The Rise Of Direct Listings: Understanding The Trend, Separating Fact From Fiction

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Fenwick & West LLP | Ran Ben-Tzur and James D. Evans | Dec 5, 2019

Direct listing - The Rise Of Direct Listings: Understanding The Trend, Separating Fact From FictionJust What Is a Direct Listing?

For people not familiar with the term, a direct listing is an alternative way for a private company to "go public," but without selling its shares directly to the public and without the traditional underwriting assistance of investment bankers.

In a traditional IPO, a company raises money and creates a public market for its shares by selling newly created stock to investors. In some instances, a select number of investors may also sell a portion of their holdings in the IPO, although in most instances this opportunity is reserved for very large stockholders or employees and is not made broadly available to other pre-IPO stockholders. In an IPO, the company engages investment bankers to help promote, price and sell the stock to investors. The investment bankers are paid a commission for their work that is based on the size of the IPO—usually 7 percent in the case of a traditional technology company IPO. In a direct listing, a company does not sell stock directly to investors and does not receive any new capital. Instead, it facilitates the re-sale of shares held by company insiders such as employees, executives and pre-IPO investors. Investors in a direct listing buy shares directly from these company insiders.

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So now you ask: If my company does a direct listing, does this mean that we don't need investment banks? Not quite. Companies still engage investment banks to assist with a direct listing, and those banks still get paid quite well (to the tune of $35 million in Spotify and $22 million in Slack). However, the investment banks play a very different role in a direct listing. Unlike in a traditional IPO, in a direct listing, investment banks are prohibited under current law from organizing or attending investor meetings, and they do not sell stock to investors. Instead, they act purely in an advisory capacity, helping a company to position its story to investors, draft its IPO disclosures, educate the company's insiders on the process and strategize on investor outreach and liquidity.

Why Have Companies Only Started Considering Direct Listings Recently?

The concept of a direct listing is actually not a new one. Companies in a variety of industries have used similar structures for years. However, the structure has only recently received a lot of investor and media attention because high-profile technology companies have started to use it to go public. But why have technology companies only recently started to consider direct listings? A few trends have emerged in recent years that have made direct listings a viable, and sometimes attractive, option relative to an IPO:

The Rise of Massive Pre-IPO Fundraising Rounds: With an abundance of investor capital, especially from institutional investors that historically hadn't invested in private technology companies, massive pre-IPO fundraising rounds have become the norm. Slack raised over $400 million in August 2018—just over a year prior to its direct listing. Because of this widespread availability of capital, some technology companies are now able to raise sufficient capital before their actual IPO either to become profitable or to put them on a path to profitability.

The Insider Sentiment Against the Current IPO Process: There has been increasing negative sentiment, especially amongst well-known venture capitalists, about certain aspects of the traditional IPO process—namely IPO lock-up agreements and the pricing and allocation process.

IPO Lock-Up Agreements. In a traditional IPO, investment bankers require pre-IPO investors, employees and the company to sign an agreement restricting them from selling or distributing shares for a specified period of time following the IPO—usually 180 days. This agreement is referred to as a "lock-up agreement." The bankers argue that these agreements are necessary in order to stabilize the stock immediately after the IPO. While the merits of a lock-up agreement can certainly be debated, by the time VCs (and other insiders) are allowed to sell following an IPO, oftentimes the stock price has fallen significantly from its highs (sometimes to below the IPO price) or the post-lock-up flood of selling can have an immediate negative impact on the trading price.

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Over time, VCs have gotten companies to chip away at the standard 180-day lock-up period. For example, on many recent IPOs, companies have been able to negotiate for an early release of the 180-day lock-up if the company's stock price has traded above certain thresholds after the IPO or if the lock-up period expires during a blackout period under a company's insider trading policy. Despite this, lock-ups haven't gone away completely.

