Who Really Benefits From A Direct Public Offering?

Who Really Benefits From A Direct Public Offering?

The cryptocurrency exchange Coinbase went public earlier this month. But rather than following the standard initial public offering (IPO) process, the company chose to do a direct public offering (DPO), also known as a direct listing. What’s the benefit to the company, and, more importantly, what’s the benefit (if any) to investors?

In a standard IPO the company hires an underwriting firm such as an investment bank to raise capital by (1) determining company valuation and the number of new shares to issue, (2) promoting the IPO event, and (3) providing price stability for a short period afterwards by buying shares in case of order imbalances. A DPO, on the other hand, uses existing shares owned by company insiders and other investors rather than issuing new shares. There’s also no underwriter involved. The company itself promotes the event and the shares are valued based on supply and demand.

The primary benefit to the company is cost savings. Underwriters charge as much as 5% – 8% of the total value of the shares sold, which can amount to a huge fee for a big IPO. But for founder and employee shareowners a DPO can be thought of as a less regulated and easier to implement (as compared to an IPO) liquidity event enabling them to sell some of their company stock and unlock some of the equity they had been building up. Case in point: Coinbase CEO Brian Armstrong personally raised almost $300 million from the DPO and sold only a fraction of his shares in doing so. And the total amount realized by all insiders and early investor shareholders came to nearly $5 billion in just one day.

Do post-DPO investors benefit more than post-IPO investors? That’s less clear. There’s a limited supply of available shares in either case, making it particularly hard for rank and file investors to participate whichever way the company chooses to go public. Which may be all for the good given the poor longer-term performance of IPOs (see https://www.cognizantwealth.com/2019/04/23/why-invest-in-ipos/). It’s also hard to determine if initial valuations are artificially higher under one approach versus the other. Logically one might assume that since an underwriter makes more money with a higher IPO price they will do what they can to pump it up, as compared to the more basic market supply and demand mechanism operating under a DPO. But I doubt there’s enough data available to reach anything close to a definitive conclusion.

If you don’t have access to either approach but still want to invest in a startup, you can alternatively invest in a publicly-traded special purpose acquisition company (SPAC). Its sole purpose is to use investor money to acquire (technically to merge with) a privately-held business, effectively circumventing the IPO process. But the sponsor generally gets to reap 20% of the deal’s equity, effectively diluting the SPAC’s post-merger valuation. For that reason the majority of SPAC investors end up dumping their shares before the merger even completes, making such an investment less like an IPO and more like a cash/warrant arbitrage. SPACs were on a tear in 2020 but have recently experienced significant volatility.

If you are sitting on cash you don’t need for your family’s future needs and goals, I see no problem using it to try for a killing through some IPO, DPO, or SPAC deal. Otherwise I’d stick with a less risky well-diversified portfolio. Peace of mind is more beneficial to the human body than the occasional adrenaline rush.

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