005 – Comparing Direct Listings and IPOs

There has been a lot of discussion lately in the venture community about the favorability of direct listings over the IPO process. The chief complaint of IPOs is that securities are underpriced at issue. To better understand the comparison between the two methods, we took a look at 25 of the top tech IPOs in the last two years.
Before we look at the underpricing argument, it’s helpful to look at the cost of IPOs and direct listings. At the most basic level, the cost of a direct listing and traditional IPO are relatively similar in our sample. We found that the average company paid between $29.6M and $34M in underwriting fees based on the level of exercise. It’s important to note that this doesn’t include any fees incurred by sellers. Total underwriting fees in deals where sellers sold shares as part of the IPO process ranged slightly higher, an average between $32M to $37M. The two direct listings to date, Spotify and Slack, paid financial advisory fees of $35M and $22M respectively.
An appeal of the IPO process is that it allows companies to raise additional capital, which companies aren’t currently able to do during a direct listing. In our sample, the average company raised between $794M and $913M during the IPO process. This translates to ~$26M raised for every $1M in fees. If we look at the fees that Spotify and Slack paid for a direct listing, the companies could have raised an estimated $937M and $590M respectively.
This brings us to the main point of the debate: the underpricing of IPOs. When comparing the issue price to the opening price on the first day of trading, our sample found an average underpricing of 38%. Of the 25 companies we looked at, only two, Peloton and Uber, opened below their issue price. If we add the underwriting fees and underpricing costs together, the true cost of an IPO is between $333M to $382M with only 10% of the cost from underwriting fees. The vast majority of this amount is value transferred to those who are allocated underpriced shares at issue.
If Spotify and Slack had raised capital in their listings via a traditional IPO at the levels described above and their shares were underpriced at the average 38% level, it would have represented $346M and $217M in underpricing respectively.
As we noted, there is currently no mechanism for companies using a direct listing to raise capital at the listing. One potential solution that’s been mentioned is doing a private capital raise 3-6 months ahead of the direct listing. Given the amount of private capital in the market, this should be easily achievable. Another potential option is to do a follow-on offering after the direct listing establishes a fair market price for shares. Follow-on offerings typically have a discount to the most recent public price (an average of 7.3% in 2018).
Investors in follow-on offerings demand a discount. Private investors ahead of a planned direct listing are likely to do the same. The discount is necessary because if an investor wants to take a position in a public company, or one soon to be so, there’s no incentive for them to do so as part of a structured capital raise at the market price. They can just buy shares on the open market. Companies looking for the liquidity of the public markets plus capital should be able to get it cheaper than current IPOs, but they won’t get it for free.
Top 3 Takeaways:

* At the most basic level, the cost of a direct listing and traditional IPO are relatively similar. We found that the average company paid between $29.6M and $34M in underwriting fees. The two direct listings to date, Spotify and Slack, paid financial advisory fees of $35M and $22M respectively.
* When comparing the issue price to the opening price of recent tech IPOs on the first day of trading, we found an average underpricing of 38%. Of the 25 companies we looked at, only two, Peloton and Uber, opened below their issue price.