The stock market is often derided as a casino where we — small investors — are the suckers.
I think that’s mostly true, but the New York Stock Exchange and Nasdaq, the two primary US trading venues, also play a vital role in the economy: helping companies owned by private investors raise money by selling shares to the public, a process known as an initial public offering.
You may remember when Mark Zuckerberg, then not public enemy No. 1, took Facebook public in 2012, bringing in more than $16 billion in exchange for giving outside shareholders an ownership stake in his company. Zuckerberg & Co. used that IPO money to expand, create jobs, and build a massive machine to profit from our personal data (but that’s a different story).
So why would one of today’s up-and-coming tech stars go public without raising a single dime for itself? Here I am referring to Slack Technologies, the San Francisco supplier of workplace messaging and group-chat software.
Slack said this week that it plans to go public, but it’s not launching an IPO. Instead, according to The Wall Street Journal, the company will employ an unconventional technique called a direct listing, also known as a direct public offering, or DPO.
Slack’s decision to do a DPO — as well as Spotify Technology’s successful direct listing 10 months ago — prompts an important question: Are big tech names like Uber, Lyft, Airbnb, and WeWork, which are all expected to go public this year, also candidates for a DPO?
Before we get to that, and in the spirit of Benjamin Franklin (“An investment in knowledge pays the best interest”), here is a primer on going public.
The fundamental difference between an IPO and a DPO: the seller
In an IPO, a company creates and sells new shares — representing an ownership stake — to investors who were lined up by the investment banks hired to handle the deal. On the evening before trading is set to begin, the banks, in consultation with the company, set a price (a compromise based on a valuation of the company and what investors are willing to pay), and tell investors how many shares they have been allocated. Those initial investors buy the shares and trading begins the next morning. The company pockets the proceeds from the sale, minus the hefty cut taken by the banks as their fee.
Companies that aren’t publicly traded may also have stock, held by founders, venture capital firms and other early investors, executives, and employees. In a DPO, only those existing private shares are put up for sale. This allows the pre-public owners to cash out of some or all of their stock. But since the company itself isn’t selling shares, it receives no proceeds.
The advantages of going direct
First, as in any transaction, cutting out the IPO middleman reduces the cost.
Investment banks working on an IPO on average split 7 percent of the gross proceeds. If a company raises $500 million, for example, the fees would be $35 million.
And there are other costs, including for the accountants and lawyers who vet the company’s finances and prepare all the SEC documents, and for the “road show,” where executives pitch the IPO to big investors such as pension plans and mutual funds. When all is said and done, the biggest deals could run a tab of $100 million.
Bankers still get hired as advisers for a direct listing, but their duties are lighter. They don’t spend weeks lining up investors and negotiating an IPO price, and they don’t agree to buy any unsold shares.
The fees are lighter, too. Spotify paid $36 million to Goldman Sachs, Morgan Stanley, and Allen & Co. Snap, in a traditional IPO of about the same size, paid $100 million to its banks. That, as they say, is real money.
Second, in most IPOs, there is a lockup period (often 90 to 180 days) when company insiders can’t sell their shares. This prevents the market from being swamped with more shares right after the new ones are sold. It also means that the stock price may be lower when insiders are finally free to sell.
In a DPO, where the sellers are all insiders, there is no such restriction.
Third, when banks underwrite an IPO, they don’t seek the highest price possible for the company’s shares. Instead, they price the deal at a somewhat lower value so that the first public buyers (their biggest clients) are pretty much assured a quick profit if they immediately flip the stock. The average first-day gain was 17 percent in 2018, according to Renaissance Capital, a provider of institutional IPO research.
With a DPO, the price of the shares is set by trading on the exchange, just as it is with the shares of already-public companies. At least initially, this tends to yield a higher price for sellers than they would have seen in an IPO negotiated by bankers trying to keep their clients happy. It also makes it a lot easier for the little guy to get shares right out of the gate.
The DPO downside
With all these advantages, why don’t more companies choose a direct listing?
Since most companies go public to finance their growth, a direct deal is attractive only to those that already have enough cash from private fund-raising or cash flow to expand. That rules out biotechs, which account for most of the Massachusetts companies that go public, because they desperately need cash to fund their drug research and testing.
In addition, while underwriters are expensive, they do take risks to support an IPO by agreeing to sop up unsold shares if demand falls short on pricing night. They may also step in to buy shares after trading begins if the price starts to fall below the offering price. That doesn’t happen with a DPO.
“All of these experiments are good,’’ said Nikunj Kapadia, a finance professor at the Isenberg School of Management at the University of Massachusetts Amherst, referring to DPOs, as well as Dutch auctions (the method Google used to go public) and provisions in the JOBS Act of 2012, which made it easier and cheaper for companies with revenue of less than $1 billion to stage an IPO. “However, over the years, most firms tend to choose the traditional IPO process. That tells me there are huge advantages to it.”
The Slack factor
But on Wall Street, as in Hollywood, success brings imitation. If Slack’s listing performs well, will other companies opt for a DPO? Perhaps, but those candidates would come from that select group of private companies that don’t need to raise capital and already have enough name recognition to attract a broad range of investors.
“Direct listings won’t have a big impact on overall market but could draw a couple of big companies,” said Matt Kennedy, a senior IPO market strategist at Renaissance Capital.
Yet just a small number of deals could have an impact on Wall Street’s investment banking and underwriting revenues as more companies question how much they pay to go public regardless of the method.
“If it keeps working, the amount of money that companies are willing to pay in fees could go down,” said Peter Cohan, a lecturer in strategy and entrepreneurship at Babson College.
DPOs will always be few and far between. But anything that makes it cheaper to go public benefits companies that need to raise money. And anything that levels the playing field for small investors, that makes the stock market less casino-like, is a good development.You can reach me at email@example.com and follow me on Twitter @GlobeNewsEd. Sign up for my Talking Points AM newsletter here.