Morrison & Foerster Discusses Investor Exits: U.S. Direct Listing Rules in Flux

Amid intense focus on investor liquidity (and paths to potential liquidity) in private companies, we provide an update on developments around direct listings as an alternative to traditional IPOs in the United States.

On August 26, 2020, the SEC approved a change in New York Stock Exchange (NYSE) rules that would, for the first time, allow private companies to raise capital through direct listings of their shares on a U.S. market, as opposed to the usual route of underwritten public offerings. (The SEC approval order is here.) To date, direct listings have been available only for sales by the company’s shareholders. This rule change would result in a major change in how certain companies could “go public” in the U.S. But an industry group of institutional investors immediately objected to the rule change, and, on August 31, the SEC suspended its approval of the NYSE rule pending further review (in a brief note here).

Given the importance of these exit routes for private equity investors, in this update we provide some background on these developments, highlighting key differences between direct listings and traditional IPOs (Section 1), the perceived advantages of direct listings (Section 2) and legal restrictions on direct listings (Section 3). Finally, we outline several key considerations for private company investors in light of these ongoing developments (Section 4). The way in which related rights are negotiated in the investment documents will impact each of the traditional exit, force exit, company cooperation and registration rights of the investors.

1. Direct Listings versus Traditional IPOs

Direct listings and traditional IPOs are both paths for privately held companies to go public and have their shares listed for trading by public investors on a stock exchange. As a general matter, the same U.S. securities rules apply to both alternatives. In particular, the company’s shares can be sold to the general public only pursuant to a registration statement that has been declared effective by the SEC, and the company will be subject to “gun-jumping” rules, public disclosure requirements and marketing restrictions throughout the process.

Direct Listing: In a direct listing, the company’s shares are sold directly to public investors at a market-determined price. Specifically, under the proposed NYSE rule, the initial block of company shares to be sold to the public would be priced in an opening auction conducted by an NYSE market maker, but the resulting opening price must be within a range specified by the company in its registration statement.

Traditional IPO: In a traditional U.S. IPO, by contrast, the initial offering price is agreed between the company and the underwriters before public trading begins. That initial price determines how much the company (and any selling shareholders) will receive in the IPO, less the underwriters’ fees. The underwriters typically assume the risk that the shares cannot be sold at the initial offering price (in a so-called “firm commitment offering”), but the underwriters will have already built a “book” of initial buyers at this point in the process, which follows the marketing activities of the roadshow. The underwriters immediately arrange the initial sale of the shares, and public trading then begins.

2. Perceived Advantages of a Direct Listing

On the first day of trading in a traditional IPO, there is often a significant jump (often referred to as the “pop”) in the price of the newly traded shares. In the eyes of many pre‑IPO investors, the pop represents value that could have been captured by the company and selling shareholders if they had been able to sell directly to public investors. This is often cited as the main attraction of a direct listing.

Another key distinction for pre-IPO investors is their ability to sell shares in and after the initial listing. In a traditional IPO, certain shareholders might be granted the right to sell shares in the initial offering, but underwriters will normally require significant shareholders and management to agree not to sell any additional shares for 180 days following the IPO. By contrast, shareholders are not subject to any such restriction in a direct listing.

3. Legal Restrictions on Direct Listings

In theory, direct listings could potentially allow for sales by the company (primary direct listings) and by its shareholders (secondary direct listings). However, U.S. rules have prohibited companies from selling their own shares in direct listings. Companies can only procure secondary direct listings to allow shareholders to sell shares to public investors without an underwritten offering. This is what Spotify did in 2018, for example.

This restriction on company capital raising has made direct listings significantly less attractive. On August 26, the SEC approved NYSE’s proposed rule allowing companies to sell their own shares in direct listings, and NASDAQ has submitted its own proposed rule change to the SEC, which would allow primary direct listings on its platform as well. However, as noted above, the SEC’s approval of primary direct listings on the NYSE has been suspended. A challenge to SEC final rules of this nature is somewhat uncommon, and it is unclear how and when the SEC will react to the challenge.

We further note that, in adopting the NYSE’s proposed rule, the SEC did not approve the NYSE’s initial proposal to provide companies with additional time to meet its initial listing distribution standards. As a result, only a fairly select group of private companies would be eligible for primary direct listings on the NYSE. Among other NYSE requirements, (1) the company must have, at the time of listing, at least 400 shareholders who each own at least 100 common shares and (2) either (a) the company must sell at least $100 million in market value of its shares to the public in the direct listing or (b) there must be freely tradeable company shares outstanding with a market value of at least $250 million upon the direct listing.

4. Implications for Investors

It is now important for investors to consider direct listings as viable alternatives to the traditional IPO when negotiating their governance and liquidity rights in private companies. Investors should also factor in the possibility of future rule changes around direct listings, as well as potential misalignment of interests between investors and the company.

We briefly outline three considerations below.

A. The IPO Construct in Private Company Arrangements

Under the shareholders agreements and organizational documents of many private companies, an IPO (or sometimes only a “Qualified IPO”) will have a fundamental impact on the rights of investors. For example, an IPO will trigger the conversion of all preferred stock to common stock and the termination of certain key governance, veto and information rights.

In many agreements, direct listings—especially secondary direct listings—will not count as “IPOs,” which typically require underwritten offerings (sometimes even firm commitment underwritten offerings that result in a minimum amount of sale proceeds to the company, commonly referred to as a “Qualified IPO”). To be sure, most investors will want to err on the side of a tight “IPO” or “Public Listing” definition, given the dramatic consequences on their rights. But investors should be wary of an overly narrow construct, as small shareholders could gain hold-up value over an attractive direct listing and the company itself might have a contractual basis not to pursue a direct listing (for example, where the company’s efforts must expressly be directed toward a Qualified IPO). Furthermore, the shareholding percentage-based approval thresholds need to be clearly negotiated and structured.

B. Misalignment of Investor and Company Interests

The current rules on direct listings, where company share sales are prohibited but shareholder share sales are allowed, can clearly cause tension when management and the shareholders discuss how the company should go public. This highlights the significance of board control, as well as investor veto rights over public listings. If the current imbalance in direct listing rules continues, we might see more accommodation on both sides. For example, the company might agree to allow major shareholders to take up a greater portion of any traditional underwritten IPO, while shareholders eager to sell in a secondary direct listing might facilitate one or more incremental private placements by the company.

C. Direct Listing Procedural Terms

The longstanding model of the underwriter-led IPO has spared investors and companies from negotiating in advance many of the parameters of the listing process. But that may no longer be the case. Direct listings do not have to follow many cornerstones of the traditional IPO process, such as roadshows directed at major institutional investors.

Of course, banks can still be engaged to advise on direct listings. Still, investors should consider whether to set out more rules for the direct listing process or simply to reserve the right for greater involvement. For example, investors might worry about the company’s commitment to marketing a secondary direct listing, where the company is not raising any funds.

Similarly, investors should consider the importance of “orderly sell-down” provisions to govern shareholder sales in and after direct listings. As noted above, the traditional underwriter-mandated lockup, which restricts insiders and significant shareholders from selling shares for the first 180 days following the IPO, does not apply in the direct listing context. But trading price could be adversely impacted if there is a market perception that all pre-IPO shareholders are rushing to exit.

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As we describe above, U.S. direct listing rules are still in flux, but may present new opportunities—and complications—for private companies and their investors. At this point, we can only anticipate more twists in the SEC rulemaking process and will continue following developments in this space.

This post comes to us from Morrison & Foerster LLP. It is based on the firm’s memorandum, “Investor Exits: U.S. Direct Listing Rules in Flux,” dated September 4, 2020, and available here.

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