Stock exchange: the difference between IPO and Direct Listing

Going public is a complex financial process that requires an in-depth understanding of market mechanisms. But to put it simply, a company seeking to raise interest-free capital by listing its shares has two main options: an Initial Public Offering (IPO) or a direct listing. These two methods are the most common for taking a company public, but they are not the only ones. While both methods serve the same purpose of taking a company public, they differ in several aspects. ScaleX Invest shows you how.

Going public: making a strategic choice

In the financial community, an IPO conveys the image of a company in good financial health, open to development and capable of meeting the challenges of the future.

On the company side, a stock market listing can be motivated by a number of factors:

-      accelerating growth,

-      increasing brand awareness,

-      preparing for a takeover,

-      offering liquidity to investors

...

Whatever the initial objective, going public transforms the company and profoundly changes its relationships with customers, suppliers and banks. To date, 2021 remains a record year for IPOs, with the majority taking place in the United States. Europe doubled its number of IPOs between 2020 and 2021. The technology sector leads the way, and the largest IPO in 2021 was by Rivian Automotive, a US manufacturer of electric vehicles.
There is every reason to believe that the tech sector will continue to drive IPOs in the coming years. As part of this digital transition, the French government hopes to take 10 French unicorns public by 2025.

Behind the three letters: IPO

An IPO (Initial Public Offering) is a process whereby a private company offers its shares to the public for the first time. In practical terms, this takes the form of a capital increase or the sale of shares already held by investors. This traditional IPO method uses underwriters, usually investment banks, to facilitate the process.

The mechanics of IPOs

Pre-IPO preparations

The company chooses one or several investment bank to act as underwriters for the IPO. The underwriter’s role is to guide the company through the IPO process. The group of underwriters works with the issuer to structure the issue, spreading the risk across several companies rather than concentrating it on a single investment bank.

The IPO process generally consists of two simultaneous phases prior to the operation:

- the documentation phase, with the drafting of a prospectus

- the marketing and communication phase to announce the approach of the IPO

The underwriter and the company work together to prepare a prospectus.

 The prospectus

The prospectus is the official legal document, the cornerstone of IPO preparation. It is generally consisting of a core document and a transaction memorandum divided into standardised sections. It presents the company, its risks and its main activities, and includes accounting and financial data. This document contains all the information that will subsequently be shared with investors and analysts, ensuring fair distribution to all parties.

The Information memorandum or securities note defines the characteristics of the offer, namely:

- the number of shares to be issued

- the proposed price range

- a timetable for the subscription period

- the intended use of the proceeds.

This document also provides a summary of the main information about the company and the transaction.

Once approved (by the Autorité des Marchés Financiers in France, for example), the prospectus is published on the regulator's and the company's websites, making the listing project public.

The communication strategy

At the same time as the prospectus is being drafted, a marketing strategy is put in place to arouse investor interest and create a positive momentum around the deal. The prospectus is far too long and indiscriminate to be used as a communication medium. It is aimed at regulators rather than investors. It is therefore a good idea to present the IPO in a more concise way. This marketing document, known as a slide show, will be used at meetings with investors and financial analysts.

At the same time, financial analysts give their assessment of the company and suggest a price range. The price range is then defined based on feedback from investors. On the day of the IPO, the offer price is set and orders are allocated.

 Shares in newly listed companies often soar on the first day of trading. Investment banks then find themselves charged with intentionally underpricing IPOs to ensure that all the shares are sold. This is why other ways of going public, closer to the market, may be considered, such as direct listing.

The alternative: Direct Listing

Direct listing, sometimes called Direct Public Offering (DPO), is a more recent method of going public. In a direct listing, a company sells shares directly to the public, without the involvement of underwriters. This method offers greater transparency as the share price is determined purely by market demand.

In this case, fewer legal documents are required, although detailed disclosures and a prospectus are expected.

The Intricacies of Direct Listings

In the case of a direct listing, the company bypasses the traditional subscription process. Instead, existing shareholders sell their shares directly on the open market. This method is quicker and cheaper than an IPO. In an IPO, underwriters charge a commission per share that can range from 4.à% to 7.0%, according to a study by PwC. This means that a significant proportion of the capital raised during an IPO is used to pay intermediaries. This is one of the reasons why the innovative approach of direct listing is enjoying growing success across the Atlantic. In April 2018, Spotify's shareholders began selling their shares to the public on the New York Stock Exchange (NYSE). The music streaming service went public without raising any new capital.

The advantages of a direct listing include:

-      immediate liquidity

-      a price structure determined by market demand

-      no issue of new shares and therefore no dilution of existing shareholders

Direct listings also save considerable amounts of money by avoiding the need to pay IPO fees to investment banks. However, there is a flip side to this.

Because direct listings are relatively new, the process can be riskier. A company that decides to go for a direct listing must be sufficiently well informed to avoid legal assistance, for example. Also, with direct listing, there is no guarantee that the price of the company's shares will be fair or that a sufficient number of shares will be sold. With an IPO, on the other hand, the share price is set after assessing investor appetite.

In conclusion, both IPOs and Direct Listings are methods for a company to go public, but they differ in several key aspects, including the role of underwriters, the pricing process, and the ability to raise capital. Our exploration of the different methods of going public doesn't stop there, as there is also the SPAC that stands for Special Purpose Acquisition Company, a company that buys controlling stakes in private companies. We'll be taking a closer look at the future of SPACs soon.

Contact ScaleX Invest to track trends and identify the tech companies most likely to go public. We help financial institutions to mitigate the risk of their investments.