For private companies to go public, they must offer investors the chance to purchase shares of their stock, most notably done either through an IPO or a direct listing. This article will explain these methods of raising capital, what they entail, and the key differences between them.
The terms “IPO” and “direct listing” both refer to methods that companies can use to raise capital. In this article, we will address what each method entails and unpick the key differences between the two processes in order to help you to understand them better.
What is an IPO?
As the name suggests, an initial public offering (IPO) is the process in which shares of a private company are sold to the public for the first time.
An IPO enables a company to raise capital from investors by listing its shares on the stock market, allowing investors to purchase and trade them as part of their overall investment strategy.
Tip: This listing converts the organisation into a publicly traded company.
Facebook and Uber Technologies (IPOs in 2012 and 2019 respectively) present two examples of highly successful IPOs, while the $25bn raised by Alibaba Group Holding Limited is the largest IPO in history.
Why do companies choose IPOs?
For companies, there are several possible motivations for choosing an IPO.
Primarily, by selling shares, a company can raise additional capital, which can be used to help business development and expansion. An IPO can also provide a large amount of publicity and credibility for a company, as it shows that the company is serious about growth and is willing to be scrutinised by investors and analysts. In some instances, an IPO might be used as an exit strategy by the company founders or venture capitalists.
After a successful IPO, a company might enjoy additional benefits. The demonstrated confidence and demand for its shares can enhance its reputation among analysts and investors, potentially leading to improved terms with lenders. Moreover, this positive momentum may facilitate future mergers or acquisitions.
Conversely, the IPO process might have some drawbacks. The process may diversify ownership, impose restrictions on management, and open the company to regulatory constraints.
There is also a significant cost involved when a company looks to go public. IPO charges will vary according to the underwriter used and the size of the offering being prepared. While the underwriting fee is the largest single expense, tax, legal and accounting costs can all add a substantial amount to the overall charges that a company is faced with.
The IPO process
Once a privately held company is ready to go public, the formal IPO process usually takes around six months. The process has many steps and involves many shareholders. The steps are detailed below:
Investment bank selection
A company should first select an investment bank to advise on the IPO. This choice is pivotal, as the chosen bank will play a central role in advising and underwriting the IPO.
Underwriting is the process in which an investment bank acts as a broker between the company and the public, to help the company sell its initial shares.
The investment bank should be chosen based on reputation, research quality and industry expertise.
Due diligence
Following the selection of the investment bank, the due diligence phase commences. During this stage, the chosen bank thoroughly examines the company, aiming to determine the appropriate number and price of shares that should be issued.
The underwriters will consider various factors, including:
- The strength of the management team
- The growth potential in the industry
- The consistency of the profits to date
- Audited financials
- The debt-to-equity (D/E) ratio (they will want this to be low)
Tip: Findings from the due diligence process significantly influence the subsequent steps in the IPO journey.
Filing
Once due diligence is complete, the company proceeds to the filing stage. This involves submitting IPO registration paperwork, including a letter of intent. For US companies, for instance, an SEC Form S-1 should be submitted.
The underwriters, in collaboration with the company, then navigate the regulatory landscape and ensure legal compliance by facilitating the necessary documentation for the IPO.
Pricing
The investment bank will subsequently need to set an IPO price. This is the value at which the company’s shares will be offered to the public.
The price is typically set after the bank has gauged the level of demand among institutional investors. Following the establishment of the IPO price, the investment bank will market and promote the offer and attract potential investors.
Stabilisation
On the day of the IPO, the shares are released onto the stock exchange. During the initial weeks pre-listing, the underwriters will attempt to keep the price as stable as possible. This is usually deemed to be a 25-day “quiet period,” characterised by efforts to mitigate price volatility and establish a solid foundation for the company’s market presence.
Transition period
The final phase of the process typically starts 25 days after the IPO. During this transition period, investors shift their reliance from compulsory disclosures and the IPO prospectus in favour of market forces and investor sentiment as the primary sources of information regarding the company’s shares.
The dynamics of the market become increasingly influential, marking the conclusion of the formal IPO process and the company’s full transition into the public realm. Sometimes, this period also includes a lockup period, in which existing investors do not sell any shares.
What is a direct listing?
As an alternative to an IPO, another approach that a company can consider is to go public through a direct public offering (DPO). A direct listing differs from an IPO in that no new shares are created, but existing ones are sold.
The direct listing approach is a way for a company to raise capital by offering stock directly to the public, without using intermediaries such as underwriters and investment banks. By eliminating these intermediaries, the company can cut costs and avoid restrictions set by central authorities. This particularly appeals to small companies.
In a DPO, the company looking to sell its shares assumes the position as the underwriter. This allows the company to set its own offer price, determine the quantity of shares to sell, and assume authority on other decisions.
Spotify and Slack are two examples of major companies that used their large customer base to carry out a DPO rather than an IPO.
Why do companies choose a direct listing?
