If you’ve looked at investing in early-stage companies, you’ve heard the terms IPO, SPAC, and direct listing. What do they mean, and how are they different?
There are several ways a company can list on the stock exchanges. Three of the most common are initial public offerings (IPOs), special purpose acquisition companies (SPACs), and direct listings. Let’s take a look at each of these listing options in detail.
The IPO: High Profile, High Cost
In an initial public offering or IPO, the company creates additional shares underwritten by an investment bank that acts as an intermediary. The investment bank charges a fee to the company and works closely to ensure the IPO process is successful.
There are several regulatory requirements a company needs to follow during an IPO. Before an IPO can proceed the company must submit a detailed registration statement called a form S-1 to the SEC, with up-to-date financials and other information investors need to assess the company’s prospects. The SEC may comment on the statement and request further information before approving the IPO.
The investment bank helps the company set an initial offer price for its shares. The bank then purchases these shares from the company, which are then sold to retail and institutional investors via a network of distributors. This network encompasses other investment banks, mutual funds, insurance companies, and brokers.
Individual investors may have a difficult time purchasing IPO shares. You will need to have an account with a broker that has a share allocation and follow the broker’s procedure. The broker may have requirements for participation.
Before the IPO, the company and the underwriter partner to conduct a roadshow, similar to a marketing campaign. In a road show, the primary focus is creating interest and demand for the company’s shares, which will soon be listed.
The underwriter can then evaluate if the roadshow successfully captures investor attention, allowing them to set a realistic IPO price for the listing. Generally, an underwriter guarantees the company the number of shares it will sell to the public at the IPO price, and may also cover the shortfall in some cases.
There are two ways to distribute shares to prospective investors. One is by book-building, where you invite institutional investors to provide bids for the number of shares, and the price one is willing to pay for the same. The other method is auctioning, when investors bid above the offer price to participate in the IPO.
The fees charged by the underwriters make the IPO process expensive. Underwriting fees may range between 3.5% and 7% of the offering total. So, if the company raises $1 billion, it will pay between $35 million and $70 million as underwriting fees, which is quite significant.
IPO shares typically have a lockup period, meaning that they cannot be sold for a fixed time after the IPO. The lockup period is typically 90 to 180 days.
Several companies went public through the IPO process last year. Some of the big-ticket names include Affirm, Poshmark, and Coupang.
An IPO is a high-profile and high-cost move to public status. It’s often chosen by relatively high-value companies that are in a position to hit the public markets with an attention-drawing splash.
Smaller, lower-profile companies may consider a direct listing or even a SPAC.
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What is a SPAC and How Does it Work?
A Special Purpose Acquisition Company or SPAC is also known as a blank check company. They have existed for several decades but have gained popularity in recent years. A company with no commercial operation is formed and raises funds via an IPO solely to acquire or merge with an existing entity.
A SPAC is generally created by those with expertise in a particular sector and aims to pursue partnerships or acquisitions in that space. Of course, it’s entirely possible for a SPAC to already have a target acquirer in mind, but these details are not revealed during the IPO.
The funds raised by SPACs in the IPO are placed in a trust account and can be used only to complete an acquisition. If the SPAC fails to identify a target company within the stipulated period, it is liquidated, and funds are returned to investors.
Unlike an IPO, a SPAC listing may take just a few months to complete. The promoters of the target company may be in a position to negotiate a premium valuation as the deal has to be completed within a specific time frame. If well-known executives back the SPAC, the target company may benefit from an experienced team and improved market visibility.
A SPAC investor investing in the IPO is betting that the promoters will successfully acquire or merge with a target company. But as the regulatory requirements are lower for SPACs, retail investors may buy shares of overhyped entities. The registration statement describes a company with no operations and investors don’t know what the acquisition will be, so a pre-acquisition purchase of shares in a SPAC is purely based on confidence in the management team.
⚠️ In March 2021, the Securities and Exchange Commission cautioned investors as many celebrities ranging from athletes to entertainers were promoting SPACs aggressively. As a result, the investor alert advised investors to refrain from purchasing SPACs just based on celebrity involvement.
SPACs were on an absolute tear in 2021. The number of companies going public via SPACs rose to 613 in 2021, up from 247 in 2020 and 59 in 2019. The volume of SPAC deals has declined dramatically in 2022.
A SPAC is similar to a reverse merger, which was once a common way to go public. In a reverse merger, a private company would acquire an inactive but still listed company, called a shell, and merge into it. Reverse mergers flourished in the late 90s and early to mid-00s, but the SEC introduced strict rules to deal with dubious practices in the reverse merger market and they faded from popularity. Some analysts believe that SPACs will have the same fate.
Direct Listings: Cheap and Simple
A direct listing process is a good bet if a company wants to minimize its listing costs, avoid diluting existing shareholder wealth by creating new shares, or avoid lockup agreements.
