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What Are Direct Listings, SPACs, and Reverse Mergers?

Why do companies avoid a traditional IPO? What other options do they have?

A traditional initial public offering may not suit every company. This article will explain direct listings, special purpose acquisition companies, reverse mergers, and why such non-conventional routes to becoming publicly listed could be preferable to some.

In essence, an initial public offering (IPO) involves the creation of new shares that are sold to the public, which is comprised of institutional investors (e.g. pension funds, insurance companies) and retail investors, who are typical citizens with savings to invest. IPOs are a type of equity financing, which denotes the creation and sale of new ownership units (shares) in order to raise capital to fund a business. Although the injection of new capital into the business is undoubtedly positive, there are several drawbacks to an IPO which explain why this process is not always desirable. One concern are the significant costs, which arise from multiple sources. A company that is planning to go public must employ the services of investment banks (IBs). Acting as intermediaries, these IBs perform extensive due diligence and pitch the company to prospective institutional investors on ‘road shows’ with the goal of winning orders for the company’s shares. They provide this service in exchange for a hefty commission, which typically makes up 4-7% of the gross proceeds from the IPO. The larger the IPO (also known as the deal size), the more IBs serve as underwriters. Besides underwriting fees, which typically make up more than half of the total IPO expenses, the company also has to cover the costs of complex accounting and legal procedures which satisfy regulatory requirements.

The complex nature of a traditional IPO means that the entire operation is very time consuming: it can take between six months to a year to be completed. Timing is important with an IPO as companies generally want to take advantage of a frantic bull market to secure a higher valuation and more capital. As bull markets eventually fizzle out, companies would narrow their window of opportunity by spending months preparing an IPO that could go live just when market sentiment has turned bearish, risk-averse, and pessimistic. To companies that depend on speculative investors – picture an unprofitable, hot startup that projects stratospheric growth and disruption – the importance of timing only grows. Another consideration for the owners of private companies is the dilutive effect of issuing new shares in an IPO. As opposed to debt financing, equity financing has the result of watering down (diluting) owners’ existing stake in a business since the creation of new shares means existing shares become worth proportionally less. For example, if 100 shares are in circulation prior to an IPO and 25 new shares are created, the exercisable votes of the previous owners and their entitlement to profits such as dividends drops by 20%.

The charts on the left indicate both the total amount of global IPO proceeds (funds raised) and the total number of worldwide IPOs in the last five quarters.

The COVID-induced market crash occurred during Q1 (March) of 2020, causing the S&P 500 to fall around 31%. However, between then and March 2021, the S&P500 returned approximately 49%. Notice the strong positive correlation between the market’s excellent return during this period and the number of IPOs and funds raised. This is an example of timing IPOs to capitalise on bullish market sentiment.

Considering the aforementioned drawbacks of a traditional IPO, a company may opt for a direct listing. Direct listings do not involve the creation of new shares and thereby they avoid the problem of dilution. Additionally, this method of going public removes the need of an underwriter and all associated expenses, making it an excellent option for a company whose owners simply wish to sell their shares in the market and not raise fresh capital. There are more reasons for why this is the case. In contrast to traditional IPOs, direct listings do not have a lock-up period, the purpose of which is to prevent owners from rapidly selling their shares and thereby driving down the price. This means that owners face far fewer restrictions which dictate when and how many shares they may sell. Furthermore, whereas new shares created in an IPO are typically sold by IBs to institutional investors at a discount to sugarcoat the transaction and reduce investors’ risk, direct listings permit owners to sell all shares at the market price. A limitation of direct listings is that they are not always successful: companies that are relatively unknown, out of favour with consumers or that have overly complex business models may face problems. Indeed, as shares are not offered to institutions which often provide stability and a ‘floor’ under the stock price, direct listings are associated with higher volatility (price swings) and greater uncertainty about the eventual valuation.

A firm may also decide to go public via a special purpose acquisition company (SPAC). Here’s how that works. A group of sponsors (management group) – typically high-profile individuals with successful track records – create a corporate shell that has no assets or revenue. Next, the sponsors advertise the company as a SPAC and take it public via an IPO, the proceeds of which are used to acquire or merge with an unnamed yet promising private company within the next 18-24 months. A SPAC’s IPO typically involves the sale of $10 ‘units’ to the public, which consist of one share and a partial or complete warrant. Warrants give an investor the right to buy a specific number of common shares at a certain price some time in the future. During this time period, the funds raised are kept in a trust that invests in short-term government securities or a money-market fund to generate interest whilst a target is identified by the sponsors. If no suitable company is identified, the SPAC is dissolved and shareholders’ money is often returned in proportion to their ownership stake. A successful merger or acquisition initiates the ‘de-SPAC’ process which allows investors to either pull their money or stay invested, in which case their investment rises or falls in line with the stock price of the newly public company. SPACs can be incredibly lucrative for sponsors because they often hold warrants that allow them to purchase many shares at a hefty discount. The popularity of SPACs has risen dramatically in recent times, as you can see below:


Reverse mergers are similar to SPACs, although there are some differences. As opposed to a SPAC, in a reverse merger, the private company does the acquiring/merging with a publicly traded corporate shell instead of the other way around. Additionally, reverse mergers do not raise funds as SPACs do, nor do they have prominent sponsors to convey legitimacy and steward the process. However, the advantages of both methods are the same. SPACs and reverse mergers are faster than a traditional IPO, require no underwriters (resulting in significant cost savings), and bypass traditional size-based listing requirements.

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Johan Lunau – 25/05/21

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