One of the newest actions taken by NASDAQ and the NYSE is to allow companies the ability to Direct List without the assistance or guidance of an underwriting firm.
Recently, the ability of companies to sell their shares from their treasure was added so companies can, in effect, raise capital without the assistance, guidance or review of an independent underwriter.
This might be a good idea for companies that are very well known and have had significant media coverage. It may also be a good approach for companies that have raised significant amounts of money in the private market with large institutional investors. I am not sure it is a good thing for small to mid-size companies and, more importantly, it might not be a good thing for the general investing public.
My interest has always been for the small to mid-size companies and for “Mr. and Mrs. John Q Public” giving the investor the chance to invest in venture capital. In effect, venture capital investments for public investors.
These “Unicorn” companies using the Direct Listing method do not allow the general public to participate until the shares are registered and the insiders and large institutions have bid up the valuations to arbitrary heights that are not determined by the “free market”, but by an inside group of investors determining the value – who clearly are incentivized for higher valuations for their own personal gain. The public investors get to invest at a price determined by the insiders and private investors which sounds like an unfair system to me.
Let me discuss the important reasons an underwriter is required for small to mid-size offerings and why, even in the case of Unicorns, should be considered.
The underwriter provides an independent due diligence process that is not influenced by the company’s insiders or larger shareholders. When an underwriter does this, it exposes them to significant liability so the underwriters take this process very seriously.
Although the Securities and Exchange Commission reviews all registration statements, they do not approve the content and have no legal responsibility should there be a problem.
The Unicorn companies hire an independent party to review and opine on the valuation, but; the key word is hire. As anyone in the business knows, when you pay to have an evaluation it usually comes out in your favor.
Underwriters may also feel pressure to accept a particular value but, believe me, the legal and reputational exposure to the underwriter is much more significant than the profit motive they have with over valuing an offering.
Also, an underwriter is trying to price the transaction at a value that will benefit the new investing public. They want the transaction to be fairly priced so the stock will perform in the after-market. While the insiders and private investors want to price the Direct Offering at the highest value possible.
Where is the independent arbitrator in a Direct Listing that sets the price for the investing public? The values that are arrived at in Direct Listing are by parties that are much less interested in the companies immediately after market. While an underwriter’s future business and clients have a significant interest in the after-market performance.
When a company has an underwriter, they are very concerned with immediate after- market trading. They want to stabilize the stock and, hopefully, get it off to a good start.
This is important to an underwriter for two reasons:
1) They want to make sure the deal is paid for by settlement date; and
2) They want their clients who invest in their underwriting to do well so they will continue to invest with them.
In my opinion, with a Direct Listing the immediate after-market does not seem to be as important to the insiders. However, for me, the overwhelming societal impact is that the first time the U.S. investing public gets a chance to participate in this new American company or “dream” is when the company’s values have been set by insiders and insider capital raises.
As for the small to mid-size companies, Direct Listing is not really an option for the following reasons:
1. They are not well known and need public distribution to raise capital.
2. They need shareholders to create a public listing and develop a trading market.
3. They do not have market-makers ready to trade their securities that know the company and will trade the stock.
Direct Listing is a fact of life and works for Unicorn companies but; let me repeat one of my favorite observations:
The US economy’s real growth and new jobs are created by the smaller to mid-size companies that are the backbone of our Country. These are the companies that need strong, dedicated underwriters to usher them into the US capital markets.
This is where the public investor can still invest in true venture capital opportunities before a large part of a company’s potential value has been acquired by larger institutions and insiders that gather most of the company’s venture capital value.
Damon D. Testaverde