A direct listing process, called a DLP, allows a company to sell shares directly to investors without involving intermediaries. There is no underwriter. No additional shares are issued, and there is no lockup period as well. In a DLP, existing shareholders (investors, employees, and co-founders) can directly sell their shares to investors in the stock market.
Because it does not involve the issuance of new shares, a direct listing will not raise substantial new funds for the company. It is used by companies that wish to list publicly and don’t need to raise capital.
A direct listing will have to meet requirements set by the exchange on which the company plans to list. The current rules of the New York Stock Exchange (NYSE), for example, require that a Company must have at least 1.1 million public shares valued at a minimum of $4 per share.
Companies planning a direct listing must also file an S-1 form with the SEC.
While it’s a relatively low-cost process, going public via a DLP carries certain risks. As there is no road show, investor sentiment might be subdued, resulting in tepid demand for the company’s shares. In addition, no underwriter guarantees the sale of shares, and there may also be lesser participation from institutional investors, which might increase the volatility of share prices after the listing.
While direct listings are usually associated with smaller companies, several relatively high-profile firms have used gone public through a direct listing process, including Coinbase, Spotify, and Slack.
Which Listing Process Is Best?
What’s best for the company and the investor, an IPO, SPAC, or direct listing? Companies use different listing processes for different reasons. From an investor’s perspective – particularly long-term investors – the health and prospects of the underlying company are more important than the method used to go public.
2021 saw a record number of companies going public, driven by a late-stage bull market with soaring stock prices. In 2022 that pattern has been reversed, with IPOs, SPACs, and direct listings all spiraling downward. A FactSet report states that IPOs in Q1 of 2022 declined 87.6% year-over-year to 57 and fell by 82.5% year-over-year in Q2 to 35.
In fact, gross proceeds from IPOs in Q2 stood at $3 billion, the lowest since Q1 of 2016.
Similarly, the number of SPAC IPOs fell over 90% in the first six months of 2022 to just 27.
The ideal listing process depends on the needs and resources of a particular company. An IPO, SPAC, or direct listing does not guarantee success or failure: they are appropriate for different companies.
For those looking to raise capital and create brand awareness by engaging with their investor base, IPOs are a good bet. Alternatively, a direct listing should be the priority of companies that don’t want to raise capital but want to list on the exchange at a low cost.
Many investors prefer IPO companies, simply because the IPO process indicates that the company has enough credibility and resources to attract an underwriter and go through the IPO process. The underwriter’s due diligence does not substitute for your own, but it is at least an indication that the Company has been through a vetting process.
How Do You Evaluate Early-Stage Companies?
An IPO, SPAC, or direct listing are all viable ways for a company to go public. Before investing in any of them, you’ll need to evaluate the company’s financials, its management team, and the key trends and drivers which will impact its revenue and earnings over time.
Business valuation is extremely tricky as no two companies are the same, and the companies may have limited track records. It’s easier to value mature businesses that generate steady and predictable sales and profits and have extended operating histories.
Valuing early-stage companies or unprofitable startups with little or no revenue is much more difficult. The complexities increase if these companies are creating an entirely new market, such as Uber or Airbnb.
Investors also have to consider the regulatory burden of going public, especially for smaller companies. Public companies have significant compliance requirements that can occupy a great deal of time, attention, and resources.
Let’s look at the different ways you can evaluate early-stage private companies.
Comparable Company Analysis
Comparable company analysis is one of the easiest ways to value a private company. You need to identify publicly listed companies similar to the private entity. So, the public company should ideally be a competitor of a similar size and grow at a comparable rate.
Analysts can also include several companies in the same sector, and calculate the averages of their valuation multiples to see if the private company is reasonably valued relative to its publicly traded peers.
Discounted Cash Flow
Discounted cash flow, or DCF, is a highly detailed and comprehensive evaluation method. First, you estimate the revenue growth of the private company by calculating the average growth rates of peers that are listed. Similarly, you need to estimate operating margins, working capital requirements, capital expenditures, and taxes to calculate free cash flow.
Further, analysts and investors should look at tax rates, the average beta, the weighted average cost of capital (WACC), and debt-to-equity multiples. The WACC provides a discount rate used to discount the company’s future cash flows, allowing you to arrive at a fair valuation.
Uncertainty and Risk
Valuing an early-stage company is complex. The process is full of assumptions, estimates, and peer averages. The lack of transparency and access associated with private entities makes it difficult to obtain an accurate valuation.
The registration statement of any company in the process of going public will be the primary source of information, and a thorough review of the statement is an essential first step toward an investment decision.
Investing in newly listed companies carries significant risks, and these stocks are exceptionally volatile in the initial years. Investors need to consider their risk-reward profile before investing in an IPO, SPAC, or direct listing.
