Major tech companies are ditching IPOs in favour of direct listings – here’s why

Small problems
Although the advantages of direct listings are clear for some firms, the sacrifices made along the way can make them illogical for others. For example, bankers tend to bundle analyst coverage in with the traditional bookbuilding process, meaning those seeking a direct listing would not be guaranteed any coverage.

While the huge reputations of Spotify and Slack ensured they would receive abundant analyst coverage following their direct listings, smaller companies taking this route wouldn’t be so lucky. Moreover, the conventional move also includes a road show, during which the bankers underwriting the IPO present the company and management team to a series of investors in order to drum up interest ahead of the listing. Removing these elements may not put off a company like Airbnb, which has already made waves in the investment community as an innovative disruptor, but lesser-known organisations could find them to be unsuitable until they can gain more exposure.

“Smaller companies that want analyst coverage from influential analysts will probably continue to use bookbuilding as a way of paying for the coverage,” Ritter explained to World Finance. Gray, meanwhile, suggested that even well-known tech firms appreciate the traditional process of bankers building excitement ahead of an IPO. She told TechCrunch: “I expect most unicorns will still choose to pay the fat underwriting fees to be paraded around by investment bankers.”

Due to the high bar that firms must meet to achieve a direct listing, Braun does not envision a big wave of companies following Spotify and Slack: “For a company to be able to [directly] list, it is necessary for the company to have positive earnings growth and a strong balance sheet. Very few new firms meet these criteria.”

Even Jaffe and Rodgers acknowledged this in their case study: “While Spotify proved that a direct listing is a viable alternative to an underwritten IPO, the process is certainly not right for every issuer.” They argued that Spotify was ideally positioned: it was well capitalised, did not need to raise funds and had a large, diverse shareholder base. What’s more, the brand was widely known and its business model was easily understood. “Companies that do not share these traits may not be the right fit for a direct listing,” Jaffe and Rodgers wrote.

McGurk, however, argued that the direct listing route could open up to lesser-known companies over time: “As direct listings become more popular, the need for brand recognition will dissipate. The job of buyers in both a traditional IPO and a direct listing is to get to know the companies coming to market long before they actually do.”

A niche market
For now, the bottom line for direct listings is that they are not the right fit for every company, and for that reason it is likely they will remain something of a novelty. “I expect direct listings to be a niche,” Ritter said. “I think that the most likely scenario is that a handful of large, highly visible companies will do direct listings.”

In Braun’s view, the fact that just two companies have pursued direct listings does not signify that any significant changes to the IPO process will flourish: “Direct listings can only occur for specific companies. I can only envision alternatives to traditional IPOs happening internationally, if at all.”

However, Spotify was not the first company that sought to break out of the confines of the conventional IPO process. In 2004, Google went public through a so-called ‘Dutch auction’. In theory, the auction process delivers a higher price than a traditional IPO while giving individual investors – rather than just fund managers – the opportunity to buy shares.

With traditional IPOs, the underwriter decides who gets shares (and how many, if the offering is oversubscribed). “In other words, with bookbuilding, underwriters have discretion in allocating shares, and in an auction, they don’t,” Ritter explained.

Although a handful of companies followed Google’s lead, the Dutch auction method did not take off. Ritter believes this was because underwriters were unable to allocate under-priced shares to their most profitable clients. What’s more, through IPOs, underwriters can also recommend a lower offer price to maximise the profits of their buy-side clients.

“Thus, bookbuilding is a win-win arrangement for the underwriters and their hedge fund clients, but the issuing firms are losers because they raise less money than they could have,” Ritter said. While it is unlikely that big departures from the traditional IPO process will occur right away, companies could begin to look to tweak the process here and there.

As Jaffe and Rodgers wrote: “For example, could IPOs without lock-up agreements or with shorter lock-up periods begin to enter the market? Will other companies choose to conduct an Investor Day like Spotify’s and forgo more traditional, small-group meetings held as part of a road show?”

As the tug of war between companies, investors and underwriters continues, changes inspired by the direct listing method could very well begin to transform the process of companies going public.