciled company may choose to register a class of its securities under Section 12 of the Securities Exchange Act of 1934 and list its stock on a national securities exchange without undertaking an offering of its securities at the same time. It can do that by preparing, filing, and clearing with the Securities and Exchange Commission a registration statement on Form 10 (for U.S. issuers) or on Form 20-F (for foreign issuers).

The SEC’s Division of Corporation Finance recently changed its policy and now allows an issuer to submit for confidential review a Form 10 or Form 20-F for this purpose. An issuer that has confidentially submitted a registration statement under Exchange Act Section 12(b) must file it publicly at least 15 days before its expected effective date.

This process now resembles the approach that an emerging growth company can employ in a traditional IPO. A registration statement on Form 10 or 20-F requires the preparation of detailed disclosures and financial statements similar to the disclosures and financial statements that would be required for an IPO registration statement.

The SEC staff’s review process also is quite similar. As in the IPO process, the company must apply to list its securities on a national securities exchange.  Assuming that the company meets the listing requirements and that the relevant exchange allows a direct listing, upon completion of the SEC review and listing processes, the company’s shares will start trading on the securities exchange.

Over the years, several small, mainly life sciences companies, have undertaken direct listings, generally as a last resort during an inhospitable IPO market. The companies listed their securities on an exchange later sought to raise capital through private investment in public equity, or PIPE, transactions.

Their existing security holders in such firms also may have obtained some liquidity by reselling their shares following the direct listing. But these direct listings generally failed to achieve most of their intended objectives.

Because the companies were small and not mature, they would have benefitted from a traditional IPO. In a traditional IPO the underwriters introduce the company to institutional investors both through test-the-waters discussions (in the case of emerging growth companies) and through a formal road show.

Through the IPO process, the company and its underwriters refine the company’s presentation of its business and strategy and have meaningful discussions regarding the appropriate valuation. The book-building process that leads to the ultimate pricing of the company’s securities is also important in terms of providing some transparency and reflecting the views of many well-informed voices.

The active involvement of the underwriters and their sponsorship of the company becomes meaningful in providing secondary market support for the company’s stock post-IPO, and also usually results in equity research coverage. The market making and research activities contribute to liquidity in the company’s stock.

Many issuers that undertook direct listings in the past came to realize that they had the burdens and costs associated with being SEC-reporting companies without the accompanying benefits. Their stocks were thinly traded, and the issuers had limited institutional ownership. Their opportunities to raise capital post-IPO were limited.

Should these experiences serve as cautionary tales? Or have circumstances changed?  The answer may be different for each company. Many unicorn companies have raised amounts in private placements that eclipse the amounts raised in most IPOs.

Through their private-financing rounds, they’ve been successful in attracting the types of institutional investors that usually invest only in IPOs or that are introduced to IPO issuers by their IPO underwriters. Many unicorns have well-known brands familiar to consumers.

Even without ever having undertaken IPOs, they’re viewed as successful companies and have attained an elite status.  In the past, many of the signifiers of success were only attainable through completion of an IPO.

Such a company may not need to raise additional capital; it could choose to undertake another private round of financing. But the company and its principal existing shareholders might nonetheless favor having a class of securities listed on a securities exchange.

For such a company, having a listed stock provides it with an acquisition currency.  To the extent growth through acquisitions is contemplated, having a listed stock facilitates that.

For recruitment and retention purposes, having a listed stock can also be very meaningful. Even with the development of private secondary markets, liquidity opportunities for employees and consultants are limited without a listed stock.

Venture capital, private equity, and hedge funds that invested in the company might be interested in having a current market price at which to value their stakes even if they don’t plan to dispose of their positions.

A direct listing might be the most efficient approach to meeting these objectives for a unicorn.  A well-known, mature company with existing institutional holders and a dispersed investor base is expected to have a liquid market develop for its stock.

Also, even without “underwriters,” financial intermediaries that have served as advisers to the company in the past, have assisted the company with the direct listing process, or provided a valuation could likely be expected to start research coverage after the direct listing.

We may soon have a test case that will reveal whether, in light of the changed financing ecosystem, unicorns or other large, mature, and well-known companies can enter the SEC-reporting system effectively through direct listings. Smaller companies are likely to continue to benefit from the traditional IPO.

Anna T. Pinedo is a partner at Morrison & Foerster, specializing in securities and derivatives.