When a company decides to raise capital via public stock markets, there are two primary ways they go about it, an initial public offering (IPO) or direct listing. These methods offer companies the opportunity to secure interest-free capital that can be critical for growth and expansion.
The differing approaches offer a common solution to the problem of public fundraising, though each has its own advantages and disadvantages, depending on the specific company and situation. What are these pros and cons when it comes to IPOs or direct listings? Let us explain.
What is the difference between stock IPOs and direct listings?
When a company chooses to raise capital via IPO, new shares in said company are created. These shares are initially purchased from the company by an underwriter. An underwriter is an individual or firm that assesses and assumes another party’s risk for direct compensation. During an IPO, the underwriter works in turn with the company in question to prepare paperwork for the Securities and Exchanges Commission (SEC), help determine an introductory price for the shares, and finally work to sell said shares to investors.
During the IPO process, it is common for executives of the company seeking capital to pitch the company to large funds, brokers, and dealers. This is known as a roadshow. The underwriter can get the shares to investors through book building or auctions. Auctions are rarer, but not terribly uncommon. Google’s IPO in 2004 featured an auction for shares.
Underwriters are known to charge companies anywhere from a three to seven percent fee for each share dispersed during the IPO. While going the IPO route can be considered a bit safer than direct listing due to the help of an underwriter, some of the proceeds will always go to the middleman rather than the company in question.
Should a company seeking a capital boost through publicly sold shares choose to eschew the services of an underwriter, they can sell stock directly through a direct listing. Some companies choose this path if they cannot afford to compensate an underwriter or if they do not want to dilute existing shares. In the direct listing process, shares are sold from existing holders.
Direct listing does bring some increased risk compared to IPOs. The biggest is the lack of support from an underwriter and the advantages that such an arrangement entails. Because an underwriter does not buy the shares in a direct listing, there is no guarantee the shares will sell. This approach also prohibits the chance of a greenshoe option. A greenshoe option is allowed during an IPO that allows an underwriter to sell additional shares in the face of unexpected demand. A notable example of a successful direct listing came from Spotify in 2018.
While both approaches have benefits for a variety of situations, a more recent trend has seen some companies opting to go public via a special purpose acquisition company (SPAC). You can learn more about SPACs and the potential benefits they can offer in our recent SPAC feature.