Spotify is proceeding with the first “Underwriter-less” IPO that the New York Stock Exchange has seen in modern times.[1] Will it attract other “unicorns”?[2] Spotify has made a confidential filing of its registration statement with the SEC and intends to use a novel procedure known as a “direct listing,” which means that it will issue no new shares and only list the shares it previously issued in private placements or other exempt offerings. Eager to accommodate Spotify, the NYSE has filed proposed amendments to its listing rules with the SEC (and twice amended this filing, most recently in December).[3] Apparently, the SEC has signaled its readiness to approve the proposed NYSE rule changes (which largely mirror the rules for direct listings on Nasdaq[4]). Barring some last minute difficulty with the SEC, the NYSE new rules are scheduled to be approved by mid-February, and the offering will be in March or April.

This development raises issues on several levels: (1) How will this new procedure work?; (2) Will this model attract other private issuers, who have found abundant financing in the venture capital market and have shown little interest in undertaking an IPO?; (3) What legal risks or issues lurk in this new procedure?; and, most importantly, (4) Why would “unicorns” that are indifferent to an IPO be attracted to a direct listing? To state the obvious: that a direct listing is permitted does not imply that the market will embrace it.

Direct Listing: How and Why?

In a traditional IPO on the NYSE, there is a “firm commitment” underwriting, with the underwriters selling the registered shares to public investors, after a “road show” tour and much marketing. Pricing is a three-way process, with the issuer, the managing underwriters, and the largest mutual funds all having a voice. In a “direct listing,” in contrast, no new shares are issued by the company; rather, shares that it has previously issued are listed on the NYSE or Nasdaq. In principle, although the issuer must file a Form 10 with the SEC to register under the Securities Exchange Act of 1934, there is no inherent statutory obligation to register these shares under the Securities Act of 1933, because the issuer is not making any offer or sale. Those holding shares in the issuer who are not “affiliates” could presumably sell under Rule 144 (at least once the issuer had been subject to the reporting requirements of the Exchange Act for at least 90 days prior to their sale[5]). Affiliates would be required to “trickle” their shares out under Rule 144's volume limits in unsolicited brokerage transactions, and they would only be able to use Rule 144 if the issuer was current in its filing obligations under the Exchange Act.[6]

That may have been the procedure that the NYSE initially intended to follow, but it is not the way the amended procedure will actually work. Whether because of SEC pressure or the undesirability of having to wait 90 days after the Form 10's filing, the listed shares will be covered by a registration statement (which Spotify has already filed). This means that the liability provisions in §§11 and 12 of the Securities Act will be applicable, but that Spotify's shareholders will be able to sell immediately on effectiveness.

How is pricing expected to occur without a negotiation between the issuer and the underwriter? When an issuer transfers its listing from one market to another, trading would normally begin on the new market at the last trading price on the former market. By analogy, if a privately held issuer had traded actively in a private placement secondary market (such as SharesPost), the “designated market maker” on the NYSE (which is the successor to the now defunct specialist) could adopt the most recent price in the private market, adjusting that price, as it saw fit, to balance the buy and sell orders in its book. But Spotify (and many other unicorns) do not trade regularly in private markets. This poses a problem for how the opening price will be determined. The NYSE's proposed amendment to its listing rules would permit, as an alternative to the old requirement of a private market trading price, a recent valuation by an independent financial adviser.[7]

As proposed, this recent valuation would have to indicate at least a valuation of $250 million for just the publicly traded shares (i.e., not the issuer as a whole). This will pose no obstacle for Spotify, which has received valuations in recent rounds of private financings and share exchanges of between $13 billion and $20 billion. Rather, this $250 million figure (which is two and one-half times the minimum $100 million valuation required by the NYSE's direct listing rule for firms that are privately traded) sounds as if it was required by the SEC to protect against smaller fly-by-night issuers sneaking onto the NYSE based only on a dubious valuation by a less than independent expert. The NYSE's latest amendment will also tighten the independence standard for this financial adviser, and preclude the use of any financial adviser that has recently served as an underwriter, consultant, or other adviser for the issuer.[8]

What then are the practical implications of the NYSE's proposed rule? Presumably, issuers that want to do a “direct listing” will hire a financial firm specialized in valuation to provide the requisite valuation of the shares that are to be listed. Let's suppose that valuation comes to $1 billion, or $50 per share for some 20 million publicly held shares. The designated market maker on the NYSE would presumably start from this $50 per share valuation and possibly raise it before the opening trade if there was a high ratio of buy orders to sell orders. This is only marginally different from a “firm commitment” IPO, where the negotiated price between the issuer and the underwriter might be $50, but the opening price on the NYSE could be $60.

