Thursday, 7 December 2017

Here’s how a hot company can go public without an IPO

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Spotify, the song selection service, has suggested that it might list its shares for trading on an exchange without doing an initial public offering (IPO). This process, which we call “direct listings,” has significant advantages for both large, so-called unicorns trying to provide a liquid market for their shares and smaller private companies trying to raise capital quickly.

Yet this process has been rarely utilized, so it deserves more attention from both company executives and securities regulators.


Searching for direct listings over the last two decades, we found only 11 examples — all of them small companies with a median market capitalization of $530 million. All followed a similar pattern — a private offering by a privately held company of its own shares to raise capital, with a commitment to the purchasers to list the company’s shares for trading on Nasdaq NDAQ, -0.24% within one year. If that deadline was not met, the company’s executives would not get bonuses for that year.

For these companies, directing listings had one key advantage — speed of capital-raising. If a company decided to do a direct listing, it had to wait just six weeks on average to receive the needed funds. This period included the time needed to complete the due diligence, prepare the documents, and find qualified purchasers.

By contrast, if the same company tried to sell its shares through an IPO, that process would have taken at least three months, and possibly up to a year, to file the relevant documents with the SEC, respond to comments and wait for “clearance” from the SEC staff. During that time period, the price of the stock offering could have declined or the window for capital raising could have closed.

Of course, the purchasers in the private offering had to wait longer than in an IPO for their shares to begin trading on an exchange. After the private offering was completed, the company filed a registration statement for its shares with the SEC and waited to obtain staff “clearance.” To list the shares for trading, the company also had to file other forms with the SEC and the exchange.

While these purchasers obviously wanted a liquid market to trade their shares, they were less time-sensitive than the companies selling these shares in a private offering. These purchasers expected to be compensated for delayed public trading by paying a lower price-per-share than they would have paid in an IPO. Yet these purchasers were better off in a direct listing than in a simple private offering, where their ability to trade their shares would have been limited to qualified purchasers in a private venue.

Transaction costs for these 11 direct listings related to recent private offerings were about the same as those for companies of comparable size that listed for public trading through IPOs in the same years. In both cases, companies usually paid the underwriter or broker a 7% commission for raising the capital. Similarly, according to our interviews, the legal costs for a direct listing were only slightly lower than for an IPO. In both cases, the lawyers did due diligence, negotiated with an investment bank and prepared SEC filings.

The trading market — as measured by volume and spreads — was initially weaker in direct listings than in IPOs. That’s because the syndicate behind an IPO generated a lot of investor interest, and the primary underwriter in an IPO typically agreed to support the after-market. Nevertheless, these differences disappeared three months after public trading began. Similarly, in the fourth month after trading began, the number of analysts covering direct listings was almost exactly the same as in IPOs.

Thus, in the past, direct listings have offered a few companies a much faster way to raise capital than an IPO with similar costs. Going forward, direct listings would be most attractive when a small- or midsize company is raising capital through a private offering, since the company already must go through a due diligence process and prepare an offering circular for purchasers. Moreover, when trading does begin, the market makers on the exchange have a recent reference price for the company’s shares — set by sophisticated investors.

At the same time, direct listings also should be seriously considered by large, well-known private companies such as Spotify, which may not need to raise more capital quickly. Rather, these companies are likely interested in providing a liquid market for their employees and founding investors, who want to reap their unrealized gains and diversify their portfolios. These companies could file a registration statement with the SEC for public trading of a specified number of shares held by their employees and founders.

Companies like Spotify have a vast base of potential investors because consumers know their products and services. With such a strong base, financial firms will be interested in making a market for the shares of these better-known companies if they were listed on an exchange — without a private offering or IPO. That way, companies like Spotify can avoid the 7% commission charged by investment bankers.

However, without a related capital raising to set a reference price, an exchange listing poses a challenge for the market makers to value the company’s shares when they start trading. Perhaps a reference price could be set based on a recent private sale of shares by employees or founding shareholders. In any event, to help establish a reference price for trading, the company could hire an investment bank to value its shares and promulgate its valuation report.

More broadly, a company like Spotify may be wary of the pressures involved with a public listing — from both Wall Street analysts on quarterly earnings and activist funds on strategic issues. To reduce such pressures, a company might list only 20% of its shares for exchange trading so that the insider group can retain effective control of corporate decisions.

Given these advantages of direct listings, the SEC should facilitate them by taking two actions:

First, the SEC should approve the proposed NYSE ICE, -0.30% rule change to permit direct listings there, just as they have long been permitted by Nasdaq’s rules.

Second, the SEC should clarify that the benefits of the JOBS Act for emerging growth companies extend to companies going public by direct listings in addition to IPOs. These benefits include a two-year exemption from internal controls reports, confidential treatment of filings at the SEC, and more flexibility to talk about the company as its filings are being processed by the SEC staff.

Robert Pozen is a Senior Lecturer at MIT Sloan School of Management. Shiva Rajgopal is the Kester and Byrnes Professor at the Columbia Business School. Robert Stoumbos is an instructor in business at the Columbia Business School.

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