Direct Listings May Pose Challenges for Cash Intensive Life Sciences Companies

Are direct listings a viable potential alternative for all companies seeking to go public?  The answer may likely be no, especially for early stage life sciences companies that are not household names.  In this Insight, we analyze some key terms of a direct listing that may prove insurmountable for some life sciences issuers – and how the landscape may be changing in the future to potentially open this door to life sciences issuers (or other cash-intensive companies seeking to go public).

As counsel to life sciences companies developing important drug, gene therapy, device and other novel therapies, we are often asked to be as innovative as the companies we represent – especially when it comes to financing events.  As direct listings have become the newest talking point for all capital markets practices (disregarding that only two have actually been completed to date), life sciences companies have started to explore this alternative route to the traditional IPO. However, the current pathway for direct listings may not enable this method of taking a company public to be a viable option for life science companies looking to go public.  Life sciences companies have been increasingly accessing the public markets, and doing so earlier in their life cycles.^[1] Generally, going public provides a company with optionality to use the public markets to raise cash, typically lowering its cost of capital and increasing flexibility in capital strategy and planning.  Investors have been willing to accept clinical trial execution and regulatory approval risk in return for the potential upside upon a product candidate’s eventual commercialization, thus making the public markets an attractive avenue for early stage life sciences companies. Going public therefore is an attractive proposition to many pre-commercialization and research and development life sciences companies.

For a bit of background, a direct listing is the listing of a privately held company’s stock for trading on a national stock exchange (either Nasdaq or the NYSE) without conducting an underwritten offering, spin-off or transfer quotation from another regulated stock exchange. This lack of capital-raising (at least as currently formulated on Nasdaq and the NYSE) means direct listings may not be a viable option for life sciences issuers, which often utilize an underwritten initial public offering to raise funds to continue development of their products prior to regulatory approval and subsequent commercialization. Under stock exchange rules as of the date of original publication of this article, direct listings involve the registration of a secondary offering of an issuer’s shares on a registration statement on Form S-1 (foreign private issuers are not covered for purposes of this article) or other applicable registration form filed with, and declared effective by, the Securities and Exchange Commission (the “SEC”). Existing stockholders, such as employees and early-stage investors, whose shares are registered for resale are able to sell their shares on the applicable exchange. This provides these stockholders flexibility and value by creating a public market and liquidity for the company’s stock, but also does not obligate the stockholders to sell. Upon listing of the issuer’s stock, the issuer becomes subject to the reporting and governance requirements applicable to publicly traded companies, including periodic reporting requirements under the Securities Exchange Act of 1934, as amended, and governance requirements of the applicable stock exchange.

There are a number of likely advantages of a direct listing as compared to a traditional IPO, but many of these advantages may not be as applicable to life sciences issuers as compared to more recognizable late stage technology companies. First, all stockholders whose shares are registered as part of the direct listing will be able to participate in the first day of trading of the issuer’s stock. Stockholders who choose to sell are able to do so at market trading prices, rather than only at the initial price to the public set in an IPO, which can be a significant benefit to existing stockholders who elect to sell. However, this benefit assumes there is sufficient market demand for the shares offered for resale, which may not be the case for life sciences issuers who are likely unknown to the general public and have significant cash burn in advance of regulatory approval and subsequent commercialization, all prior to any potential revenue generation for the company.

Next, the traditional IPO process includes a limited set of market participants, and institutional investors tend to feature prominently in the initial allocation of shares to be sold by the underwriting syndicate placing the securities. In a direct listing, any prospective purchasers of shares are able to place orders with their broker-dealer of choice, at whatever price they believe is appropriate, and such orders become part of the initial reference price-setting process.  Again, life sciences issuers may not be able to take advantage of this benefit because of the potential lack of prospective purchasers and perhaps lack of broker-dealers willing to assist such prospective purchasers.

