Direct Listings Gain Traction as IPO Alternative: SEC Approves Nasdaq Rule Change to Permit Capital Raising in Direct Listings
Once considered an unorthodox path to going public, direct listings are gaining traction as an alternative to the traditional IPO. On Wednesday, the Securities and Exchange Commission (SEC) approved a rule change, with immediate effect, that will permit companies to raise capital in a direct listing on the Nasdaq Global Select Market. Historically, Nasdaq has limited direct listings to secondary sales by existing shareholders. The new rule, however, will enable a company to sell newly issued primary shares on its own behalf in connection with its initial listing upon effectiveness of a registration statement, without a firm commitment underwritten public offering. Under the new rule, a company can raise capital in a direct listing in addition to or instead of facilitating sales by selling shareholders. Last December, the SEC approved a substantially similar rule change by the NYSE.
Nasdaq’s rule change may result in a broader array of attractive investment opportunities while providing private companies, particularly those in their high-growth stage earlier in their lifecycle, greater flexibility to pursue IPO alternatives.
Aggregated Market Value of Publicly Held Shares Requirement
To qualify for a direct listing with a primary capital raise on the Nasdaq Global Select Market, the market value of a company’s publicly held shares before the offering, together with the market value of the shares to be sold by the company in the opening auction on the first day of trading, must be at least $110 million (or $100 million if the company has stockholders’ equity of at least $110 million). The market value requirement is considerably lower than Nasdaq’s current $250 million market value requirement for a direct listing without a primary offering component. Nasdaq believes this requirement should ensure that companies using a direct listing with a capital raise have adequate public float and a liquid trading market after completion of the opening auction.
Market value will be calculated using a price per share equal to the lowest price of the price range disclosed in the registration statement on Form S-1, and the S-1 registration statement for a direct listing with a primary offering component must disclose a price range, unlike if the S-1 relates only to secondary sales. Nasdaq will determine that the company has met the applicable bid price and market capitalization listing requirements based on the same per share price. The company will continue to be subject to and need to meet all other applicable Nasdaq Global Select Market initial listing requirements.
Opening Auction Process and Role of Financial Advisors
Nasdaq’s rule change introduces a new order type (a “Company Direct Listing Order” or “CDL Order”), which must be submitted by the company in the opening auction for the full quantity of offered shares, as reflected in the registration statement. The CDL Order must be executed in full at the price determined through the opening auction, which must fall within the price range disclosed in the registration statement. If that price does not fall within the disclosed price range, Nasdaq will not release the securities for trading.
In contrast to the original proposal, which would have permitted the company’s financial advisor broad discretion to postpone or reschedule the offering, Nasdaq will have exclusive discretion to determine whether to postpone or reschedule the offering, and will do so only if there is insufficient buy interest to satisfy the market orders, or if the actual price calculated in the auction is outside the price range disclosed in the registration statement.
Lack of Traditional Underwriter Involvement and Section 11 Liability
In its order approving the rule change, the SEC attempted to address the concerns of some critics that direct listings lack the investor-protection safeguards of conventional IPOs due to the lack of traditional underwriter involvement, and could be used as a tool to sidestep Section 11 liability under the Securities Act of 1933 (Securities Act).
The SEC noted that financial advisors engaged in direct listings “may, depending on the facts and circumstances including the nature and extent of the financial advisor’s activities,” be deemed statutory underwriters with attendant underwriter liabilities, including under Section 11 of the Securities Act, and thus should have incentives to engage in robust due diligence.
However, underwriter participation in the public capital-raising process is not required by the Securities Act, the SEC wrote, and companies regularly access the public markets for capital raising and other purposes without using traditional underwriters. The SEC further observed that issuers, officers, directors and accountants, with their attendant liability, play important roles in assuring that disclosures to investors are materially accurate and complete, and a firm commitment underwriting therefore is not necessary to provide adequate investor protection in the context of a registered offering.
The SEC also addressed the criticism that direct listings compound problems that shareholders face in tracing their share purchases to a registration statement for purposes of Section 11 claims. Investor concerns about the traceability of shares in a direct listing are at the core of current litigation involving a direct listing by Slack Technologies, where the district court concluded that Section 11 did not preclude plaintiffs, at the pleading stage, from pursuing claims just because they could not definitively trace the securities they acquired to the registration statement. The U.S. Court of Appeals for the Ninth Circuit has agreed to consider the Section 11 standing issue on appeal. The ultimate decision in the Ninth Circuit, which includes Silicon Valley, will have significant implications for future direct listings.
 By comparison, to qualify for a direct listing with a concurrent capital raise on the NYSE, a company is required to either (i) sell at least $100 million in market value of shares in the opening auction, or (ii) have a market value of freely tradeable shares immediately prior to listing, together with the market value of the shares to be sold by the company in the opening auction, of at least $250 million.
 These include the requirements to have 450 round lot holders (or 2,200 total shareholders), 1.25 million unrestricted publicly held shares outstanding and a price per share of at least $4.00, all at the time of the initial listing.
 The CDL Order cannot be modified or canceled by the company once entered.