What are the differences between an IPO, a SPAC, and a direct listing?

"Going public" is an important growth milestone for many companies and a dream of entrepreneurs worldwide. IPOs, SPACs and direct listings are all methods for accessing the public equity markets. This blog provides a discussion of the pros and cons of taking a private company public and an introduction to these methods of doing so.

Securities laws and capital markets are not stagnant. While all three of these types of public offerings have been available for some time, there have recently been some significant changes in practice and Securities and Exchange Commission (SEC) rulings, with DPOs and SPACs becoming more common. For an overview of equity and debt financing, see our blog, Raising Capital: Young and Mature Business Techniques.

Raising capital to fund growth is one important reason a business becomes a public company.

Another primary reason to take a company public is to let founders and early investors, including angel investors and venture capitalists, realize a return on their investment by selling their existing shares.

In addition to gaining access to all types of investors, going public can increase a company's brand recognition and prestige, further increasing its value. The increased transparency created by the reporting that the Securities and Exchange Commission requires can also allow public companies to get better credit terms for debt financing.

Founders and owners risk losing control of their companies through equity dilution when they go public.

Undertaking a traditional IPO is complicated, expensive and time-consuming. There's also no guarantee that the IPO will raise the desired amount of capital, although that's one of the things that underwriters strive to ensure. Direct listings cost less but are riskier and still expensive.

The transparency created by reporting requirements for publicly traded companies adds to the company's operating overhead and may require disclosing sensitive business information that competitors could leverage.

Company leadership may also over-index on share prices because of the common practices of issuing stock as part of employee compensation packages and evaluating managers based on share price performance.¹ Excesses spawned by this tendency led to the corporate social responsibility movement and the formation of B-corporations.

IPO is a familiar term on Main Street as well as Wall Street. The first IPO actually happened at the beginning of the seventeenth century, when the Dutch East India Company offered public shares to finance its sailing ships and voyages for the spice trade.²

There have been just under six thousand IPOs in the U.S. since the year 2000, with 2021 seeing a record number of 1,035 initial public offerings. In contrast, there were only 173 in 2022, with 76 of those IPOs being for SPACs.^{3, 4}

In an IPO, the company issues new shares of stock to raise capital on a public stock exchange. The process is accomplished through intermediaries including investment bank underwriters and broker-dealers.

Six to nine months is how long it typically takes a well-organized IPO team to go from the initial decision to the public offering.⁵ When a company decides to pursue an IPO, the first step is to find one or more investment banks to provide underwriting for the offering.

The underwriters will help the company make SEC filings, including the final prospectus, determine the correct number of shares to issue, build a public market for the offering, place a value on the company and set a price for IPO shares. They also acquire company shares at a discount for later distribution in the public markets. Only about 20% of the company's outstanding shares are released to the public during the initial offering.⁶

Currently, average fees for underwriters range from 3.5 to 7% of the gross proceeds of the initial public offering. These fees have come down as alternative methods of accessing the capital markets have gained popularity. An article from the early 2000s quoted standard fees of 13%. ^{7, 8}

In traditional IPOs, the investment banks underwriting the issue and the company's management team go on a roadshow to major cities to introduce institutional investors, qualified individual investors, fund managers, hedge funds and analysts to the offering. They work to build excitement about the offering, gauge the investors' interest and set pricing through a process called book building.

Book building means recording the initial price that potential investors would be willing to pay for shares. This information is used to set the price in the prospectus filed with the SEC. When the stock begins trading, share sales are usually awarded to investors who participated in the book-building process. In some cases, the stocks are released through an auction to investors willing to bid above the IPO offer price. ⁹

Some notable companies that have recently gone public through the IPO process include the Robinhood brokerage firm, the dating app Bumble, Airbnb and DoorDash.

The amount of capital raised in an IPO can be eye-popping. Alibaba is one company that used the traditional IPO process in 2014 and raised $21.77 billion, making it the largest IPO to date.10 The underwriters for large IPOs are also very well compensated. If, for example, the Alibaba underwriters got 7%, they would have earned over $1.5 million.

