Despite the social and economic devastation wrought by the Covid-19 pandemic, the year 2020 has witnessed an initial public offering (IPO) boom in the U.S. capital market—494 IPOs were recorded for the entire year and $174 billion raised, more than twice the scale in 2019, making it literally the busiest year for IPOs since the dot-com bubble. At the same time, two new developments in the equity capital market have won close attention of companies and investors. Unlike previous years, the hot IPO market in 2020 was fueled in large part by the surge in Special Purpose Acquisition Companies (SPACs), also known as blank check companies, which represented about half of the number of IPOs and the amount of proceeds raised.
The exponential growth of SPACs over the past few years has been stunning. In addition to the “SPAC frenzy,” another big story for the public market last year was that the Securities Exchange Commission (SEC) approved a new listing rule from the New York Stock Exchange (NYSE) that would allow primary direct listings of companies seeking to go public so that companies that choose this route can raise capital outside of the traditional IPO process. Some wonder whether the increasing popularity of SPACs and the emergence of direct listings as alternative paths to going public sound the death knell for the traditional IPO. To answer that question, it is necessary to unpack the advantages and disadvantages of each of the three avenues to the public market.
In a traditional IPO, a company seeking to go public engages an underwriter—an investment bank—to manage the whole process. The underwriter conducts financial due diligence and ensures that the company satisfies all regulatory requirements. It then helps to market the company to prospective buyers of the stock, mostly institutional investors through a process called roadshow, and handpick a price at which the shares of the company will be sold. Unless in poor conditions, the underwriter will guarantee the sales of specific amount of stock in the IPO and have to buy the remaining outstanding shares itself if not enough investors end up buying the shares. The involvement of the underwriter gives rise to two major problems. Due to the contractual arrangement between the company and the investment bank, the latter is incentivized to set the IPO price relatively low so that the stock will open successfully and trade at a premium on the day it debuts. The underpricing of shares leads to the “IPO pop”—the stock price suddenly trades at a higher price on the first day and the company “leaves the money at the table.” Besides, the pre-listing purchase of the underpriced shares is accessible only to a few institutional investors, who would then be able to profit from the discount they have received by selling to the others, including the many retail investors.
For the first alternative route to going public, the SEC defines a SPAC as “a company with no operations that offers securities for cash and places substantially all the offering proceeds into a trust or escrow account for future use in the acquisition of one or more private operating companies.” Typically, a SPAC raises capital through its own IPO as a shell company with no operations. Its sole purpose is to find a target operating company to acquire or merge with within a defined timeframe, usually two years. The second step is usually achieved by structuring the transaction, referred to as the De-SPAC process, as a reverse merger in which the target company merges with and into a subsidiary of the SPAC. Following the acquisition or merger, the target company becomes a publicly traded company. The management team of the SPAC is typically comprised of experienced and highly regarded businesspersons, commonly referred to as sponsors, upon whom the investors of the SPAC rely to identify a suitable target company. In the event that no desirable target is identified, or attempts to close a De-SPAC transaction fail by the pre-determined deadline, the SPAC will be liquidated, and the proceeds raised by the SPAC IPO will be returned to the investors. Also, even if a merger is agreed upon, the SPAC’s public shareholders may still vote against the transaction and redeem their shares. When the redemption of shares results in the need for additional capital to complete the De-SPAC merger, the SPAC can obtain financing through a private investment in public equity (PIPE) deal. It is no overstatement that SPAC has been all the rage. According to SPAC Research, there are 387 active SPACs currently seeking target operating companies as of this writing. More privately held companies will conceivably go public via reverse mergers with SPACs.
SPACs offer a number of advantages over traditional IPOs. First, they provide more access to capital for small and growth companies, for which traditional IPO may not be possible. Companies of this sort need financing but would like to maintain its management team and structure. Going public through reverse merger with a SPAC therefore kills two birds with one stone. Second, a SPAC provides greater market certainty and flexible deal terms. The SPAC and the target company will negotiate a fixed price for the merger and other terms such as additional financing through a PIPE. Third, going public via a SPAC is much faster than a traditional IPO. A De-SPAC transaction takes only a few months to complete, whereas the grueling traditional IPO process could take up to six months.
There are certain downsides that come with merging into a SPAC. First, the sponsors of the SPAC typically receive a substantial number of shares of the SPAC for nominal consideration, commonly referred to as the “founder promote.” Because the founder promote will be converted into shares of the resultant public company as soon as the De-SPAC merger is completed, other shareholders will suffer immediate dilution—arguably incurring higher cost of equity than other routes to the public market. Second, the redemption rights of the investors undermine the certainty of the funding of the De-SPAC merger. If a large number of SPAC investors do not approve of the business combination and elect to redeem their shares, the SPAC will have to resort to other funding sources. Third, the absence of underwriter engagement results in a lack of institutional investor relationships and the company, though becoming publicly listed, will not receive as much equity research coverage down the line, potentially undercutting the prospect of subsequent equity or debt offerings.
