Are Dutch Auctions Right for Your IPO?

by Nayantara Hensel

Editor's note: Google's decision to launch its 2004 IPO via a so-called Dutch auction process has caused a pause in many companies considering their own IPOs. After all, shares of the Internet search engine provider soared and remain high today. But is Google a special case? Would some IPOs fare better than others in a Dutch auction?

IPO expert Nayantara Hensel (Harvard College '97; HBS PhDBE '01) offers her opinion on IPO auctions, highlighting pluses and minuses of a process whose ramifications are still not perfectly understood. She is an assistant professor of finance and economics at the Graduate School of Business and Public Policy at the U.S. Naval Postgraduate School. Previously, she was the primary economist for Ernst & Young's litigation group, and worked on many of the cases of IPO manipulation during 2001-2003.

Google's controversial IPO last year generated much interest not only because of its global name recognition, but also because of its use of the Dutch auction method in pricing and selling its offering. While the IPO was seen by some as a success—the company's shares today are selling near $200—a closer examination of the results raises questions about the benefits of the auction process to issuing companies. What can companies considering IPOs learn from the Google experience?

Was Google efficiently valued?
One of the supposed benefits of the Dutch auction process, which Google used in its recent IPO, is its alleged minimization of the increase between the offer price and the opening price of the offering. From the perspective of the issuing company, this price increase represents "money left on the table" and, therefore, value which it did not appropriate.

In the traditional IPO allocation process, investment banks in charge of the IPO take the issue on a "road show" to various possible investors (often large mutual funds or preferred clients of the investment bank) to determine the appropriate price for the IPO. In return, these investors often receive the initial allotments of IPO shares and benefit from the price appreciation imbued in the increase between the offer price and the open price.

Unlike the traditional method, in which only the institutional and sophisticated investors are involved, the Dutch auction method enables small investors to participate in the pricing by posting the price that they are willing to pay and the number of shares that they wish to purchase. The final price of the IPO in a Dutch auction is the lowest price at which all of the shares are sold. The role of the investment bank as the middleman is minimized. Proponents of the online process argue that the value of the IPO goes to the company which is going public, rather than to the favored clients of the investment bank.

The performance of Google in August 2004, however, does not suggest that the online auction process served as an efficient pricing mechanism since the increase between Google's offer price and its open price was much greater than the increase for typical IPOs in 2004. This should raise significant concerns for companies considering using the auction process for their IPO.

The offer to open price increase represents value which the issuing company could have appropriated if the IPO had been adequately priced. Google's offer price was $85 and it opened at $100, reflecting a 17.6 percent increase; 83 percent of the IPOs issued between January and November 2004 experienced less of a jump from the offer price to the open price than Google did. Furthermore, Google's offer to open price increase exceeded that of IPOs in its peer group: IPOs in the Internet search arena in 2004 (excluding Google) exhibited average price growth from the offer price to the open price of 10 percent. Furthermore, Google's $85 to $95 target price range was a reduction from the initial target price range of $108–$135 range projected in late July.1 At that time, many analysts suggested that the earlier Google price range had been overpriced; yet, Google's closing price reached the lower end of that price range after 18 days of trading and reached the higher end of that price range after 32 days of trading.

The enormous post-auction price increase of the stock, especially in the absence of substantive news releases on strategy changes, further suggests that the online auction method did not efficiently price Google. Shares opened at $100, closed at $100.33, and then subsequently soared in the following months to a high of $216.80. As of the end of the first week in December, Google had exhibited price appreciation of 78.8 percent; this was higher than the average price appreciation for 94 percent of the IPOs issued between January and November 2004. Google's price appreciation was, however, roughly comparable to that of other Internet search IPOs, which exhibited, on average, 73.3 percent price appreciation. It is significant to note, however, that 50 percent of the Internet search IPOs came out in October and November, after Google's debut, so their price spiral may have been driven, to some degree, by post-Google enthusiasm.