The lock-up period in a traditional IPO depends on the size of the offering and is usually determined by contractual arrangements between the investment banks and the company going public. The point of the lock-up is to stabilize the stock price when the shares are first made available to public investors. The lock-up provision keeps existing shareholders, such as company founders, owners, employees and private equity investors, from selling their existing shares and creating downward pressure on the share price.⁶

Direct listings (DLs) are also referred to as direct public listings (DPLs) and direct public offerings (DPOs). The direct listing option has been available since the mid-1970s but has evolved significantly since then.

Stocks are only one of the securities that can be sold through direct listing. Others include REITs and debt securities. U.S. Treasury bonds are a notable example of debt securities available through direct public offering.¹¹

A 1992 SEC rulemaking that established the Small Business Initiatives Program was intended to lower the financial barriers stopping small companies from raising capital by selling their securities to investors.

Even after the simplification, there were several different types of DPO, each with different rules about allowed investor classes, capital raising limits, and trading.

In a direct listing, a company sells its stock directly to public investors without the intermediaries involved in the traditional process for going public. This lowers the cost of capital but increases the company's financial risk since there are no underwriters. Originally, direct listings were not vehicles for raising capital, but that has changed.

Other key differences between a direct listing and an IPO include:

• The offer is subject to fewer SEC regulations, but the company must comply with applicable state regulations
• There is no lock-up period prohibiting existing shareholders from selling their stock
• There is a category-dependent cap on the amount of money that can be raised

The time required to prepare a direct listing is variable and depends on how widely available the offering will be since compliance documents must be filed in each state where it's offered. Before the listing, the company prepares its offering paperwork and marketing plan, and may set a minimum or maximum number of securities to be sold.

Unlike the IPO, the stock price in a DPO is driven by market demand when trading begins. While that increases the risk for the issuing company and its existing shareholders, many in the entrepreneur and venture capital communities see it as a way to avoid "leaving money on the table" when investor demand drives the stock price much higher than that set in the IPO.¹²

As entrepreneurs, investors and regulators have gained familiarity with the direct listing process and its advantages over traditional IPOs, there have been additional changes in practice and regulations.

In 2018, Spotify's successful DPO and listing on the New York Stock Exchange signaled another development in the public listing story, showing its utility for larger companies.

Other high-profile DPOs followed and in 2020, the SEC revised its rules to allow companies to raise capital through direct listings as well as through traditional IPOs. Now both the NYSE and Nasdaq exchanges list DPOs.

Notable DPOs that followed Spotify include Slack Squarespace, Coinbase, Roblox and Palantir.

SPACs are created through IPOs as publicly traded shell companies with no operations but a mission to acquire a private target company and take it public. Congress mandated the regulations governing the current SPAC landscape and the first SPAC operating under those rules was formed in 1992. Like DPOs, SPACS really started drawing interest from the investment community only recently.

The lifespan of a SPAC is limited to two years, at the end of which it must have either completed its acquisition, sometimes called a business combination. If that has not happened, the SPAC's sponsors must return investors' money.

The SPAC IPO share price is standardized at $10, and SPACs must keep their IPO proceeds in interest-bearing trust accounts. Because the SPAC's sponsors are not required to declare the acquisition target at the IPO, SPAC investors have the right to withdraw their funds, plus interest, from the company if they don't approve of the acquisition.

Three groups are involved in a SPAC combination: the sponsors, the target company and the investors.

Like principles in private equity firms, with whom they compete for desirable investments, SPAC sponsors usually have significant domain expertise in their investment field. The substantial financial risk they face begins with nonrefundable costs for forming and operating the SPAC, including fees for bankers, lawyers, and accountants. Their rewards for a successful business combination can be significant.

Target companies are often innovators with the potential to disrupt a sector. They may have large capital requirements and short track records, making these companies risky investments.

Companies that agree to a combination with a SPAC risk the possibility that investors will withdraw, causing the combination to fail and costing the target company time and resources. they also risk equity dilution if the process succeeds.

Potential combination benefits to target companies can justify the risk and include:

• Significantly shorter time to reach public status
• More certainty about the money that they can access
• Increased visibility through association with the SPAC
• A strategic business partnership with the SPAC sponsorship team

Institutional investors and sophisticated individuals with expertise in the sector are drawn to SPACs for a variety of reasons. They may be looking for a large ROI on the combination or be more interested in learning about the target company while earning interest on their SPAC shares.¹³

Notable examples of companies that have gone public through SPAC combinations include DraftKings, Virgin Galactic, QuantumScape and Opendoor Technologies.

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