Startups can be challenging to fund due to the limited options available. When companies get incorporated, they have to deal with those challenges. Usually, startups refer to their existing owners for financing needs. Some startups may also obtain funds from other investors, for example, angel investors and venture capitalists. Usually, these companies start as private companies and may stay that way for long.
Private companies cannot offer their shares to the general public through a centralized market. During the initial days, these companies can obtain finance from various investors. As time passes, those investors also look to other options. On top of that, most of those investors seek startups instead of private and established companies. For most private companies, the financing options become more limited as time passes.
As companies grow, their need to expand and continue operating will also increase. It creates a challenge for private companies as they may have limited resources. In these cases, private companies may try going public to obtain funds. By doing so, they can offer their shares to the general public. For that process, they may use an IPO or direct listing. While they can help in financing companies, both differ.
What is an IPO?
An initial public offering (IPO) is a process companies use to go public. During this process, a private company issues stock to the general public. An IPO allows companies to raise finance through those shares. During this process, the private company also transitions from private to public. At the same time, the company becomes listed in a stock exchange.
An initial public offering is a public offering where companies sell their shares to institutional investors. These investors usually include commercial banks, central banks, investment funds, etc. Apart from these, companies can also offer their shares to retail or individual investors. Another name used for IPOs is stock launch. The IPO process usually includes various steps and an underwriter, usually an investment bank.
An underwriter is an institution that arranges for a company’s shares to get listed on a stock exchange. This party also guarantees payments in case of damage or financial loss. Furthermore, it also accepts the financial risk or liability from such guarantees. For most companies, an IPO constitutes a transition between private and public status. During this process, companies can raise significant capital.
After an IPO, companies can offer their shares to the market freely. Stock exchanges may dictate how many of these shares companies can offer. However, it depends on the company’s needs as well. Usually, IPOs can raise enough capital for companies to meet their current operational needs. Some companies can also use those funds to expand their businesses or pay off debts.
Overall, an initial public offering refers to the process of offering shares to the public. An underwriter helps companies administrate the process and help with some parts. Startups or private companies can use this process to go public. Some companies can also use this process to pay off their initial investors and replace their capital. Others may go public to achieve a higher potential.
What is a Direct Listing?
A direct listing is similar to an IPO as it helps companies go public. Consequently, companies can sell their existing shares instead of issuing new ones. Companies that choose the direct listing method have different goals than those with IPOs. Direct listings also involve private companies going public and listing on a stock exchange. However, it does not require them to perform an IPO.
Direct listings allow private companies to list on a stock exchange. This way, they can achieve similar results as with initial public offerings. However, it does not require using the same process. When a company goes public through a direct listing, its shares become listed on the same day. Therefore, investors can buy and sell those shares on the stock exchange on that day.
Historically, direct listings have involved selling pre-issued shares. With this process, companies could not issue new shares. For most companies, the only available option was IPOs. Recently, some jurisdictions have allowed companies to issue shares during the direct listing. Therefore, these companies can sell their existing and new shares during the process.
The direct listing process requires companies to hire a financial advisor. Usually, it includes an investment bank that advises companies on various steps. The bank also undertakes several steps, such as regulatory filings, investor communication and price discovery. This process occurs before the company’s shares start trading in the stock exchange. Apart from that, the financial advisor may not provide additional services.
Overall, a direct listing is another method companies use to go public. While it has some similarities with initial public offerings, it can also be significantly different. Despite its similarities, however, most companies opt for IPOs. One of the reasons behind it may also stem from the regulatory requirements for the process. Nonetheless, direct listings can help companies go public.
What Are the Differences Between an IPO and a Direct Listing?
Despite a similar goal, IPOs and direct listings are different. While both are similar processes, IPOs have been more prominent for companies. Some companies, like Spotify, have chosen the other route and opted for the direct listing approach. Nonetheless, some differences between an IPO and direct listing are below.
Focus
Usually, IPOs focus on raising additional capital. As mentioned, most companies use it to obtain enough funds to expand their operations. On top of that, some companies may also use it to continue their operations. On the other hand, direct listings don’t focus on additional capital. This feature is evident from the process only allowing companies to sell existing shares during direct listings.
Costs
Due to the immense popularity of IPOs, the process is more costly. On top of that, the process involved during an IPO is also more complex than direct listings. Usually, the primary costs difference between the two processes comes to using an underwriter. IPOs require companies to hire one or several underwriters. These parties cost significantly more. On the other hand, direct listings entail hiring financial advisors, which are less costly.
Support
Most traditional IPOs provide more support to companies. This support comes from the investment banks that these companies hire. On the other hand, direct listing companies may also receive assistance from their financial advisors. However, this assistance may come in a limited capacity. Companies that require additional support during direct listings may have to hire help.
Volatility
Direct listings can be more volatile than traditional IPOs. With IPOs, the share prices get negotiated before companies go public. In direct listings, however, the share prices can vary significantly. This price can vary per the supply and demand in the market. This process can make the pricing less predictable. Overall, it also leads to higher volatility for direct listings.
Lock-up period
The lock-up period is the time that follows a traditional IPO. During this time, the company’s shareholders cannot sell their shares in the market. Usually, it ensures the prevention of oversupply in the market for stocks. On top of that, it also boosts the new investor’s confidence. However, direct listings do not involve the same lock-up period.
Conclusion
When going public, companies have various options. Usually, companies choose an initial public offering. This process involves issuing new shares to institutional and retail investors. On the other hand, companies may also choose direct listings. This process involves selling existing shares to the market. While both can be similar, they also have some differences, as listed above.