In a direct listing, there is no lock-up agreement. All of the company's insiders are free to sell their shares on the first day of trading, providing equal access to the offering to all of the company's pre-IPO investors, including rank-and-file employees and smaller pre-IPO stockholders.

IPO Pricing and Allocation. In a traditional IPO, shares are often allocated directly by a company (with the assistance of its underwriters) to a small number of large, institutional investors. Traditional IPOs are often underpriced by design to provide large institutional investors the benefit of an immediate 10-15 percent "pop" in the stock price. Over the past few years, some of these "pops" have become more pronounced. For example, Beyond Meat's stock soared from $25 to $73 on its first day of trading, a 163 percent gain. This has fueled a concern, particularly shared amongst the VC community, that investment banks improperly price and allocate shares in an IPO in order to benefit these institutional investors, which are also clients of the same investment banks that are underwriting the IPO. While the merits of this concern can also be debated, in instances where there is a large price discrepancy between the trading price of the stock following the IPO and the price of the IPO, there is often a sense that companies have left money on the table and that pre-IPO investors have suffered unnecessary dilution. If the IPO had been priced "correctly," the company would have had to sell fewer shares to raise the same amount of proceeds.

Because a company is not selling stock in a direct listing, the trading price after listing is purely market driven and is not "set" by the company and its investment bankers. Moreover, since no new shares are issued in a direct listing, insiders do not suffer any dilution.

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The Spotify Effect:  Before Spotify's direct listing, technology companies hadn't used the direct listing structure to go public. Spotify was, in many ways, the perfect test case for a direct listing. It was well known, didn't need any additional capital and was cash flow positive. In addition, prior to its direct listing, Spotify had entered into a debt instrument that penalized the company so long as it remained private. As a result, it just needed to go public. After clearing some regulatory hurdles, Spotify successfully executed its direct listing in April 2018. After Spotify's direct listing, Slack (relatively) quickly followed suit. Slack's direct listing was notable because it represented the first traditional Silicon Valley-based VC-backed company to use the structure. It was also an enterprise software company, albeit one with a consumer cult following.

Combine all of these trends and mix in some prominent VCs writing about the benefits of the structure, the media picking up the story and running with it, and even the big investment banks pushing the structure—and the rest is history: Direct listings have now become the hot topic for many late-stage private technology companies considering going public.

Debunking Myths and Misconceptions

As advisors to many late-stage technology companies that are considering a direct listing, we keep hearing a number of common misconceptions. Here are the top three:

"Direct listings are a capital-raising event for the company."
No! This is one big misconception that we are still continuing to hear. A direct listing is not a capital-raising event for the company. If your company needs additional capital at the time of its IPO, a direct listing is likely not the right structure for your company. And as we discuss in "How to Prepare for a Direct Listing—Best Practices," although the U.S. Securities and Exchange Commission recently rejected an NYSE proposed rule change to allow for a company to raise capital and do a direct listing at the same time, we expect significant regulatory developments in the near future that will give companies more flexibility to pursue alternatives to a traditional IPO.

"I want to do a direct listing because there is less due diligence required."
Also no! For companies considering a direct listing, limited investment banker due diligence should not be a reason to choose a direct listing over a traditional IPO. That's because the investment banks and their legal counsel put companies through the exact same due diligence process as in a traditional IPO. They do this in order to protect themselves from liability if a court were to determine that they acted in the capacity of an underwriter. Moreover, a company and its directors and officers are subject to the same liability as in a traditional IPO, so companies are well served by going through the same stringent due diligence process, which serves to protect the company and its officers and directors from liability.

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"The direct listing process is totally different from an IPO."
(Mostly) No! While there are certain aspects of a direct listing that differ significantly from a traditional IPO, the process for each of these transactions is actually quite similar. A company doing a direct listing still selects investment bankers (they are just called "advisors" instead of "underwriters"), holds an organizational meeting, prepares an S-1 registration statement, goes through the same lengthy SEC review and comment process, and has the same liability exposure.

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