Last Wednesday Coinbase went public with a valuation of $85 billion through a direct listing. Direct listing is a lot different than doing an IPO especially for the company’s balance sheet. Before we explore the distinction, it is important to understand how we go here.
In 1929 the US experienced the worst financial crisis the world and the US economy had ever seen. This happened for a plethora of reasons one of them being the lack of uniform standards and reporting requirements. There was a huge information gap between what companies were required to disclose and what they did disclose, it was essentially the wild west of trading securities. I think of the scenes of “The Wolf of Wall Street” where Leo is calling people on the phone telling them he has a “great deal”. Although that wouldn’t be stopped by what I am about to describe this behavior was even more rampant in the 1920’s.
In response to the crash of 1929 Congress passed the Securities Act of 1933 which established the SEC, Securities Exchange Commission. The SEC then went on to set standards and regulate how companies were able to come to the market and standardized the process in which they do so. Fast forward 87 years and there are three distinct ways that a company can enter the market to be traded as a public company.
In an IPO, Initial Public Offering, a company raises new capital. This is by far the most popular way that companies enter the public market. This is new capital to the company and is used for them to invest in projects that are designed to make the company more efficient. For example, in 1997 when Amazon went public they said they would use the money to buy more books. Clearly their business model has evolved over the past two decades. In an IPO a company looking to go public hires an investment bank who underwrites the deal and gauges interest among institutional investors and the public and then determines the price and quantity of shares that will be issued. This process comes with a lot of disclosures where the company is looked at under a microscope and has a lot more headaches to deal with than simply being a private company where they can make their own decisions unencumbered by shareholders. Through all the headaches after the company, the investment bank and the SEC all agree the company is traded on an exchange. This comes with a lot of restrictions for all parties involved however the company is on the market and can be traded by investors.
Direct listings are the second way for companies to go from being privately held to publically traded. This process allows current shareholders, usually employees and investors from seed rounds, to directly (hints the term direct listing) sell their shares to the public. This still requires reporting to the SEC however there are several advantages for this method. For one there is no lockup period which in an IPO denies insiders the option to sell shares for the first 180 days following the offering. Another huge benefit for the company is that it is cheaper to do a direct listing. Instead of the company paying five to seven percent to an investment bank they can now save that money. The most important distinction between and IPO and a direct listing is that the IPO generates new money to the firm and the direct listing does not.
In the IPO the company dilutes it percentage of ownership by selling new shares in exchange for new capital. On the other hand, with the direct listing the company is selling existing ownership which is a liquidity event opposed to a cash event. Instead of raising new capital for the company as is done in the IPO, employees and the company are simply converting their equity positions into cash, this just transfers the equity from one person to another, it does not create more equity. The last distinction is in the way that the price of the shares are determined. In and IPO the investment bank decides a predetermined price based on a variety of factors. In the direct listing the exchange sets a reference price at what they think investors will buy and sell. Investors have the option to buy at that price or move it higher. In the case of COIN the reference price was set at $250 however no trades were executed at that price because it was determined too low. Instead the first trade was executed at $409.62.
The third was for companies to make an entrance on the public trading floors is through a SPAC. SPACs, Special Purpose Acquisition Companies, are companies that are created simply for the purpose of going public. There is no underlying business, just the intention to raise capital via going public and then, after already publically traded, the company acquires an established company. The benefit of this route is it allows the company being acquired, to go public in a way that is significantly quicker and cheaper than going at it through IPO or SPAC. SPAC are often referred to as “blank check companies” because that is essentially what an investor is doing when they invest in that company, handing the SPAC a blank check to invest in whatever they think is best. SPACs are a relatively new way to raise capital and have become increasingly popular with over the last few years. The major downside to the SPAC is the underlying company loses control to the process.
It is important to understand the difference between these three because over the next decade it is anticipated that we will see a lot more of the last two. Understanding how they work as well as why a company would want to use one over another is increasingly important. Two decades ago tech companies would go public via IPO however as we saw with COIN companies will have to find creative ways to get to market. As cryptocurrency becomes more mainstream and more popular I anticipate seeing other companies tied to the crypto space go public via direct listing and SPAC.