Slack IPO: What Investors Need To Know About Direct Listings

Workplace messaging software company Slack Technologies has filed for an IPO, but it isn't using the traditional method of going public. Instead, Slack -- a service that aims to foster efficiency and collaboration among coworkers through chatrooms -- is choosing to pursue a direct listing of its shares, becoming the second major company to do so in the past year. Spotify Technology (NYSE:SPOT) used the same method when it went public in 2018.

While we don't yet know the timetable or most other details of Slack's potential IPO, here's a rundown of how a direct listing is different from a traditional IPO, and why the company may have decided to use this route.

What is a direct listing?

Generally, when a company wants to do an initial public offering, or IPO, they will hire one or more underwriters. Think major banks with investment banking operations like Goldman Sachsor JPMorgan Chase. These underwriters essentially facilitate the process -- determining the initial offering price, dealing with regulatory issues, and selling the shares to the initial investors.

On the other hand, a direct listing, also known as a direct public offering, or DPO, is a process by which the company sells its own shares directly to the public. There are no underwriters involved. In simple English, the company's existing shares are listed on an exchange, and people who own them, such as the company's existing investors, can choose to sell their shares directly on the public markets.

By using a direct listing instead of a traditional IPO, companies aren't raising any new capital, as they do in a traditional IPO. Rather, it simply creates a public market for existing investors' shares.

What is a direct listing?

Generally, when a company wants to do an initial public offering, or IPO, they will hire one or more underwriters. Think major banks with investment banking operations like Goldman Sachsor JPMorgan Chase. These underwriters essentially facilitate the process -- determining the initial offering price, dealing with regulatory issues, and selling the shares to the initial investors.

On the other hand, a direct listing, also known as a direct public offering, or DPO, is a process by which the company sells its own shares directly to the public. There are no underwriters involved. In simple English, the company's existing shares are listed on an exchange, and people who own them, such as the company's existing investors, can choose to sell their shares directly on the public markets.

By using a direct listing instead of a traditional IPO, companies aren't raising any new capital, as they do in a traditional IPO. Rather, it simply creates a public market for existing investors' shares.

Why might Slack want to pursue this route?

According to The Wall Street Journal, citing people familiar with the business, Slack has significant cash on its balance sheet, which explains why it wouldn't need to raise capital in an IPO.

If a company doesn't need to raise new capital there are a couple of key advantages of a direct listing, such as:

• No need to pay underwriters or other third parties. This can be a major money-saver when compared with the traditional IPO route. The company still hires some advisors -- in fact, Slack is working with Goldman Sachs, Morgan Stanley, and Allen & Co. on the deal (the same advisors when Spotify directly listed its shares). However, the costs are significantly lower.
• There is no lock-up period, meaning that insiders don't have to wait a certain amount of time after the IPO before selling shares. Existing investors are free to cash out and sell their shares to the public on day one if they choose to do so. Slack was most recently valued at $7.1 billion after an August funding round, and insiders have indicated that the company's public listing could result in a similar valuation, so it's fair to assume that insiders could be in for a hefty payday when the listing is completed.

To be clear, there are some risks involved with a direct listing. In a traditional IPO, underwriters market the shares to investors and help establish an initial price. With a direct listing, the share price is largely governed by simple supply and demand dynamics.

When Spotify went this route in 2018, the process went smoothly and its efforts produced solid results as the company shares roughly maintained the IPO price. But Spotify was already a brand well known to the public, making it easier to sell to retail and institutional investors.

So, why might Slack have chosen the direct listing route? Most likely, it's because the company's immediate capital needs are met and management feels that there is enough public demand for its shares to support the stock price. And, the ability for early investors and other insiders to cash in some of their shares immediately likely doesn't hurt. It is yet to be seen whether the company will be able to capitalize on its unicorn status.

This article originally appeared in the Motley Fool.

Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.