Sources of the problem
What are some possible explanations for the mispricing of the auction process? One explanation is that the small investor, who is supposed to be a primary participant in this auction, may lack access to sufficiently detailed information sources to appropriately price the security based on fundamentals, rather than on name recognition. This potential problem is compounded by the lack of information that the online process (in contrast to the traditional IPO process) requires to be disclosed.

A significant criticism of Google throughout the process was that it was "secretive" in how it would use its funds and conveyed little detailed information in its briefing at the Waldorf-Astoria Hotel in New York.2 Google faced several strategic issues which, in the absence of more detailed information on the uses of the capital to be raised, may have been difficult for the smaller investors to evaluate. For example, unlike Yahoo and Microsoft, Google is not diversified in its revenue sources, and relies primarily on online advertising, rather than other subscription-based services, or on additional entertainment and news offerings on its site.3 Consequently, Google's position could be damaged if Microsoft successfully develops a rival search engine. Furthermore, if economic growth slowed, expenditures on Internet advertisement spending could fall due to their procyclicality, which would hurt Google since Internet advertisement spending is key to its profitability.

A second explanation for the mispricing is that, due to the less rigorous scrutiny by investment banks and the consequent reduction in information provided by the issuing firm, the auction process could be used more by companies that may not have a clear sense of the uses for the funds that they are raising. This may lead to an initial risk aversion on the part of investors, and a consequent discounting of the initial offer price. (Morningstar's decision in January to use the IPO auction process is seen by some as consistent with this theory. The company last year was the subject of an SEC investigation concerning inaccurate data on its Web site, and the agency as well as New York State Attorney General Eliot Spitzer began looking into possible conflicts of interest over Morningstar Associates' recommendations.4)

A third explanation for Google's mispricing and the initial reduction in its target price range may have been cautiousness on the part of investors over the online auction process in general. Although online auctions have been used for IPO issuance since 1999, there have been few well-known companies that have used this method. The reduced price range may have made investors feel as though Google were "on sale," and this greater desire to purchase may have later placed upward pressure on the price. In addition, subsequent aftermarket purchases of hedge funds and institutional investors who had sat out the auction process may have contributed to the price spiral. It is unclear whether this type of effect will manifest itself with subsequent IPOs.

What can an issuing company do?
Here are some things for an issuing company to consider to ensure efficient pricing of its auction IPO.

Mispricing can occur due to: (a) lack of information on the part of the small investor; or (b) a perception on the part of the investors (which may or may not be true) that the process is used by firms which would be unsuccessful using the traditional route. The primary solution to these problems is issuance of explicit information on the uses of the capital being raised, the corporate governance structure of the new firm, and the solutions that the new firm has for combating potential challenges.

In addition, firms should discuss why they are using the online auction process relative to the traditional IPO process, in order to reduce the adverse selection problem inherent in online auctions and to enable investors to more effectively sort out any "lemons."

The recent SEC proposals to liberalize the "quiet period" will make it easier for firms to provide investors with information. During the quiet period, companies traditionally have been allowed to provide information in oral presentations, but not in written form (except for the company's prospectus). This rule provided an informational advantage to institutional investors, since small investors are less likely to be able to attend company presentations. The greater involvement of the small investor in pricing online auctions could have further exaggerated the impact of this informational asymmetry in the online process relative to the traditional process. Furthermore, smaller and less well-known companies doing IPOs were handicapped to a greater degree than larger, more well-known companies by their inability to use the media and the Web during the "quiet period" to generate interest.

In late October 2004, the SEC voted to liberalize these rules by allowing companies planning an IPO to communicate information to investors verbally or in writing, provided that this information would be filed with the SEC.5 Indeed, the SEC has also proposed to allow the marketing "roadshows" of IPOs to be broadcast online to all investors.6

Companies considering using the online auction process for an IPO should be interested in which parties are likely to benefit from mispricing, should it occur.

