The SEC just approved a new way for companies to go public and raise cash. Here's how it works, and why it could transform how hot tech companies think about IPOs.

Traders and financial professionals work on the floor of the New York Stock Exchange

Summary List Placement

A year after a change was first proposed, the Securities and Exchange Commission on Tuesday finally greenlighted the New York Stock Exchange’s plan to allow companies to raise capital through a direct listing.

Direct listings, in which companies can make a public debut but leapfrog the costly underwriting fees required by IPOs, have already been creating a buzz, especially among tech companies that are looking to go public. Until now, though, companies could not raise fresh money in a direct listing. 

Now, so-called primary direct floor listings offer a new twist on the strategy that productivity startup Asana and Palantir, Peter Thiel’s data-mining company, used to go public in September, as well as Slack and Spotify in 2019 and 2018, respectively.

The SEC had originally approved the NYSE’s proposal back in August, only to be thwarted by a notice filed in September by the Council of Institutional Investors, which argued that primary direct listings would allow companies to sidestep shareholder protections built into the traditional IPO process, thus putting investors at greater risk.

But now that the regulator has signed off, securities experts expect the process will gain traction.

“This is a great innovation for the market, and companies will want to make use of it,” said Trace Schmeltz, partner and co-chair of Barnes & Thornburg’s financial and regulatory group.

Insider spoke with three securities experts on how the SEC addressed critics’ concerns over transparency, and the outlook for companies taking this new route of going public.

Read more: A new twist on direct listings could trigger more big lawsuits against buzzy startups over valuations, lawyers say

Regulators say there will be the same diligence and protections in place for direct listings as there are for IPOs

Schmeltz said that the SEC did a thorough job of reviewing investors’ critiques over transparency.

The SEC, for instance, noted that the financial-services firms doing diligence for direct listings are the same investment banks that handle the underwriting process in IPOs, ultimately performing the same protection and transparency. 

In addition, officers and directors have the same fiduciary duties to not make material misrepresentations, while anti-fraud and other regulatory provisions will similarly equally apply to direct listings, as outlined in the modifications that the SEC required the NYSE to make since its original proposal.

“Basically, [the SEC] concluded that there are no more material concerns with direct listings, than there would be with IPOs,” said Schmeltz. “So they expect you’ll have adequate investor protection for direct listings the same way you do with initial public offerings.”

Read more: Top IPO lawyers who worked with companies like DoorDash and Airbnb give a behind-the-scenes look at a hectic 2020 — and share their predictions for next year

Direct listings offer some perks, but aren’t necessarily the right path for every company

Steven Khadavi, a capital markets partner at Troutman Pepper, said direct listings “are not for everybody.” Companies should have an established reputation to back up their financial statements in the absence of the typical underwriting process.

Traditional IPOs have come under renewed scrutiny from critics due to big “pops,” which occur when companies’ shares are priced higher on the first day of trading relative to their original IPO price.

Airbnb and DoorDash, for example, both went public via IPOs in December and saw huge pops that stunned the market. Airbnb’s shares skyrocketed 115% in their first day, arguably costing the company and its early investors $4 billion.

“That’s money being left on the table for the companies,” said Khadavi. Direct listings, on the other hand, could solve that problem by potentially reducing the gap between the initial price — set by bankers during the underwriting process — and the pops that may occur on the first day of trading.

A vocal critic of the traditional IPO process voiced support of the change on Tuesday. Bill Gurley, a prolific startup investor who has for years been an advocate for direct listings, said in a tweet that the news was “a wonderful 2020 Xmas present to the founders, employees, & investors at VC-backed startups.”

In addition to solving the problem of IPO pops, which benefit institutional investors more than the company itself, companies going public via direct listings would also skip the underwriting fees.

That’s not to say that bankers go entirely empty handed, though — for Palantir’s direct listing the company earmarked $38 million to pay the banks that advised it on the process.

“If I’m a company looking to raise money, I’d go for the option that would get me more dollars in the door,” said Schmeltz of Barnes & Thornburg.

The NYSE’s direct listings approval will likely pave the way for a similar proposal by Nasdaq

Now that the SEC has approved the NYSE’s direct listings proposal, there’s no reason to see why it wouldn’t greenlight a similar proposal made by Nasdaq, said Rob Peters, a senior director at Intelligize, a research platform for securities and compliance professionals.

In December, the SEC announced that it would delay its decision on Nasdaq’s August proposal to allow direct listings with a capital raise.

Peters said that there is one potential “hiccup” for Nasdaq: the Biden administration.

“The Trump administration has been very non-prescriptive toward the markets, and there may be a shift toward a more prescriptive regulatory process under Biden,” explained Peters.

That said, it wouldn’t make sense for the SEC to approve one, but not the other, regardless of leadership changes in the commission.

Read more on the role banks play in direct listings: A Morgan Stanley trading desk headed up by a former NFL quarterback will play a central role in Palantir’s and Asana’s public debuts. Here’s an inside look at how it’ll all go down.

SEE ALSO: A new twist on direct listings could trigger more big lawsuits against buzzy startups over valuations, lawyers say

SEE ALSO: Here’s what lawyers and former regulators say Biden’s pick to lead the transition for bank regulation means for Wall Street

SEE ALSO: A Morgan Stanley trading desk headed up by a former NFL quarterback will play a central role in Palantir’s and Asana’s public debuts. Here’s an inside look at how it’ll all go down.

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