As Slack gears up to go public via a direct listing, we expect to get a few questions about what exactly that means, how it’s similar and different from a traditional initial public offering, and why a company may choose one over the other.

What is an Initial Public Offering (IPO)?

An initial public offering, or IPO, is the process through which a company raises capital by selling ownership in the company (stock) to the public for the first time. An IPO is underwritten by an investment bank who manages the registration and eventual listing of the company’s stock on a stock exchange. Historically, private companies have gone public by listing their shares via an initial public offering.

What’s the role of an underwriter in an IPO?

A privately-held firm desiring to offer its stock to the public will first hire an intermediary – one or more investment banks – to manage the IPO. An investment bank may choose to work alone, or a group of banks may join to form what’s called an underwriting syndicate. The syndicate structure allows the banks to spread the funding, and the risk, amongst themselves; however, competition may be fierce between investment banks to serve as lead underwriter for a highly anticipated IPO. JP Morgan, Merrill Lynch, Morgan Stanley, and Goldman Sachs are all well-known underwriters.

Once an underwriting deal is inked between the company and its underwriter(s), the lead investment bank drafts and files a registration statement with the Securities and Exchange Commission (“SEC”). This document is intended to provide a reasonable basis upon which an investor can make an informed investment decision. It contains detailed information about the company and its products, business plan, management team, financials, current ownership structure, use of proceeds, and any other information pertinent to a potential investor. The SEC will review this information for accuracy and completeness but does not endorse or approve the company or its stock. When the SEC is satisfied that all relevant information has been disclosed, it will work with the company and its underwriting team to set a date for the IPO.

Underwriters are also responsible for organizing roadshows, which may be global events and include video, internet, and physical presentations. These shows are intended for large institutional investors, such as hedge funds, rather than individual investors, and an underwriter may at this point legally offer an interested party an IPO allocation at the price set before the stock begins trading on the secondary market – or stock exchange. Underwriter profit is the difference between what they paid the company for its stock and the price at which the underwriter sells that stock – either via IPO allocations or on the secondary market.

While their services don’t come cheap, underwriters manage the entirety of the shares listing process, shouldering a significant amount of often complicated work for the company itself. Because they commit to purchasing the stock directly from the company, they are incentivized to make their best effort towards a positive market debut for the company.

Why would a company choose an IPO?

When a company hires an underwriter, they are hiring them for their financial expertise as well as their network of potential buyers such as other investment banks, hedge funds, broker-dealers, mutual funds, and insurance companies. As the underwriter solicits interest from these parties, they are better able to determine investor appetite and set a realistic IPO price per share.

What is a Direct Public Offering (DPO)?

A direct public offering, also called a direct listing, cuts the underwriter out of the equation. Unlike an IPO, where new outside capital is raised, a DPO allows owners of privately-held shares (employees and early investors) to convert their ownership into stock that can be listed on an exchange. Once listed, shares can be purchased by the general public.

How are the price and number of shares determined for a direct listing?

Unlike a traditional IPO, there isn’t a predetermined number of available shares or price per share for a direct listing. On the day of the DPO, the number of shares available depends on those owners of privately-held stock who opt to list their shares, and pricing subsequently depends on market demand and conditions.

Why would a company choose a DPO over an IPO?

A DPO is certainly a riskier endeavor, but there are a few reasons why a company may choose it over a traditional IPO:

• Well-capitalized & well-known: A DPO may be a better option for a company with sufficient cash on hand to meet immediate capital needs and with sufficient brand recognition to eschew the roadshow process. Rather than raising money, such firms are instead providing liquidity to their early investors and those employees with an ownership stake.
• Cheaper: Underwriters often charge a commission between 2-8%, which means a pretty big chunk of the change raised through the IPO goes directly into the pockets of the underwriter intermediaries.
• Faster: Because there is no lock-up period, current shareholders don’t have to wait to sell their stock post-IPO.
• Anti-dilution: As no new shares are being issued, current ownership isn’t diluted.
• More democratic: By removing intermediaries and enabling existing investors and employees to sell directly to the public, the DPO process is often viewed as more egalitarian. Pricing is determined by supply and demand economics.

What companies have gone public using a direct listing?

In the past, primarily small companies have gone public via DPO. That changed in 2018 when Spotify became the first large tech company to pursue the direct listing route, rather than a traditional IPO, and it was a success. The company opened at $165.90 per share, reportedly 25% more than top private stock sales, giving the company a $29.5 billion valuation. Following in Spotify’s footsteps, Slack will be the second large tech company to take this route, and it will likely not be the last.

• According to CB Insights’ 2019 Tech IPO Pipeline report, the median time from seed funding to public offering for VC-backed tech companies has grown from 6.9 years in 2013 to 10.1 years in 2018;
• The same report notes that $100M+ private funding rounds for these firms have outpaced IPOs every year since 2014; and
• The standard expiration date for employee stock grants is often (but not always) 10 years.

While the only prediction one can make about the stock market it that it’s unpredictable, there is logical support for the argument that these tech unicorns are making the DPO less of a…unicorn.