Unlike the traditional process, initial shares are not necessarily allocated to preferred clients of the underwriting investment banks or to institutional investors. In the case of Google, the beneficiaries in the price appreciation have been: (1) those investors who bought Google when it first began trading and held it until the price increased substantially and (2) the Google co-founders and the chief executive, as well as the venture capital firm involved in financing Google, who were allocated shares early in the process, but who could not sell them until the "lock-up period" expired.

The Google co-founders and the chief executive announced, at the end of November, their plans to sell 16.6 million shares over the next 18 months. Indeed, two vice presidents sold 55,000 shares of Google in late November for $9.5 million. The lock-up period on 39 million Google shares expired in the third week in November, and over the following three months, the lock-up period expired on 227 million shares. The venture capital firm involved in financing Google, Kleiner Perkins Caulfield & Byers, distributed shares to 200 investors, including twenty institutions and individuals who invested in its Fund IX-A, on the day that IPO restrictions ended on some of its Google holdings.7 From the perspective of the issuing firm, some transfer of value to the firm's owners and initial venture capital investors may provide good incentives for management. Consequently, although the online auction process may not minimize the increase between an IPO's offer price and its open price, the company's management and initial investors (and, indirectly, the company itself) still benefit.

Conclusion
The online auction process is full of advantages and disadvantages from the perspective of the issuing company. On the one hand, it increases the ability of small investors to participate in the IPO process, and minimizes the traditional dominance of larger institutional investors who were lucrative clients of the underwriting investment bank. On the other hand, small investors may lack the ability to efficiently price an IPO due to lack of information. This information gap could arise because small investors lack access to the sources that institutional investors have, or because companies are not required to provide detailed information in the online process.

Furthermore, investors could discount an IPO issued through the auction process by perceiving it to be a company that may not have a clear sense of the uses for the funds that it is raising, or that may have done poorly using the traditional IPO issuance processes. Although the online auction process certainly provided publicity for Google's IPO, which may have stimulated the interest of small investors and others who are normally less involved in the process, it is unlikely that it would have generated this benefit for a less well-known IPO.

One of the principal advantages of the online auction process is supposed to be that the increase between the offer price and the open price of an IPO is minimized, providing the issuer with greater value. Although this did not occur in the case of Google, the management and venture capital firms did benefit from the ultimate high valuation that the markets placed on Google stock. It is unclear if a less well-known company, once it experienced underpricing relative to its true value, would enjoy the price spiral that Google achieved.

On the other hand, the traditional process leaves much to be desired. With the recent Spitzer probes into a variety of extensive and common business practices ranging from "bid rigging" in the insurance industry to market timing and late trading in the mutual fund industry, the confidence of the public in traditional processes may be at a low ebb. Many of the informational problems inherent in the online process can be overcome by issuing firms if they are willing to provide detailed information to investors. Managers of issuing companies should be explicit about: (1) the uses for the capital that they are raising; (2) the transparency of their corporate governance structures (including the number of outsiders on their board of directors); (3) the potential challenges that they face and how they would overcome them; (4) the reasons why they are using the online process as opposed to the traditional process; and (5) their involvement in current or future litigation enquiries.

As managers of issuing companies react to the lessons from Google and other online IPOs, the transparency of the process will increase. Investors will become less skeptical of the types of companies using the process, and the pricing of the IPOs may become more efficient. This, in turn, will make it easier for smaller, less well-known firms to generate interest in their IPO.

As involvement of investors and issuers broadens, the online process will become a more egalitarian and transparent alternative to traditional processes for providing new companies with capital. But, the first step in this cycle is understanding and learning from the experience of Google and other online IPOs.

Copyright 2005 Nayantara Hensel.

Nayantara Hensel (Harvard College '97; HBS PhDBE '01) is an assistant professor of finance and economics at the Graduate School of Business and Public Policy at the U.S. Naval Postgraduate School.