Understand the different types of listing processes and the differences between them.
The startup journey, described a financial sense, is a process of raising larger and larger amounts of funding to support growth. This money usually comes from private investors like venture capital firm and family offices in the earlier rounds, but eventually, a startup may want to access a wider pool of investors and raise a substantially larger amount. This means that the startup will need to go public.
A startup or any private business can go public, i.e. become a publicly-traded company through the process of an Initial Public Offering (IPO). Through IPOs, startups can raise money from public or retail investors by issuing shares of the company to the public.
The IPO process can be lengthy and grueling. Not only does your startup need to comply with all the requirements of the stock exchange you aim to list on, it also becomes accountable to public investors for all its actions. Your startup will be required to submit detailed disclosures and share its annual financial statements with all shareholders.
Because this accountability is hard to cope with and requires significant financial resources, startups usually choose to go public only after reaching a reasonable growth stage. At the time of the IPO, private investors like venture capitalists either sell their shares to gain the expected returns, or hold on to them in expectation of higher returns.
It is important to remember that to take your company public, your startup is required to have underwriters. These are investment banks that create and price the shares you will be offering. You can hire more than one underwriter to spread the risk of investment between the banks.
There are two main types of IPOs based on the type of share pricing mechanism used: fixed price offering and book building offering.
Fixed Price Offering
In this type of IPO, companies issue their shares at a fixed price. This price is determined by the company and its underwriters after evaluating the financial health of the company, taking into account assets, liabilities, and growth potential. Based on the evaluation, an issue price is determined to reach the company’s target fundraise.
The fixed price is mentioned in the order document, which justifies the price based on quantitative and qualitative factors. In fixed price offerings, demand for the shares is known only after the issue is closed.
In order to participate in the IPO, investors are required to pay the full share price when making an application. Oversubscription, which refers to the demand for IPO shares exceeding its supply, is generally higher in fixed price offerings. Sometimes, oversubscription can even be several hundred times the original supply.
Oversubscription can lead to a higher IPO price, since it shows that investors are eager to buy the company’s shares. Additionally, such a company can also increase the number of shares it issues to garner greater investment.
Book Building Offering
Under this type of pricing mechanism, the shares are offered at a 20% price band to investors before going public. The lowest price in this price band is called the ‘floor price’ while the highest price is called the ‘cap price.’
Therefore, instead of a fixed price, the company sets a price range and investors place their bids. In their bids, investors are required to specify the quantity of shares they want to purchase and how much they are willing to pay.
The demand for the shares is recorded each day as the bids come in. This demand is also published every day as the book is built. Finally, after the close of the bidding process, the share price is decided according to the bids.
Which one should you choose?
The book building method of pricing shares is preferred in developed markets like the U.S., U.K., and E.U. This is because in the book building process, the price of the shares are fixed according to the market demand for those shares. Therefore, the process is viewed as a fair way of pricing shares.
On the other hand, in the fixed price issue, there are chances that the fixed price may not be fair. Put simply, it is possible that a company’s fixed price is higher or lower than the market fair price as determined by demand. This means that through a fixed price offering, undervaluing or overvaluing your startup is a possibility.
In the end, it is important to remember one thing: you can do the IPO through a fixed price issue, a book building issue, or a combination of both.
An IPO is the most commonly used and traditional method of going public, but there are other methods available to startups who want to consider all the options. One method that’s become overwhelmingly popular in 2020 is what’s commonly known as a ‘backdoor listing,’ and involves a merger or an acquisition by a special purpose acquisition company (SPAC).
How you can list your company with a SPAC
A blank check company or SPAC raises capital through IPO and acquires a private company. SPACs have no commercial operations at the time of listing and receive investment from public investors as well as institutional investors.
This capital raised through IPO is then used to acquire the target private business. Once the acquisition is complete, the previously private company gains the status of a publicly-traded company. This is because the SPAC which acquires or merges with the target business is listed. In other words, if your startup is either acquired or merges with a SPAC, it will become a publicly-traded company. This form of going public is also called a ‘reverse merger.’
Since the SPAC route circumvents the traditional and lengthy IPO process, it has recently gained massive popularity. In fact, as of September this year, SPAC listings in 2020 alone have raised more than the combined SPAC IPO proceeds from the last four years.
Notable startups that went public following the SPAC route this year include electric truck maker Nikola, Chinese co-working space Ucommune, and digital asset financial services company Diginex.
Apart from IPOs and reverse mergers with SPACs, you can also use direct listing to take your startup public. In a direct public offering (DPO), companies do not need to hire underwriters, brokers or other intermediaries. Instead, the company directly offers its shares to the public to raise capital.
In a DPO, the company underwrites the transaction itself and reduces the cost of capital required for the listing process. Moreover, by cutting the investment banks out of the transaction, companies can also avoid the stringent rules and regulations associated with bank and venture capital financing.
The startup sets all the rules and sets all the conditions related to the offering, including offer price, minimum investment per investor, limit on the number of securities one investor can buy, settlement date and the offer period.
It is important to keep in mind that it may be difficult for your startup to attract the interest of investors without investment banks, especially if your company is not well-known. However, unlike an IPO, direct listings do not have a lockup period, meaning that existing investors can sell their shares immediately.
One final important thing to note is that in a DPO under current rules, only existing outstanding shares are offered to the public and no new shares are allowed to be created. However, in August this year, the U.S. Securities Exchange Commission approved a new plan for the New York Stock Exchange. The plan involves creating a new type of direct listing process which would allow companies to issue new shares.
This is a relatively unpopular method of going public. Dutch auctions gained prominence after the dotcom bubble in the late 1990s. The most notable company to use a Dutch Auction to go public was Google in 2004.
The basic concept of a Dutch Auction is that instead of the investment banks, the investors themselves decide what a stock is worth. The company decides how many shares to offer, and sets a minimum bid price. The investors then bid on the stocks, and the winning bidders pay the same price per item (called the ‘clearing price’). Nowadays, the Dutch Auction is used primarily by companies when buying back shares.
Ultimately, no matter which process you choose to list your startup, you have to remember the obligations and regulations you would have to follow as a publicly-traded company. Moreover, you need to account for market volatility before an IPO to understand whether it is a good time to list your company.
Header image by Csaba Nagy from Pixabay