Additionally, a direct listing allows a company to avoid the rigidity of the traditional roadshow conducted for a specified period of time following the publicly announced launch of an IPO and allows it to tailor marketing activities. These marketing efforts may include one or more investor days and a roadshow-like presentation, conducted at advantageous times, subject to the requirement that the registration statement for the direct listing must still be publicly filed for at least 15 days in advance of any such event. Although the approximate timing of the direct listing can be inferred from the status of the publicly filed registration statement, the company may have more flexibility as to the day its shares commence trading on the applicable stock exchange. This would be a benefit to life sciences issuers as they would be able to interact with potential investors in a less formulaic manner – something companies developing products with the potential to assist those with health issues will be able to utilize to a potential great extent.

Of most significant consequence for life sciences issuers considering a direct listing, companies, to date, have not raised capital as part of the direct listing process and are not currently able to do so due to the existing rules governing such listings by the NYSE and Nasdaq. Without the ability to raise capital as part of going public, most life sciences issuers will not view a direct listing as a viable potential alternative to a traditional IPO because going public is viewed as a significant fund raising opportunity by these companies. Cash intensive businesses like development stage life sciences companies are constantly in need of capital to enable its development activities prior to commercialization – the opportunity to raise capital as part of becoming a public company to access the capital markets in most cases will be too much of an opportunity to pass up, especially considered along with the other potential challenges faced by doing a direct listing for these companies.

Direct Listing Terms and Challenges for Life Sciences Companies
Direct Listing Term	Challenge for Life Science Company
Stockholder participation on Day 1 of being public	Potential lack of demand for company unknown or marginally known and have significant cash burn in near-term
Broadly distributed market participants early on in public life cycle	Potential lack of prospective purchasers and/or broker dealers willing to transact
Current lack of ability to raise capital in conjunction with direct listing (noting that the NYSE has proposed rules to allow simultaneous offerings)	Cash intensive life sciences companies utilize traditional IPOs as significant fund-raising event   Even if proposed rule change approved, life sciences companies may still face challenges because setting a reference price on day one will likely prove difficult without the benefit of a large secondary market for reference; however, the ability to raise capital as part of the process may be the key to enabling direct listings to be more available to certain issuers under the right circumstances with the right profile

 

The NYSE recently proposed changes to its rules that would allow a primary offering along with, or in lieu of, a direct secondary listing. ^[2] The NYSE’s proposal would allow a company to sell shares on its own behalf, without underwriters, in addition to or in place of a secondary offering by stockholders. Under the NYSE’s proposal, companies hoping to conduct a primary offering while pursuing a direct listing would have been required to alternatively sell at least $100 million in the opening auction on the first day of listing or the aggregate market value of publicly held shares immediately prior to listing and the market value of shares sold by the company in the opening auction is at least $250 million.

In a traditional IPO, the preliminary prospectus contains a price range of the anticipated initial sale price of the shares, which is set by the underwriters following discussions with potential institutional investors. By contrast, in a direct listing, the initial reference price (which is the current market value on the first day of trading) is derived by buy and sell orders collected by the applicable exchange from broker-dealers willing to participate in the transaction. These buy and sell orders have been largely determined with reference to high and low sales prices per share in recent private transactions of the subject company. In cases where a company does not have such transactions to reference, which would be the case for most, if not all, early stage life sciences companies, additional information will be necessary to educate and assist investors and help establish an initial bid price. The likelihood of such additional information being available or advisable to disclose would be minimal in most cases due to the likely lack of scientific knowledge or variety of unknown factors, including clinical trial length and general regulatory uncertainty. However, the ability to raise capital, if approved, could potentially mean that the door is open for life sciences issuers to pursue a direct listing should the circumstances align.

On March 26, 2020, the SEC instituted proceedings to determine whether or not to approve the NYSE’s proposed rule, with comments due 21 days from the filing of the order in the Federal Register.  Nasdaq is expected to introduce a similar proposal in order to allow it to best compete with the NYSE as the direct listing practice evolves.

Direct listings will continue to be a potential alterative to the traditional IPO and will likely continue to gain traction as early stage investors pursue liquidity without the pricing and other drawbacks of traditional IPOs. Although direct listings will provide new opportunities for companies with a well-recognized brand name or easily understood business model, direct listings should not be expected to replace traditional IPOs in the near future for life sciences issuers. Any life sciences (or technology) company considering the public markets is encouraged to carefully consider the risks and benefits of a direct listing in consultation with legal counsel and financial advisors.