The real difference will be that in “firm commitment” IPOs, the underwriters will have oversold the offering, building their book by hopefully lining up commitments to buy the issue that may be six or seven times the number of shares to be sold. Such a ratio ensures a “hot” offering with a large first day “pop,” which, back in the days of the late 1990s dot.com bubble, regularly produced first day price run-ups of over 100 percent. Absent such high-powered marketing, a first day price run-up is less likely in “direct listings” (and the first day returns might well be negative on average).

What then is the attraction of the “direct listings?” Cash rich companies, such as Spotify, Uber, or Airbnb, have little need to raise capital through an IPO. They can raise all the capital that they want in private placements, possibly at superior valuations and lower cost. Further, these issuers may place little value on the first day “pop” or price run-up, seeing such “underpricing” as further evidence that underwriters and institutional investors collude to benefit themselves at the expense of the issuer. Instead, unicorns are likely to focus on two advantages that a direct listing can give them: (1) a NYSE listing allows issuers to do mergers and acquisitions, using their own stock as the consideration; and (2) with a listing, the issuer enables its employees to maximize the value of their stock options.

Both goals need a word of emphasis. After a stock is listed on the NYSE (either by a traditional IPO or a direct listing), an issuer seeking to acquire a rival in a merger will only need to file a Form S-4 registration statement (and should be able to qualify for automatic shelf registration). In the hyper-competitive environment in which many unicorns find themselves, it is eat or be eaten, acquire or be acquired, and the capacity to use stock for a merger may be the leading reason that unicorns will eventually decide to go public. Second, stock options are the incentive that fuels Silicon Valley. For employees holding options, the best way to realize their highest value is a listing in a public market. To be sure, there are private markets on which employees can sell their shares, but their liquidity is limited and higher valuations seem likely on the NYSE. Neither of these goals requires, however, a traditional IPO, which may be both slower and certainly more costly than a direct listing.

Why Have IPOs Disappeared?

As many commentators have noted, the number of listed public companies in the U.S. (on all markets) has declined by over 50 percent over the last 20 years.[9] Correspondingly, the number of IPOs has declined by an even greater margin, from 310 per year on average from 1980 to 2000 to 108 per year on average from 2001 to 2016.[10] First day returns on the typical IPO have shrunk even more, from a peak of 70 percent during the dot.com era to under 10 percent over the last two years. As a result, exchanges are losing firms at both ends: Large companies disappear as the result of mergers or bankruptcies (but few voluntary de-listings), and large private companies have shied away from going public.

Relying on a flawed diagnosis that the cause of the disappearing IPO was SEC overregulation, Congress raced to the wrong answer in 2012 and enacted the JOBS Act, which sought to prune SEC rules relating to IPOs. But since 2014, the number of U.S. IPOs has fallen further and sharply, with only a minor upturn in 2017 (which saw 160 IPOs, but these were punctuated by some major debacles in the Snap and Blue Apron offerings). To realize that the problem has deeper roots than alleged SEC overregulation, it is only necessary to look to the less regulated Canadian market, where the decline in IPOs has been even steeper (with fewer than 10 a year from 2014 to date). IPOs have also slowed in Europe, suggesting that no explanation rooted in the laws and practices of a single country will suffice. But IPOs are up marginally in Japan and hyperbolically in China, showing that the vanishing IPO is not a world-wide phenomenon.

So what explanation for the vanishing IPO does work? Simply put, it is less attractive to go public today, largely because increasingly developed private markets can provide capital more quickly, at a lower cost, and with much less litigation risk. Public markets are superior (at least in the U.S. today) only in terms of their liquidity. The greatest attraction of the direct listing is that it can nearly match private markets in speed and cost, while also minimizing litigation risk, and it can provide nearly the same liquidity as a traditional IPO.

To illustrate this claim, it is useful to compare private and public market and the direct listing in terms of each of these criteria: cost, speed, litigation risk, and liquidity.

