The market for newly public companies is constantly in flux. Sometimes investors are eager to dive into the next listing, and other times, they may shy away from new potential opportunities if they see too much risk.
Whether the market for new listings is hot or cold, investors interested in public offerings should learn exactly how companies can list and what each listing strategy entails. Initial public offerings (IPOs) use a broker, while direct public offerings (DPOs) offer a more direct approach. Both, however, are ways in which companies can sell shares for any reason.
Although DPOs are not as common as IPOs, each way of issuing shares comes with potential advantages and disadvantages for both the average investor and the company itself.
Then there are special-purpose acquisition companies (SPACs), aka “blank-check companies.” SPACs have been around for a long time, but they’ve become more popular in recent days after several high-profile SPAC success stories. Technically, though, a SPAC isn’t an alternative to an IPO or DPO. In general, investors access SPACs upon (or after) a public offering such as an IPO.
With that in mind, here are some of the differences between IPOs and DPOs (with a few “SPAC facts” sprinkled in).
Initial public offerings carry underwriter expertise
The traditional way for companies to go public is through an IPO backed by at least one investment bank.
Institutional and other large investors typically have first access to the shares before market open—the general public is essentially a step behind them. So the average investor may miss out on any early gains from an IPO, whereas inside institutional investors can take full advantage.
With an IPO, an opening price is set beforehand, and the main goal is usually to raise outside capital. The underwriting process by an investment bank is usually longer than with a DPO, but the bank’s backing also provides the firm with an idea of how much capital will be raised before investors make a commitment for the offering.
Many of the largest public companies trading today opened to public trading through an IPO, including Alibaba (BABA), Visa (V), and Facebook (FB)—which were among the largest IPOs of all time.
Direct public offerings level the investing field
Direct public offerings, also known as direct listings, are not as common as IPOs, but some companies prefer this strategy when issuing shares. That’s partly because they can avoid underwriting costs. Some experts believe a direct listing can offer greater liquidity and better price discovery.
With DPOs, companies may have more control over the terms of their offerings because they aren’t working with an investment bank to issue shares. As a result, all investors have equal access to the shares (instead of some investors getting early access, as with IPOs). The price of shares at the open is determined purely by the market, not a preset price.
Instead of aiming to raise new outside capital, a DPO allows current owners to convert their stakes into stock they can sell. And because companies avoid the underwriting process, a direct listing is usually faster and less expensive.
Of course, the flip side is that these offerings don’t provide the backing of a financial institution, and sometimes have more volatile outcomes once the stock starts trading. Several well-known companies, such as tech firms Slack Technologies (WORK) and Spotify Technology (SPOT) opted to skip the IPO process for the DPO approach when they opened to public trading.
Eyeing a SPAC? They have their own unique risks
A SPAC is a company in the developing stage—with no real business plan other than to engage in a merger or acquisition within a specific time frame. It’s essentially a pool of funds created to buy another company (similar in fashion to many private equity funds). SPACs are designed to be flexible, if not a bit secretive. Although some SPACs disclose the specific industry where they seek to make an acquisition, SPACs do not pre-identify possible acquisition targets. For this reason, underwriters do not undertake any due diligence on acquisition targets.
But the risks don’t stop there. Per Securities and Exchange Commission (SEC) rules, a SPAC must typically complete an acquisition within 18 to 24 months and must use at least 80% of its net assets for any such acquisition. If it fails to do so, it must dissolve and return to its investors their “pro-rata” share of assets in escrow.
So what’s the allure? Sure, SPACs are highly speculative, but the lower regulatory bar can dramatically shorten the time it takes to get funding. In a disruptive, fast-growing industry such as electric vehicles and related technologies, a SPAC can help more speculative-focused investors get in at or near the ground floor. Just do your homework before jumping in.
Risks and opportunities of investing in newly public companies
Whether you invest in a newly listed company through an IPO or a DPO, there are several potential risks and benefits to consider.
On the plus side, IPOs and DPOs that succeed can offer investors a rapid rate of return as the market determines the company’s value. For example, shares of Zoom Video (ZM) doubled on its April 2019 IPO and then hopped along awhile, but shares took off to the upside in the 2020 coronavirus-related “stay-at-home” economy.
However, newly public companies sometimes see shares tank on their debut. In the case of social media giant Facebook (FB), shares crashed in the months following its hyped 2012 IPO. It took a while, but eventually they came back and now trade several orders of magnitude above the IPO level.
When you consider investing in an IPO or DPO, remember to look beyond a company’s brand and consider its business operations. Just because you like a company’s product doesn’t necessarily mean the stock is a good investment. Make sure you know the key financial metrics: the company’s debt, profit, and revenue trends.
Public offerings in a nutshell
Newly public companies tend to perform better when the overall market is doing well and less impressively when the broader market slumps. New publicly traded companies can at times carry more risk than more established publicly traded companies, so it’s important to assess your risk tolerance prior to making any investments.
Still, IPOs and DPOs—and even SPACs—have the potential to offer significant returns, which makes them an interesting idea to consider for many investors.
Even though companies with new offerings won’t have a lengthy history of public information available to investors, you should still be able to learn about key financial metrics by reviewing the detailed prospectus that becomes available prior to the IPO or DPO.