Going Public

The major difference between a public and a private company is how often the share price changes. Each company, public or private, has a share price, which is determined broadly by dividing a company’s total equity value by the number of shares outstanding. A public company let its share price (or stock price) trade freely amongst all investors on exchanges such as the NYSE, NASDAQ, or LSE. At a public company, your share price on any given day at 11am will likely be different than your share price at 2pm – sometimes by pennies and other times by dollars. At a private company however, you may go years in between your share price being reevaluated.

So how does a company go public? There are two paths: an initial public offering (IPO) and a direct listing (known as a DL, direct public offering, or DPO). The main difference between an IPO and a direct listing is whether the company lists new shares or existing shares. Direct listings have historically been a less traditional route to going public. In recent years however, they have become more popular and given their advantages, will likely become even more important forward.

An initial public offering (IPO) is an event where a company sells a portion of shares to investors so that its stock can be traded freely traded on a stock exchange each day. What type of shares are sold in an IPO?

1. New shares issued by the company.
2. Existing shares in the company, or
3. A combination of both new shares and existing shares

In situations 1 or 3, the company issues new shares and raises primary capital. This process dilute existing investors because it expands the total number of shares outstanding.

In the United States, a company going public files with the Securities and Exchange Commission (SEC). The most popular IPO filing is the S-1, which is the draft document that outlines the registration of new securities. The S-1 contains a company's historical financials, commentary from management, details on salary and capitalization, and a bevvy of risk factors which may impact the business going forward. The S-1 often provides placeholder information about the amount of money a company is raising and at what share price . Based on demand during the IPO process, the share price a company goes public at can move up if there is strong demand or down if there is low demand. Shortly after the S-1 filing, the roadshow begins. A company’s management team travels and meets with potential investors to tell them about the company's history and its growth prospects going forward. The goal of a roadshow is to build demand from investors who may participate in the IPO itself or buy stock on the public markets.

The filing and roadshow process culminates with the pricing and subsequent registration of a Form 424B4 Prospectus. The 424B4 is the official registration of securities associated with an IPO. This filing provides the official offering price. The offering price is the share price investors pay to participate in the IPO. The first price we see on day one of trading, the opening price, is often a different figure. The discrepancy between the opening price and the offering price is what leads to the IPO pop controversy discussed below.

One of the areas of IPO controversy is the “IPO pop” - that is, the phenomenon where the share price of a company pops and goes up, say, 10%, 20%, 30%+ on day one of trading. Those investors who are able to buy shares at the IPO can sell after the pop and walk away with a nice profit.  Not all companies experience an IPO pop. Some companies have experimented with alternate price setting mechanisms such as a dutch auction (e.g. Google in 2004) to avoid the pop.

You may be wondering how one gets an allocation in the IPO. In other words, how can I, a regular retail investor, invest in the IPO itself instead of on day one of trading. That process is notoriously mysterious. It resullts from conversationsbetween a company and its investment bankers behind closed doors in the days and weeks leading up to an IPO.

There is one other part to the IPO pop discussion, which is the greenshoe. The greenshoe, sometimes known as an over-allotment option, is a provision investment banks negotiate with a company during the IPO process, which gives the bank the right to issue additional shares in the company at the IPO price. Often, a greenshoe exists for 30 days after the IPO for up to 15% of the shares issued in the IPO, or something in that direction. Some argue the greenshoe gives the underwriters the ability to ensure some price stability in the month following an IPO. On the other hand, consider what happens if a share price pops on day one and remains at that level for the next four weeks. A profit-seeking firm would exercise their greenshoe and immediately sell their shares for a profit.

If your company is going public - not “we are a few years out from an IPO,” but “we have filed our S-1 and are kicking off our roadshow in the coming weeks,” then you should have a plan about what you are going to do with your equity. Are you going to sell all of your stock at the first opportunity? Are you going to sell some stock and hold the remainder? These are questions to consider before you see your share price daily.

Begin by determining what type of equity you have. If you have common shares, then it is an easy consideration. Often some will sell a portion of their shares when possible, which may occur at the expiration of the lock-up period (usually 90 – 180 days after the IPO). The rationale behind selling a portion of your shares is that a significant portion of your net worth is in one asset – your stock in the company. It is often good to diversify into other assets such as equity indices, bonds, or cash in the event your share price drops.

If you have vested options, then you have a few potential courses of action:

• You can exercise all of your vested options before or after the IPO. In this situation, you use your own cash to exercise your options. While you may be creating a tax liability, you own your shares outright.
• The second option is a cashless exercise. In this situation, you take some of your vested options, exercise them, and sell them immediately. The profits earned from that exercise and sale are used to fund the exercise costs and tax liability associated with your remaining vested options. You will have fewer shares in this scenario, but you have not used any of your own cash to obtain these shares.
• The final option is a full cashless exercise. Instead of receiving some shares in the end, you receive only cash. In this scenario, you simultaneously exercise your options and sell your shares on the open market. All taxes will be covered based on the cash profits you receive.

With a cashless exercise, you are technically taking out a loan and repaying it shortly thereafter. You will need to ask your broker or bank how they charge for this type of transaction.

If you have unvested options or restricted stock, then you should check if you can early exercise. If you qualify for early exercise, you may want to do so to avoid tax if your stock pops after the IPO, and also you may be able to start the clock on qualifying for long-term capital gains tax treatment.

A direct listing is an alternative route to going public. It is known as being cheaper and less complex. In a direct listing, a company issues no new shares and does not raise any capital. A primary reason companies choose to direct list is that they do not need to raise additional equity capital. It may be profitable, or it may have enough cash on its balance sheet to get to profitability. In addition, there is no underwriter in a direct listing. Investment banks may be involved to frame the company’s narrative to the public, relieve some of the administrative burdens, and help establish the initial market for the company’s shares. In an IPO, investment banks are directly responsible for selling soon-to-be-issued shares to new investors. In a direct listing, there no newly issued shares.

One of the better heuristics when it comes to direct listings is, “what happens on day one?” When there is a direct listing, any shareholder can sell on day one. There is no lock-up period. If you are an investor who buys in at the IPO, you may be allowed to trade on day one; however, if you own shares in a company prior to an IPO, you are likely subject to a 90+ day lock-up period before you can sell your shares. If you are wondering why there is a lock-up period, that is a good question. The common answer is that if every shareholder has the option to sell on day one, then there could be a massive oversupply of stock in the market, which temporarily depresses the share price and disincentives investors to buy in at the IPO. As a public investor, you do not want to invest at a $10 per share offering price and find your shares down 20% on day one. Then investors would wait until a few days after the IPO to buy, which prevents a company from selling shares in an IPO altogether. You can see how this process gets somewhat reflexive.

The direct listing removes many of the difficult to understand parts of an IPO such as a greenshoe, lock-up period, overallotment, etc. It does introduce one new term: the reference price. The reference price is a share price chosen by a company based on conversations with its financial advisors and the stock exchange its share listing on. The reference price used to build the initial supply and demand on day one of trading. If you watch a company IPO or direct list, the team rings the bell at 9:30am ET when the stock market opens, but their stock will open for trading only when there is a liquid market of buyers and sellers for the company's stock. The next time a company goes public, take a look at what their offering price or reference price is versus the opening price.

The end result of a direct listing is similar to an IPO. A liquid market now exists for the company’s shares, though the company does not add any cash to its balance sheet.

There are a few examples of direct listings. Spotify went public via a direct listing in April 2018. Slack went public via a direct listing in June 2019. There are rumors that companies such as Airbnb, Asana, DoorDash, and GitLab are each considering direct listings instead of an IPO.