Reading: Alternative Going Public Strategies

Important key considerations in the context of DPOs are:

Great Flexibility than IPOs

Because the issuing firms are not listed on a public stock exchange, their offerings are generally not subject to the stringent disclosure and transparency measures that the SEC or other stock market regulators impose on publicly listed firms. This offers the firms much greater flexibility to tailor the design, timing, and execution of a DPO.

Less Invasive Financing Terms than Private Equity

With a DPO, firms often invite a significant number of comparatively small investors to invest in the firm. These investors will generally have comparatively little power over the firm because it is rather unlikely that they act in a highly coordinated way. Therefore, even thought the original shareholders give away a certain fraction of the ownership, they often remain in control, both factually and actually.

This is in a stark contrast to what the firm might have to offer in return for an investment from a professional source of financing such as a private equity or venture capital fund. As we discuss in great detail in the module "Deal Structuring," these professional investors generally ask for preferential treatment in the allocation of the firm's returns, direct control rights, as well as the right to exit within a certain period of time.

Consequently, there would seem to be fewer strings attached to capital raised via DPO than to capital from professional investors.  At the same time, however, firms that rely on public capital will most likely not enjoy the benefits that are often ascribed to "smart" money from professional investors (e.g., management experience, network, etc.).

Additional Governance and Transparency Risks

The flipside of the lower (to inexistent) governance and transparency requirements is that it can impose additional risks on the investors:

• Governance risks: Often, the corporate governance structures of the issuing firms are less professional than those of listed firms, which could bring about significant key personnel risks, insufficient checks and balances, potential conflicts of interest, the risk of unequal treatment of shareholders, etc. 
   
• Transparency risks: Moreover, the financial statements are often not prepared in accordance with international accounting standards and, in many instances, they are also not subject to external auditing. Therefore, it is much harder to interpret and understand the issuing firm's financials, which, of course, makes it much harder to assess the "fair" value of its shares.

Information cost and Information Asymmetry

Because the investors who participate in a DPO are often comparatively small, they have limited incentives to produce information about the firm, as they would bear the full cost of that information search and share the benefits with all other investors.

These risks, combined with the fact that a DPO generally has no "underwriters" who actively inform the investing public and vouch for the issuer with their own reputation, increase the potential information asymmetry between the firm and the investing public. This gives rise to potential adverse selection and moral hazard problems:

• Adverse selection: One concern could be that DPOs attract firms that fail to pass the rigoros screening of the SEC or large professional investors such as private equity or venture capital funds. As a consequence, the population of firms that opt for a DPO could be of lower average quality.
  
  
• Moral hazard: because there is less transparency, and generally less oversight by investors or financial analysts, it could also be that issuing firms change their behavior once they have received the funds ("take the money and run"). For example, they could invest in projects that are more beneficial to the managers than the shareholders. 

any of these specific challenges that are associated with information asymmetry have already been discussed in the context of direct listings. These challenges will tend to be even more pronounced for the typical DPO because of the weaker regulatory framework.

Lack of Liquidity

Finally, lack of liquidity could be a concern. For the investing public, the key questions are if and how they will ever be able to sell the shares at a later stage. Unlike professional investors, the investing public often has little if any say in key strategic decisions, and they do not have contractual rights to force the firm into a liquidity event.

Especially in firms where a large part of the equity is controlled by insiders, the path to liquidity is often less than clear. The result is that potential investors might shy away from participating in a DPO—or they subject the firm's valuation to a discount for lack of liquidity. 

For many firms, a DPO could therefore be constitute an intermediate step to a stable long-term financing policy. In some instances, it could be that the firm will follow up with a direct listing to offer its shareholders the opportunity to liquidate their investment. In other cases, it could be that the firm uses some of its operating cash flows to feed a liquidity pool that facilitates trading among shareholders and, thereby factually acts as market maker.