First, in terms of cost, whatever the size of the issuer, the underwriter's charges dominate all other costs. According to a recent empirical study by PWC of IPO offerings, when the issuer had annual revenues under $100 million, the average total cost of the offering was $11.5 million, of which the total underwriter's charge came to $8.4 million.[11] The next highest charge (legal) was only $1.4 million. At the other end of the spectrum, for companies with revenues over $1 billion a year, the average cost of the IPO was $25.1 million, of which the underwriter's charge was $19.7 million. In short, comparing the two ends of the spectrum, the underwriter's discount ranged between 73 percent and 78.5 percent of the total costs. Not much difference, and nothing else came close (legal expenses were second, ranging between 12 percent and 10.7 percent). The costs attributable to the SEC were trivial by comparison. Bottom line: forget about the costs of an SEC filing as an explanation for the vanishing IPO!

In a direct listing, even if the offering is registered, there need not be an underwriter (or, even if there is one, it will not have any justification for the standard 7 percent discount when it is not selling any shares). Hence, the cost savings from a direct listing should be considerable.

In terms of speed, private offerings are much quicker. Spotify indeed illustrates this, having raised $1 billion in equity capital from venture capital firms in 2016, in less than a month (and without having to leave Silicon Valley). To do an IPO, it should take a month of hard work simply to prepare the Form S-1 registration statement, then another two months or so to receive SEC comments and negotiate changes with the SEC. Only then will the issuer make its registration statement public, and then it must wait 15 days under the JOBS Act before it can begin its road show. Finally, even after the effective date, there is usually a lock-up period of six months before insiders can sell their stock. In the case of a direct listing, the road show is eliminated, and there is no underwriter to demand a lock-up.

From the standpoint of litigation risk, there will be less of a first day run-up in price and thus a lesser likelihood of a later stock price fall. Also, the size of the class that can sue and thus the potential damages may be much smaller, as the trading may be modest.

In terms of liquidity, public markets surpass private markets, but the attraction of the direct listing is that it achieves the best of both worlds: nearly the same liquidity, with much less of the cost or delay.

Will other unicorns follow Spotify? Dropbox is planning a conventional IPO, which will be closely watched. Still, many unicorns resemble Spotify in that they are well-known consumer brands that do not need to acquaint the public with their products or technology. Such firms do not need a road show, and if they do not need to raise capital, they may think it wasteful to pay an underwriter anything like the standard underwriting commission. Other firms, however, may not be known in the U.S. and could benefit from the road show (although even these will want to negotiate a much lower underwriting commission for a direct listing where no capital is raised).

What Problems Lurk in a Direct Listing?

Legal and business issues do surround the direct listing, in part because experience with it is limited. Among these are the following:

Short-selling and the “Bear Raid.” Short-sellers might well seek to exploit direct listings (just as they long have been attracted to sell short on the approaching expiration of the lock-up period). In both cases, they know that insiders will want to sell in order to diversify their portfolios. With pricing particularly uncertain at the outset of a direct listing, this will present an opportunity that the remnants of the short-selling community (which has been decimated by the bull market this year) will want to exploit. The NYSE's new listing rules partially respond to this problem by allowing the NYSE to declare a regulatory halt to trading in all other markets prior to the opening of trading on the NYSE.[12]

In overview, the biggest uncertainty about market mechanics is that in an underwritten IPO, the managing underwriters will protect the offering from a “bear raid” by stabilizing. But under Regulation M, only the managing underwriter (and not the issuer) may do this.[13] If the issuer decides not to use an underwriter, it might conceivably still find some broker-dealer to do this on an informal basis, but, as next discussed, a broker-dealer that engages in de facto stabilizing may incur underwriters' liability under §§11 and 12 of the Securities Act, on the theory that it is legally an underwriter, under the exceptionally broad language of §2(a)(11) of the Securities Act.[14]

Underwriter Liability. Suppose 20 million shares of XYZ Corp are listed on the NYSE, and a financial adviser is retained, under the NYSE's direct listing rules, to value the issuer at over $250 million. It may also place a specific valuation on the shares (say, $30 per share). Could this make it a statutory underwriter with liability under §§11 and 12? In Harden v. Raffensperger, Hughes & Co.,[15] a broker-dealer was retained to review the fairness of the pricing of an offering, as required by NASD rules, because the issuer was, itself, a broker-dealer that was “self-underwriting” its own offering (and thus had a conflict of interest). Although this defendant did not promote the offering or sell any shares in the offering, it was held to be an underwriter. Similarly, the status of persons who own shares covered by the direct listing, is debatable, even when they are not required to sign the registration statement? Hypothetically, take the case of a retired senior vice president of the issuer, who owns 100,000 shares covered by the direct listing. Some precedent suggests that such a person can also be deemed an underwriter, even if this person neither signs the registration statement nor promotes the offering in any way.[16] Possibly, these cases can be distinguished, but there are uncertainties. In this light, the financial adviser who prices the stock under the proposed NYSE rules faces some potential risk.

