[Editor's note: Since we published this article, the Council of Institutional Investors (CII) submitted a petition to review the SEC’s order approving the NYSE rule related to capital raising in connection with a direct listing. As a result, the SEC’s order approving the NYSE proposal is stayed pending the outcome of the review.]
Our last in a series of articles on direct listings noted that we were expecting significant regulatory developments to give companies more flexibility to pursue alternatives to a traditional initial public offering. Those significant regulatory developments are finally here! On August 26, 2020, and after a number of back-and-forth proposals, the U.S. Securities and Exchange Commission approved a proposed rule change by the New York Stock Exchange to allow for capital raising concurrently with a direct listing. Given this important development, we thought this would be the perfect opportunity to update you on other developments we have recently seen with respect to direct listings.
Direct Listings + Capital Raise
At a high level, in addition to a direct listing where only existing shareholders offer their shares for resale to the public, the NYSE will now allow companies to raise primary capital at the time of the direct listing. This removes the biggest disadvantage of a direct listing—the inability to raise capital concurrently with the direct listing. The NYSE refers to this new type of offering as a “Primary Direct Floor Listing.”
How Can My Company Qualify for a Primary Direct Floor Listing?
To qualify for a Primary Direct Floor Listing, a company needs to either:
- Sell at least $100 million in market value of shares in the opening auction; or
- Have an aggregate market value of shares sold in the opening auction and market value of publicly held shares prior to the listing equal to at least $250 million, with market value being calculated using a price per share equal to the lowest price of the price range established by the company in its S-1 registration statement
Any company conducting a Primary Direct Floor Listing would also have to meet all of the NYSE’s other initial listing requirements, including the requirement to have 400 round lot shareholders (shareholders that hold more than 100 shares) and 1.1 million publicly held shares outstanding at the time of listing. In the NYSE’s earlier proposal, if a company met certain requirements, it would have a grace period of 90 days to meet the round lot and publicly held share requirements. However, this grace period was not included in the final rule. While compliance with these requirements is oftentimes a foregone conclusion in a traditional IPO, a lack of a grace period, specifically from the round lot requirements, will likely make it difficult for many companies to pursue the direct listing option, including a Primary Direct Floor Listing. One way a company can add additional shareholders to meet the round lot requirements is to release transfer restrictions in advance of the direct listing.
What is the Reference Price for a Primary Direct Floor Listing?
Since it has been a while, it is worth providing a quick overview of the “reference price” in a direct listing. First, it is important to remember, the reference price is merely a directional indicator to the market for where the stock might trade on the first day of trading. No shares actually trade hands at the reference price—it is simply a starting point for the price-discovery process.
For a direct listing without a capital raise and where the company does not have a sustained private placement market for its shares prior to listing, the reference price is determined by the exchange in consultation with the company’s financial advisors. There is no specific formula for determining the reference price. To determine the reference price, the exchange and financial advisors look at a variety of factors, including recent secondary trades on the private market, comparable public companies and reports from a company’s independent valuation provider. The company is not allowed to participate in the reference price determination.
Just like a traditional IPO, in a Primary Direct Floor Listing, a company would be issuing new shares and would be required to disclose a price range for the shares on the cover in its S-1 registration statement. For a Primary Direct Floor Listing, the reference price is the lowest price of the price range set forth in its S-1 registration statement.
How Does the Trade Occur in a Primary Direct Floor Listing?
As noted above, a Primary Direct Floor Listing would allow the company to sell shares in the opening auction on the first day of trading on the exchange. To effectuate this, the NYSE introduced a new order type for a Primary Direct Floor Listing called an “IDO Order.” While there are many granular details about the IDO Order in the final rules, the most important one is that the Primary Direct Floor Listing could only occur if (1) the auction price would be within the price range set forth in its S-1 registration statement; and (2) the full quantity of the order (i.e., the total number of shares that the company seeks to sell in the Primary Direct Floor Listing), can be sold within that price range.
If there is insufficient buying interest and the designated market maker is not able to price the auction to satisfy the IDO Order, the shares would not begin trading.
What About Nasdaq?
If you think Nasdaq will be left out all of this innovation, think again. Nasdaq is not too far behind. On August 24, 2020, Nasdaq submitted to the SEC a similar proposal that would allow for a primary capital raise concurrent with a direct listing on Nasdaq. Nasdaq’s current direct listing rules provide that for purposes of determining eligibility for a direct listing where a company has not had sustained recent trading in a private placement market prior to the listing, it would be required to have an independent valuation evidencing a market value of $250 million at the time of the listing.
