June 9, 2017
In the wake of changes that the New York Stock Exchange (NYSE) recently proposed to regulations surrounding direct listings of companies, several companies are keen to know: what is a “direct listing,” and how does that differ from an initial public offering (IPO)?
A direct listing allows a company to be listed on the exchange without conducting an offering. The exchanges have historically been reluctant to list companies absent an offering for concern that there would not be sufficient liquidity and the difficulty of meeting listing standards. Historically, we’ve seen smaller market-cap companies “uplist” from the over-the-counter (OTC) market to a national exchange. We’ve also seen a niche group of large public real estate investment trusts (REITs) that were SEC registered — but not traded on an exchange — list directly without an offering.
In both scenarios, the exchanges could establish a value and liquidity of the shares from the facts and circumstances surrounding these companies. That made the exchanges confident the company had met the listing standards. But for a private company without shares traded OTC or in an alternative private market, determining if the company meets the exchange standards required a rule change proposal. The key change is allowing an independent financial advisor to provide a valuation and establish that the company will indeed meet the listing standard of the exchange.
Fair enough, but what are the benefits?
In a direct listing, a company skips the traditional underwriting process by a Wall Street investment bank and lists its shares directly on an exchange — generally NASDAQ or NYSE — for public trading. Direct listings allow companies to avoid underwriter fees as well as dilution to existing holders resulting from newly issued stock. Furthermore, there can be fewer regulatory restrictions compared to a traditional IPO.
But there’s no free lunch!
While direct listings may have fewer requirements than a traditional IPO, companies still face certain market risks. With IPOs, issuers, bankers and investors in the past few decades have created a well-defined process of execution. This process establishes a strong group of well-informed initial investors and lists the stock for trading following a period of price discovery. Bankers and the issuer build demand for the stock that is unsatisfied by the IPO itself which results in robust aftermarket trading. Ultimately, the company receives follow-through visibility and investors gain insights in the form of equity research from the underwriting banks.
None of this execution process exists — at least today — for the direct listing of a private company. We’re confident the mechanism for executing a direct listing will be solved. And while other direct listings provide hints of how stock will be traded, it will be fascinating to see what ultimately emerges to enable a smooth “takeoff” for these companies.
For example, we could certainly envision a roadshow to educate potential buyers and help create demand, but trading volumes may challenge institutional buying. And because the company isn’t offering new shares, there wouldn’t be a broad, established institutional investor base, underwriters ready with research to support the company or new cash flowing to the company. These challenges may be surmountable by large, established, cash-rich venture-backed unicorn companies; however, it’s unclear how broad the appeal will be beyond a select group.
Ready to report?
The disclosure implications related to a direct listing aren’t immediately obvious. Companies may register under the Securities Act of 1933 on Form S-1 for domestic issuers or Form F-1 for foreign private issuers to allow certain shareholders to sell their shares. Alternatively, they may register under the Securities Exchange Act of 1934 using Form 10 for domestic issuers and Form 20-F(R) for foreign private issuers. Certain items in the forms, such as capitalization, dilution and use of proceeds, won’t be applicable in a direct listing as in an IPO. That said, the actual registration process is remarkably similar for a direct listing compared to an IPO. The registration statement is still subject to an SEC comment letter review process, and a direct listing can’t be declared effective without SEC approval.
Fortunately, reporting and compliance relief offered to emerging growth companies (EGCs) is still available to companies that undergo a direct listing. EGCs are broadly defined as companies with (1) less than $1.07 billion in gross revenue, (2) less than $1 billion in issues of non-convertible debt in a three-year period, and (3) generally less than $700 million in public float, meaning the company isn’t a large, accelerated filer. Confidential filing, reduced disclosure requirements and relief from Section 404 Sarbanes Oxley compliance are also available to companies that qualify as an EGC and are pursuing a direct listing. Keep in mind that three years of historical audited financial statements (as opposed to two years) is still required for companies who use either a Form 10 or Form 20-F(R). However, once a company is a publicly traded company — no matter which path it took — it’s subject to the same SEC reporting and compliance requirements.
The SEC is expected to make an initial decision on the NYSE’s proposed rule change by June 29. Will this direct listing approach become a popular path to becoming a public company? Time will tell. But if the rule passes, emerging companies will be in a position to disrupt not only their industries, but also the traditional IPO process itself.
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