Direct listings: The death of the IPO lockup?

November 5, 2019


By David Ethridge, US IPO Services Leader

Direct listings (DL) have become a hot topic among private companies, particularly those in the technology sector, with the recent listings of Slack and Spotify. Less noticed was the property and casualty insurance company Watford Holdings, which also listed by way of a DL in between those high profile tech deals. The key differences cited by most pundits in a DL compared with a traditional IPO are (1) the company does not raise capital and (2) no underwriting occurs from the banks involved in the transaction. There are also many other technical differences, including no traditional eight- to 10-day roadshow, no offering range on the SEC filing, and no stabilization by the advisory banks post offering to name a few.

Given those differences, what motivates a company to list directly? Management teams often give two reasons:

  1. No traditional IPO discount on valuation, historically about 15%
    It’s often believed that the perfect “pop” on a stock from IPO price to the first trading day’s closing price should be around 15%, given the valuation discount bankers use when setting the price range. Discounts are derived by analyzing comparable public companies and are used theoretically to reward buyers for taking a risk on a new company with no public track record. Institutions should then benefit from a built-in gain at the price they pay. However, tech companies sometimes see their stocks pop much more than 15% on the first day of trading, which often leaves management feeling that money may have been left on the table. In other words, they could have priced the IPO higher and not given away as much of their company to the buyers. Early investors in private companies have focused on this element for many years without any viable alternatives.
  2. Insiders don’t sign lockup agreements that prohibit selling for 180 days
    Lockups are an insurance policy for new IPO investors that prohibit selling by insiders until six months after an IPO prices. This helps minimize the risk of management overselling their story of revenue growth and profits. Practically speaking, it means management will have to report quarterly results before the lockup expires. If results fall short of equity research analysts’ projections, the stock will react accordingly. Of course, institutions get hurt in that scenario, but at least management hasn’t been able to sell in the interim and leave the new investors holding the bag. Institutions can rest a little more easily as their interests are aligned with management.

Now let’s consider an IPO following the DL approach and how that impacts the IPO discount and lockup.

Direct listing discount
DLs allow the selling of shares from insiders directly to institutional investors without the banks stepping in to underwrite the shares. There is no capital going to the company. There is no traditional price range on the cover of an S-1 that’s been arrived at through an analysis by the bankers of comparable public companies and the company going public. As a result, the company has to work with its advisors to assess institutional demand and match that against the supply of stock from existing holders at various price levels. The supply of stock is aggregated and sold to buyers in one large trade after the market opens – this can take a few hours – which establishes the company’s valuation. Theoretically, the buyers should be considering public comparables to establish how much stock they want to buy at potential valuation levels. Likewise, sellers are considering how much they will sell at different valuation levels. Prior DLs have successfully established high valuations at that first trade and the stocks have not “popped” on the first day of trading. Management and other sellers haven’t faced that feeling of “leaving money on the table.”

Direct listing lockup
“DL lockup” is a misnomer as no lockup exists for insiders in a DL. From the outset you have a sale of shares from early investors, management and employees to new institutional investors, and that selling can continue unabated. That’s a massive shift of risk away from insiders and onto the new institutional shareholders. Of course, the new shareholders recognize this shift, and they can simply not buy if they don’t like it at the time of listing.

Is a direct listing the right choice?
You might be thinking that companies preparing to go public would naturally shift towards the DL structure given the freedom to sell that it affords insiders. However, most companies pursuing an IPO need capital to continue funding their growth. There is a relatively small subset of companies that are willing to go through the trouble of a DL – comparable if not more work compared to a traditional IPO – and not raise capital.

We’re interested in how this plays out given the recent high-profile venture capitalists who have taken up the issue with underwriting banks. We anticipate traditional IPO lockups may be adjusted to narrow the gap between IPO and DL structures. These changes could include lockups with shorter time periods, a percentage of stock released based on milestones or the death of the traditional IPO lockup structure altogether.


Contacts

Colin Wittmer

Deals Leader, PwC US Email

Curt Moldenhauer

Deals Solutions Leader, PwC US Tel: +1 (408) 817 5726 Email: curt.moldenhauer@pwc.com