Direct Public Offerings: Threat to Investment Banking

The costs of issuing an initial public offer can be prohibitive. There are many companies across the world that want to access finances from the general public but cannot do so because they find the costs prohibitive. Hence, in order to bypass the floatation costs, these companies decide to go public without taking the help of an investment banker. This is done using a process called direct public offerings (DPOs). These direct public offerings are a threat to the investment banking business. This is because if enough companies start seeing the merit in direct public offerings, then many of them would not engage an investment banker. In this article, we will understand what a direct public offering is and how it impacts the investment banking business.

What is Direct Public Offering?

A direct public offering is an issue of shares to the general public. It can be thought of as being similar to an initial public offering, but it has three major differences.

  1. Firstly, the direct public offering process is done without the use of any intermediaries. There are no underwriters who sell shares to the public. The deal happens directly between the company and the public. Only the services of brokers may be used to actually distribute the shares.

  2. Secondly, in an IPO, new shares are registered and sold. This is not the case with a direct public offering. In the direct public offering, no new shares are created. Instead, shares that already exist and are owned by the promoter are transferred to the general public.

  3. A lot of the regulations which apply to initial public offerings don’t apply to direct public offerings. For instance, there is no fixed lock-up period or amount of time for which the promoters are legally supposed to hold on to the shares. This has been done to encourage small and medium companies to also use public issues. Up until now, regulations have been keeping these small companies at bay.

Hence, direct public offerings are faster, cheaper, and have fewer regulations as compared to initial public offerings.

How Does Direct Listing Work?

Direct listing facilities are only provided by certain stock exchanges. Hence, if a company wants to do a direct listing, they would have to select a specified stock exchange. Then they would have to register for a direct listing. After that is done, the company generally ties up with a network of brokers, which can provide them with the required last-mile connectivity.

Once such a tie-up is completed, the company published advertisements soliciting offers from the public. The public is supposed to fill in the application and pay the amount directly to the brokers. The commission for the services of the broker will be paid by the company. However, such commissions are much lower than the fees which have to be paid to investment bankers.

Based on the applications received, the company will issue shares directly via the brokers. The underwriting and issue management services of investment bankers are completely circumvented in these issues. The issuing company does not go through a price discovery process. Instead, they directly offer shares at a fixed price. The minimum and maximum quantities per investor are also decided by the issuing company.

Advantages of Direct Public Offerings

Direct public offerings provide smaller companies a chance to tap the stock exchanges to raise more money. If they tap the stock exchange, then they are not completely at the mercy of banks and venture capital firms. Generally, regulations and high floatation costs were the deterrents for these firms. With initial public offerings, both these deterrents can be eliminated.

Disadvantages of Direct Public Offerings

Direct public offerings are unlikely to go mainstream in the near future. They are only used by small companies who do not have the cash flow required to engage an investment banker. It is likely to remain that way for some time. This is because direct public offerings have a lot of disadvantages. Some of them have been listed below:

  • Firstly, the issuing company does not have any safety net. This means that since there is no underwriting, there is actually no guarantee that all the shares issued will actually be subscribed to by the public. Direct public offerings have a much higher probability of failure as compared to initial public offerings.

  • Also, since there are no investment bankers, there will be no anchor investors, i.e., institutional investors who hold the shares for a long time. It is likely that all the issued shares may go into the hands of speculators, and hence there might be a lot of volatility in the shares.

  • The lack of investment bankers means that there will not be any greenshoe option that can be exercised in order to stabilize the prices. The issuing company will have no way to control the prices of the shares once they have been launched in the open market.

  • Since there is no lock-in period for the promoters, the direct public offering mechanism can be used to conduct fraud. The promoters can sell their own shares once the company goes public. The investors will end up holding a large chunk of the shares before they find out that the company does not have the cash flow to back the valuation.

The bottom line is that direct public offerings are an offbeat mechanism that is used by some companies to raise funds. It has a lot of disadvantages as compared to an IPO. Hence, it is unlikely to make the IPO obsolete, at least in the near future.

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