For a company that has a loyal customer base and limited funds, a direct listing can make more sense than an IPO. There are various reasons why a company might choose a direct listing, as opposed to an IPO.
Firstly, a direct listing is subject to fewer costs than going public through an IPO. There are fewer filing responsibilities and registration requirements for the companies that opt for a DPO. Also, companies can retain more control of the process, as they can set their own conditions. For this reason, it can be more attractive to smaller companies.
A direct listing increases liquidity for existing shareholders, who can sell their stock to the public. A DPO also doesn’t dilute existing stock.
The direct listing process
The process for a direct listing can typically be carried out in as little as one month. Companies are required to complete and present a set of compliance documents in the jurisdictions where they plan to sell their stock. Existing shareholders can sell to the public immediately upon listing, with no lock-up period required.
Investing in newly listed companies
Investing in newly listed companies has both advantages and disadvantages. While buying shares in a newly public company offers investors the opportunity to invest in a business early-doors, potentially for a low price before the wider market recognises its potential or value, there are also potential downsides. For instance, the price of IPO stocks can be highly volatile in the initial days, and without market history, analysing past price movements, patterns or trends can be challenging for investors.
- Early access: There is the opportunity to invest in the early stages of a company’s growth, and to, therefore, potentially benefit from future expansion or success.
- Potential for high returns: There is a chance to buy stock for a low initial price and benefit from potential price increase over time.
- “IPO pop”: The potential exists for an initial surge in the stock price immediately after the IPO (referred to as an “IPO pop”), providing a short-term trading opportunity.
- Increased liquidity: Listing on a stock exchange enhances liquidity, making it easier for investors to buy or sell shares compared to private investments.
- Price volatility: Prices of newly listed stock can be highly volatile, which may increase risk in the early stages.
- Limited market history: The absence of market history and earnings data can make it difficult to perform thorough fundamental or technical analysis of a newly listed company.
- Lock-up: Early investors often have “lock-up periods,” during which they cannot sell their shares. Once these periods expire, and shares are sold, a sudden increase in supply may apply downward pressure to stock price.
- Overvaluation: Hype surrounding an IPO can lead to overvaluation, in which investors end up buying overpriced shares. If the company fails to meet these expectations, the stock price may suffer.
To purchase IPO stocks, consult an IPO calendar to identify upcoming offerings and ensure that your account allows for participation in these events. Take note of the potential lock-up period for new shares, and closely monitor your investment over the initial market period.
As with any investment, investing in newly listed companies has inherent risks. New stock listings are especially uncertain, due to their inherent volatility. It is advisable not to allocate too high a percentage of your overall investments to newly listed companies, because of their unpredictable nature. Portfolio diversification is crucial to manage this risk.
Investors shouldn’t feel the need to jump in straight away on the day of an IPO. Having a more measured approach can be beneficial to gauging the strength of the market and the stock over time, especially after the initial hype period has ended.
IPO vs direct listing: case studies
Many high-profile companies have sought new funds by going public. It can be useful to consider a few case study examples, to see how some scenarios of both DPOs and IPOs have played out.
| Company | Listing | Success? |
|---|---|---|
| Deliveroo | IPO | The Deliveroo IPO was controversial, as the food delivery service’s stock value dropped by a quarter on its first day. Deliveroo reportedly paid £49m in fees to its adviser for the IPO, but was still criticised for getting the pricing wrong. |
| Airbnb | IPO | The Airbnb IPO in 2020 presented an example of one of the world’s most popular companies going public and experiencing an immediate increase in its share price. In this case, the stock rose by over 100% on its first day of trading on the NASDAQ exchange. |
| Spotify | Direct listing | The Spotify direct listing took place in 2018, when the music streaming service joined the NYSE exchange. The company chose a DPO to avoid diluting its shareholders’ stock, as it didn’t have a liquidity shortage (a problem that makes an IPO more attractive for some businesses). |
Final thoughts
On balance, differentiating between IPOs and direct listings reveals clear distinctions. An IPO offers the advantage of a highly regulated process, ensuring comprehensive consideration of key business factors to determine the offer price. On the other hand, a direct listing provides companies with cost-effectiveness and fewer conditions to fulfil.
For investors, success lies in identifying an appropriate offer price for a company poised for growth. With new companies continually entering the market, staying informed about emerging options is essential for making well-informed investment decisions.
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FAQs
- What is the debt-to-equity ratio?
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The debt-to-equity ratio, or D/E ratio, is a static balance sheet ratio and is one of the best-known analysis tools. Comparing liabilities and equity gives an indication of how much debt a company has.
- What is a lock-up period?
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A lock-up period is the duration after a company goes public when existing shareholders are restricted from selling any of their shares. This restriction usually spans 90 to 180 days.
- What is the purpose of due diligence?
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Due diligence of an IPO is a risk assessment that allows an underwriter to examine the strengths, weaknesses and risks of a company when going public.
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