The initial public offering — the traditional method of taking a company public — has a challenger, one that web-based companies are looking at as a viable alternative. Known as a direct public offering or direct listing, this technique avoids involvement from investment bank underwriters that buy shares at a set price in an IPO and then sell them to their clients and institutional investors. In a DPO, a private company lists itself on a stock exchange but does not raise money.
Swedish music streaming provider Spotify did a DPO in April 2018. Collaboration hub Slack filed for a DPO with the U.S. Securities and Exchange Commission late last month. Airbnb, the online marketplace for property rentals, is reportedly considering a direct listing later this year.
Why a DPO?
Direct listings work best for private companies that have been around for some time, earn substantial revenue, have capital reserves, and do not need to raise funds from a public offering.
Until about six years ago, start-ups might raise a seed round of funding and two to three rounds of venture capital. They typically either went public via an IPO or were acquired within five to six years.
Now, because funding sources are not as focused on getting their money back quickly, start-ups can frequently obtain up to six rounds of venture capital or private equity over a much longer period and therefore have little need to go to the public market. Thus they stay private. However, that means early investors and employees who were given stock options have no way to sell their shares. A company that does not want to raise capital on the public market but wishes to provide liquidity to existing shareholders is a good candidate for the DPO alternative.
IPO vs. DPO
If a company wants to go public to raise funds, it needs an IPO. An IPO is more stable than a DPO because the underwriters control the opening share price. Allocations of shares are offered — mainly to institutional investors — at a set price in the company’s prospectus. This cuts out the small investor from the initial sales process.
Conversely, a DPO is more volatile because there is no set price. With a DPO, the opening stock price is subject to market demand and is vulnerable to large market swings.
If a company wants to go public to raise funds, it needs an IPO.
An IPO requires underwriters, typically several investment banks that take a hefty commission for their services, usually from 3 to 7 percent of the proceeds depending on the amount raised. An IPO requires an intensive roadshow, normally two to four weeks, before the offering to allow the company to market itself to potential investors. The roadshow may also help refine the initial price range as the underwriters get feedback from potential investors. A DPO does not require a road show.
In an IPO, existing shareholders — employees and pre-IPO investors — are typically subject to a 180-day lockup period that prevents them from selling their shares the day the company goes public. This may put them at a financial disadvantage if the stock price drops after the initial hype.
In a direct offering, the company can’t sell new stock, and there’s no lockup period. Rather, only existing shareholders sell their shares to the public.
A DPO is a considerably cheaper method of going public because there is no underwriter. A DPO is also more democratic because the process is entirely market-driven. All existing shareholders can sell their shares, and any investor can buy the shares. The ability to sell shares on the first day of trading at market trading prices rather than at the initial controlled price available to them in a traditional IPO can present a financial advantage to the shareholders. In a DPO any prospective purchaser could place an order with any broker at a price the prospective purchaser desires and that order becomes part of the price-setting process on the stock exchange.
Democratic, or Not
DPOs solve a problem for cash-rich start-ups that wish to let their employees and early investors cash out but do not want to raise any new funds. DPOs are not a good option for start-ups that are unprofitable and require more capital.
While the DPO sales process is more democratic than a traditional IPO — allowing smaller investors to buy shares at the outset — the voting rights, frequently, are not. Both Spotify and Slack have dual-class stock, allowing the founders to maintain control of the companies. I’ve addressed this in “Does Dual Class Stock Hurt Independent Investors?”
The future of DPOs will likely depend on how well the companies fare that go through this process in 2019.