“Blue Sky” Requirements and Transparency. Direct listings will presumably qualify under §18 of the Securities Act for an exemption from state “blue sky” registration requirements as “covered securities.” Even though the offering is registered, there is only a limited likelihood that this registration statement will ever be seen by investors (who may feel they are simply buying a listed stock). Other exchanges may not follow the NYSE's model with its required registration statement. The entire process will strike some as sneaking under the usual radar screen for IPOs and through a back door to the public market.

Conclusion

The direct listing procedure will be cheaper, faster, and probably less legally risky to the issuer. All that the issuer likely loses is the first day price run-up in a “hot” IPO, which seldom benefits anyone other than the institutional investors who receive an initial allocation of shares in a “hot” offering. The real implication of direct listings is that underwriters have been overselling a service (heating up the “hot offering”) that not every issuer wants. Will the Spotify example attract other unicorns into the public market? Possibly. Is all this good for investors? That question will probably not be asked in this time of rampant deregulation.

Endnotes:

[1]. See Ben Sisario and Michael J. de la Merced, “Spotify Said to be Going Public Early This Year,” New York Times, Jan. 4, 2018 at B-4.

[2]. For the very few who do not know this, a “unicorn” is a private company with a market capitalization in excess of $1 billion, generally based on a recent round of private financing.

[3]. See SEC Release No. 34-82332 (Dec. 14, 2017).

[4]. See Maureen Farrell and Alexander Osipovich, “Bankers Begone! Spotify to Get Clearance for an 'Underwriter-Less' IPO,” Wall Street Journal, Dec. 21, 2017.

[5]. See Rule 144(c)(1), 17 C.F.R. §230.144(c)(1).

[6]. See Rule 144(e)(1) and Rule 144(c)(1).

[7]. The NYSE proposes to amend (i) Footnote (E) to §102.01B of its Listed Company Manual to modify the preconditions for a company listing without a prior Exchange Act registration; (ii) Rule 15 to add a Reference Price when a security is listed under the foregoing Footnote (E); (iii) Rule 104 to specify Designated Market Maker (DMM) requirements in the case of such a listing; and (iv) Rule 123D to specify that the Exchange may declare a regulatory halt in the trading of such a security prior to its initial listing on the NYSE.

[8]. The NYSE further proposes to amend Footnote (E) to provide that the financial adviser that provides a valuation for purposes of a direct listing will not be deemed independent if (i) this adviser or its affiliates beneficially own in the aggregate 5 percent of the class of securities to be registered, (ii) the financial adviser has provided “any investment banking services to the issuer in the prior 12 months,” or (iii) the adviser has been engaged to provide investment banking services to the issuer in connection with the listing or other related services. Hence, a proposed underwriter could not give this valuation.

[9]. The number of U.S. listings fell from 8,025 in 1996 to 4,101 in 2017. See Craig Dodge, G. Andrew Karolyi, and René M. Stulz, “The U.S. Listing Gap” (2015). The current number is around 3,750.

[10]. See Xiaohui Gao, Jay R. Ritter, and Zhongyan Zhu, “Where Have All the IPOs Gone?” (2016).

[11]. See PWC, “Considering an IPO? The costs of going public may surprise you” (September 2012). This study also estimates that annual post-IPO costs run between $2 million and $4 million to stay current under the Exchange Act.

[12]. Proposed Rule 123D will permit the Exchange to declare a “regulatory halt” on trading in the newly listed issuer's stock prior to the opening of trading on the NYSE. Thus, short sellers could not begin trading prior to the opening on the NYSE by selling the new issuer short on Nasdaq.

[13]. Compare Rules 101 and 102 of Regulation M; 17 C.F.R. 242.101 and 242.102.

[14]. Under §2(a)(11), the term “underwriter” is defined to include any person that “participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking…” Arguably, this could reach a financial advisor that participates in pricing.

[15]. 65 F.3d 1392 (7th Cir. 1995).

[16]. See Byrnes v. Faulkner, Dawkins & Sullivan, 550 F.2d 1303 (2d Cir. 1977).

John C. Coffee Jr. is the Adolf A. Berle Professor of Law and Director of the Center on Corporate Governance at Columbia Law School.