Turning to the other alternative, direct listings have been around for a while, but the recent SEC approval sets a new milestone. It used to be the case that companies that elected to go public via direct listing were not allowed to raise capital by issuing new shares and could only sell existing shares to the public (which is what Spotify did when it went public in 2018). With the SEC greenlighting primary direct listings, however, companies are now able to sell newly issued and registered shares on the first day of trading. Companies will do roadshows themselves, which are open to all potential investors, large and small, institutional and retail. According to recent reports, grocery-delivery giant Instacart is considering going public via direct listing instead of IPO.
Companies have good reasons to opt for direct listing instead of traditional IPOs. First, companies do not need underwriters for direct listing and thus significantly reduce the cost associated with the listing process—while the investment bank is still involved, the fees for underwriting stock are much heftier than those for direct listing advisory. Second, unlike with an IPO, there is no lock-up agreement that restricts the sale of insider shares in a direct listing. This feature makes direct listing especially attractive to those who wish to gain liquidity as soon as the company’s shares start trading on the stock exchanges. Third, direct listing is supposed to do away with the underpricing mechanism that is linked to the underwriting process. Since shares are open to all investors and the trading is based on the match between supply and demand without being disrupted by the incentives of the investment bank to discount the price, companies are less likely to “leave the money at the table.”
The major disadvantage of direct listing, though, is uncertainty. Without the services of underwriters, companies will have to market their own shares, which makes it hard to predict the amount of capital they are able to raise. Research analysts at investment banks also provide forward financial models and other useful input for IPOs, which are unavailable if a company elects to direct list.
Some high-profile business leaders think that SPACs and direst listings would spell the death of traditional IPOs. For example, Bill Gurley, one of the best-known venture capitalists and a partner at Benchmark Capital, describes the traditional IPO process as “structurally broken” and “robbing Silicon Valley founders, employees, and investors of billions of dollars each year.” Many investors share the same negative sentiment that investment banks often perform a poor job of assessing demand. He claims that SPACs are a “truly legitimate and preferable doorway into the public markets” because SPACs have “lower cost of capital” for companies seeking to go public than IPOs due to the current over-supply of and hence the competition among SPACs. Gurley also believes that the direct listing process will “unquestionably” usher in the end of traditional IPO. He told CNBC,
“I can’t imagine, in my mind, when you can do a primary offering through a direct listing, why any board of CEO or founder would choose to go through this archaic process that has resulted in massive one-day wealth transfers straight from founders, employees and investors to the buy side.”
Others believe most companies will still opt for the traditional IPO. The principal reasons for the continued appeal of IPO, they claim, are exposure to institutional investors and market certainty. The use of underwriters ensures that companies will be introduced to potential institutional investors through roadshows and will get a rough idea of how much they will be able to raise before their IPOs. These advantages are absent in direct listings. And the while the SPAC structure arguably offers even more certainty to the company, it also means greater risk for the SPAC, which is buying a private company with uncertain valuation subject to a set of subjective and manipulable assumptions. Ultimately, these uncertainties mean that the company needs to compensate the SPAC by offering even larger discount than traditional IPO investors.
To be sure, the predictions of both sides are purely speculative at this point. While SPACs and direct listings will certainly transform the landscape of the IPO markets, whether and how they pose an existential threat to traditional IPOs will probably depend on the industry and the type of companies that mull going public.
Relatively mature and large private companies in established industries may still view the traditional IPO as the most favorable route to the public markets. This is because SPACs do not usually target such companies, and neither the lost capital resulting from the sponsor’s quasi-complimentary shares in the SPACs nor the infusion of new management team members is desirable. On the other hand, direct listings will deprive them of the benefits of market certainty, institutional investor relationships, and equity research coverage that underwriters will bring.
In the technology sphere, by contrast, traditional IPOs are likely to vanish. For an archetypal Silicon Valley emerging or growth-stage technology firm, the traditional IPO may no longer be a sensible route because merger with a SPAC offers both an influx of a large amount of capital to fund continued operations and a speedy liquidity solution for the company insiders. And for a large and mature technology firm, direct listing is probably the most cost-effective vehicle to going public. Presumably, such a company already stands in the spotlight of the media and the investment circle and the above-mentioned advantages entailed by underwriting would dwindle. With the irreversible trend of technology companies dominating the start-up universe, traditional IPOs will account for less and less of listings in the future.
Yunpeng (Patrick) Xiong: J.D. Candidate 2021, Berkeley Law School; Vol. 109 Executive Editor, California Law Review. I wish to thank Professor Robert Bartlett for his valuable advice and Natasha Geiling for editing the piece. All errors are my own.
Yunpeng (Patrick) Xiong, SPACs and Direct Listings: The Death Knell for Traditional IPOs?, Calif. L. Rev. Online (Apr. 2021), https://www.californialawreview.org/spacs-and-direct-listings-the-death-knell-for-traditional-ipos.