Both initial public offerings (IPOs) and direct listings are ways for companies to make their shares available for purchase by listing them on public exchanges. However, there are key differences between the two that you’ll want to be aware of as an investor. An IPO, which is more common, is when a company creates and underwrites new shares and then sells them to the public. A direct listing, on the other hand, involves listing only existing shares and, therefore, doesn’t require any underwriting. If you’re interested in investing in an IPO or a direct listing, a financial advisor can help you develop a plan.
What Is an IPO?
An IPO is far and away the most popular and well-known method for listing publicly available shares of a company on a public stock exchange. One of the key components of an IPO is the fact that shares are underwritten by an intermediary, and new shares are created for purchase. An underwriter typically takes a percentage of the price of each share, so underwriters can make quite a bit from a single IPO.
The first step in an IPO is the company filing an S-1 with the U.S. Securities and Exchange Commission (SEC). Through this, the company will decide how much capital it wants to raise. The company then must determine how much it will list shares for on the exchange. These shares are then sold as a block to institutional investors before being opened up to trading on the public market.
At this point, the new shares of the company are subject to the fluctuations of the public market. It’s typically a good thing to see a company’s stock price close higher than the listing price on the first day of trading. However, in many cases, you’ll see a plenty of price volatility as well.
How Does a Direct Listing Work?
A direct listing is a cheaper and simpler option for a company that wants to list its shares on a public exchange. There are several reasons why a company may choose to do a direct listing over an IPO. Note that the direct listing process may also be known as a direct placement or a direct public offering.
With a direct listing, the company will not have to pay underwriters. Initiating a direct listing also doesn’t dilute the company’s shares, so it allows current shareholders to retain as much value as possible. A direct listing can also help a company avoid a lockup agreement, which prevents shareholders from selling shares when they want.
At the end of 2020, the SEC announced changes to its rules surrounding IPOs and direct listings. The alterations now officially let companies raise funds through direct listings instead of only an IPO.
There are also risks to a direct listing, though. This could be a lack of guarantee for share sales and the fact that there are no safe long-term investors.
Pros and Cons of IPOs and Direct Listings
Both an IPO and a direct listing are ways for a company to make its shares available for public purchase via a stock exchange. IPOs are the more common choice, especially for larger companies that have the means to work with an underwriter.
A traditional IPO provides more security, as it nearly guarantees investors will buy up shares when they become available. It also usually keeps a handful of investors from selling within a short period of time.
Another benefit of IPOs is the “greenshoe option.” This will grant the IPO underwriter the option to sell more shares if there is sufficient demand. In turn, this helps raise even more capital for the company that’s going public.
A direct listing comes without many of the security features of a traditional IPO. That’s because a direct listing doesn’t involve an underwriter who basically guarantees the share of sales to a body of investors. Instead, a direct listing relies purely on the market forces of supply and demand.
Direct listings and IPOs are different, and some companies may be better off using one or the other when going public. The rule tends to be that direct listings are better for companies that have solid brand recognition, but don’t have a dire need to raise capital. IPOs, conversely, are better for the majority of companies, particularly those looking to raise capital or lock in a pool of investors.
Tips for Investors
- Investing can be tedious, so it pays to have someone in your corner helping you call the shots. That’s where a financial advisor can come in handy. SmartAsset’s free tool matches you with up to three financial advisors in your area in only five minutes. If you’re ready to be matched with a local advisor, get started now.
- When you invest your hard-earned money, it’s important to have a plan in place. This will ensure that you make investments that align with your short- and long-term objectives. Use SmartAsset’s investment calculator to determine what kinds of returns you need to earn to make your goals a reality.
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