In direct listing with a capital raise, for purposes of determining eligibility requirements regarding price, market capitalization and market value of publicly held shares, Nasdaq will:
- Calculate the value of the shares using a price per share equal to the price that is 20% below the lowest price in the price range disclosed in the company’s S-1 registration statement
- Deem a company to satisfy the market value of publicly held shares requirement if the market value of the company’s shares before the offering along with the shares sold in the offering is at least $110 million (or $100 million if the company has stockholders’ equity of at least $110 million)
Nasdaq’s proposal also describes a similar trading mechanism to the NYSE, with one big change. Unlike the NYSE, which would require the auction price to be within the price range specified by the company in its S-1 registration statement, Nasdaq’s proposed rules provide that the stock could not open more than 20% below the lowest price of the price range in the S-1 registration statement. Moreover, unlike NYSE, the proposal provides for no upper limit to the price at which the company’s share price could open. This would give companies much more flexibility to sell shares into the market based on demand. It will be interesting to see if the SEC allows for this flexibility or will require Nasdaq to change its proposed rule to conform to the recently approved NYSE rules.
Remember those pesky lock-up agreements that pre-IPO investors and venture capitalists hate? These agreements usually prevented pre-IPO shareholders from selling shares 180 days following a traditional IPO. They are back (or at least partially so)! As you may recall, the big upside of the direct listing was no lock-up and immediate liquidity for all of the company’s existing shareholders. However, following the performance of the Slack direct listing, companies have been contemplating implementing lock-ups in their direct listings to ensure a more orderly distribution of shares in the public markets and to give public company investors confidence that management and large investors won’t liquidate significant portions of their holdings soon after the direct listing. For example, Palantir is implementing a partial lock-up in connection with its direct listing. With no “market practice” having yet formed with respect to lock-ups in a direct listing, we would expect fairly bespoke lock-up structures in the near term. It is important to note that in a direct listing where the company is not selling shares, the company is relying on existing investors to sell shares to create a market for the stock. As a result, a lock-up needs to be carefully structured to strike the right balance between ensuring sufficient liquidity on the first day of trading and ensuring an orderly distribution of pre-IPO shares so that the stock price is not negatively impacted.
In our prior article series, we talked about how some of the investment banks had not yet gotten comfortable with involving their research analysts in a direct listing process. Much like with lock-up agreements, the thinking about research analysts has continued to evolve and, on recent direct listings, research analysts have been involved in the process to a certain extent. We expect the thinking around research analyst involvement will continue to evolve in the future as more companies consider direct listings.
Impact of COVID-19
Going into 2020, a number of high-profile technology companies were rumored to be considering a direct listing. Because of COVID-19, and renewed focus on maintaining a healthy balance sheet, a number of those companies switched from a direct listing to a traditional IPO. However, in recent months, we have seen a renewed interest in the direct listing structure, with a number of high profile technologies, including Palantir and Asana, deciding to pursue the direct listing path. Free from the inability to raise capital concurrent with the direct listing, we would expect direct listings to be an increasingly attractive alternative path to going public that will be available to a broader number of companies.
Direct Listing Ratchets In Private Financings
Another recent development is the introduction of direct listing ratchets in private financing rounds. Venture-backed private company financing documents typically provide that the preferred stock converts to common stock upon a traditional, underwritten IPO. Oftentimes, the automatic conversion requires that the IPO be at a certain size and price. The problem with a direct listing with no capital raise is that there is no real price. There is only an indicative reference price that is not even set by the company. Moreover, the reference price is set immediately prior to the direct listing. Imagine the utter chaos that would ensue if the exchange set a reference price that did not meet the automatic conversion requirements in a company’s certificate of incorporation!
To solve this conundrum, some private financings we have recently worked on included a ratchet provision on a direct listing which would provide an investor with additional shares if the company did not achieve certain performance-based milestones in connection with the direct listing. These ratchets require careful negotiation. For example, consideration should be given as to whether additional shares should be issued based on the reference price or based on a volume weighted-average price for some period of time following the direct listing. We would expect to see this mechanism become more prevalent as VCs look to optimize returns in an uncertain economic environment.
Learn more about the rise of direct listings:
Spotify did it. Slack did it. Many other late-stage private technology companies are reported to be seriously considering doing it. Should yours? In this article, we discuss why direct listings are all the rage and common misconceptions.
The high-profile public market debuts of tech unicorns Spotify and Slack are encouraging many late-stage, venture-backed companies to consider whether a direct listing makes sense for them. In this article, we explore the pros and cons of direct listings relative to a traditional IPO and some key considerations before choosing the direct listing structure.
Assuming you’ve already weighed the pros and cons and decided that a direct listing is right for your company, we’ve put together a list of a few must-do items to ensure everything goes as planned prior to listing your stock directly.