IPO, SPAC, and Direct Listing... What's the Difference?
Pros and cons of the various ways a company can go public, and some investment thoughts
Hi friends and happy Thursday!
If you are invested in the stock market you are purchasing, or have purchased, shares of a company. This means that you are entitled to a proportionate claim, (equivalent to your proportionate ownership of the company, represented by shares) on the firm’s assets and earnings. The platform you buy and sell these shares on are called stock exchanges, and you have likely heard of the New York Stock Exchange or the Nasdaq.
These exchanges are secondary markets, meaning that existing owners of shares can transact with potential buyers. The continuous buying and selling is not done by the corporations that initially issued the shares (although a company can repurchase its stock and issue new shares, but these are not day to day operations).
With that basic coverage of how a stock exchange works, I want to dive into the various avenues in which a company can raise money via public markets.
IPO
An IPO, or initial public offering, is the oldest and most conventional way to take a company public. Before a company is listed on a public exchange, it is considered private. Private companies typically go through multiple rounds of investments from friends and family, angel investors, and venture capitalists. In order to go through with an IPO, the company must meet specific requirements laid out by the Securities and Exchange Commission (SEC). These requirements can be both burdensome and expensive, but there are many benefits to be derived from a traditional IPO.
Advantages:
Fundraising
The greatest advantage for a company going public is the sheer amount of money they can raise. In 2020, the average IPO size was $353 million, up from $288 million in 2019. A record breaking 28 companies were able to raise over $1 billion.1 This money is used by companies to further R&D, build or expand office space/operations, hire new employees, and reduce debt.
Exit Opportunity for Investors
An IPO is a great opportunity for private investors to cash out and get the returns they are looking for. Private investors have slim chances finding the next Apple or Microsoft. In fact, investment firms can go years without seeing significant gains from their portfolio companies while simultaneously taking losses on the failing companies. (Here is a great article for further reading on how difficult profitability is for VC’s). When a company publicly lists its shares on a stock exchange, these early investors can sell its now liquid stake in the company for a (likely) handsome return.
Other Advantages
Reduced cost of capital
Ability to provide stock as compensation for employees or company acquisitions
Increased credibility due to required transparency with the public
Disadvantages:
Regulatory Requirements
The regulatory requirements listed above that help the firm from one perspective, also are one of the biggest downsides of an IPO. The SEC requires quarterly reporting, which means that companies must prepare financial statements in accordance with GAAP that are then audited by a public accounting firm. This is an expensive and ongoing process that the company will have to dedicate a large portion of its resources to, to ensure the accuracy and timeliness of reports.
Transaction Costs
Going public via IPO is expensive. There is an underwriting process, typically taken on by an investment bank, that is meant to:
Gauge investment interest from various organizations
Set the price of the company’s stock and thus set the valuation
Guarantee the transaction of X amount of shares
Again, the cost of having an investment bank facilitate these transactions is significant to the company.
Other Disadvantages:
External pressures from the public and markets
Potential loss of control to significant shareholders
Disclosure of business information could weaken competitive advantage
An IPO is the most popular method of going public for a reason. It is structured, the time it takes is not too extensive, and it satisfies a lot of parties involved in the transaction. However, I want to take a look at the other methods for a company to offer their stock to the public.
SPAC
A SPAC, or a Special Purpose Acquisition Company, is a company that is formed with the sole purpose of acquiring, merging, or undergoing another business combination with one or more businesses. The company formed will go public with no existing business operations or revenue, and potentially no acquisition targets.
Advantages:
Faster Process
The process for a company to access the public markets via SPAC is much faster due to the minimal auditing process. The SEC has less questions and hoops for the company to jump through, because the SPAC has no previous financial statements.
Cheaper Price for Equity
This is a big advantage for potential investors. A SPAC usually has two years from the date of going public to acquire a company, and before the happens, shares trade at a par value of about $10-$12.
Other Advantages
Less criteria for a target company to meet in order to become public
Disadvantages
Shareholding Dilution
Sponsors of the SPAC typically own a 20 percent stake in the SPAC through founder shares, as well as warrants to purchase more. There could also be “earnout components” which allow them to receive more shares when the price achieves a certain target.
Opportunity Costs and Potential Failure
For investors that are looking to take advantage of the potential high price appreciation when the SPAC merges with a company, that money can be tied up for up to two years. This raises a big question of what else you could be doing/earning with that money?
The potential failure simply means that the SPAC could end up not making an acquisition, or the acquired company fails (think Nikola). Because of the lighter regulatory process, the companies that are being acquired could have downright poor business models.
The hypothetical SPAC index created (using 71 various SPACs) shows that the index more or less tracks the three other major indices. However, recently there have been selections of significant outperformance by individual SPACs.
SPACs are very speculative, and if you are going to invest into a SPAC pre-acquisition, you must be very confident with the board and investment team. Post-acquisition there is a similar pop as seen in IPOs, and whether that pulls back or continues to rise is another guessing game. Bottom line is to always do your research.
Direct Listing
A direct listing is a way in which a company can list its existing shares to the public instead of issuing new ones. Going public via a direct listing usually underlines a company that has different goals than a company that takes part in an IPO.
In addition to not issuing new shares, there is also no underwriting process that takes place. This greatly reduces the cost and time requirements of offering shares to the public and can simplify the deal.
Another benefit for the current shareholders as opposed to a traditional IPO is that there is no “lock-up” period. When a company goes public via IPO, existing shareholders are not allowed to sell their shares for a period of time. For a direct listing, there would be no shares available to the public if the existing holders didn’t sell.
All of this is beneficial, however this comes with a risk too. Since the shareholders have the decision to sell or not, this is what creates the supply for the product. Although there are probably minimums written out before the listing day, there is likely going to be a different amount of shares actually on the market than what is expected. Also, without an underwriting process from an investment bank, there is no one to guarantee the purchase of a minimum amount of shares. Both of these factors weigh heavily into the increased volatility around the listing date and can create wide swings in the stock price.
Overview:
The way in which a company decides to offer stock to the public obviously depends on their specific long term goals, current capital needs, and investor requirements. Some companies may decide on a route that ends up not being the right fit, and vice versa.
Bottom line, as always, is to do your research and know what you are investing in.
Thanks for reading.
https://insight.factset.com/u.s.-ipo-market-spacs-drive-2020-ipos-to-a-new-record#:~:text=The%20average%20IPO%20size%20in,28%20raising%20over%20%241%20billion.
https://zolio.com/the-three-ways-companies-go-public/
https://insight.factset.com/u.s.-ipo-market-spacs-drive-2020-ipos-to-a-new-record#:~:text=The%20average%20IPO%20size%20in,28%20raising%20over%20%241%20billion.
https://www.fool.com/investing/2021/03/08/the-benefits-and-risks-of-spac-ipos/
https://advisory.kpmg.us/articles/2021/why-choosing-spac-over-ipo.html
https://www.r-bloggers.com/2021/02/analyzing-spac-mergers/
Great info Joey, keep up the great work!
Great info, thank you! When my kids were younger, they were very proud to be "owners" of companies like Costco. Investing has become so much more complicated but you've really helped explain the nuances.