IPO Dutch Auctions Vs. Traditional Allocation

By: Ari Weinberg, Forbes

Business as usual just doesn't fly at Google. And now the Mountain View, Calif.-based Internet company is trying to export that mantra to Wall Street. Google's $2.7 billion initial public offering, to be priced through an electronic auction, will test the large-scale viability of a so-called Dutch auction, designed to both democratize IPO share allocation and afford companies and early investors the best price for their shares. While Google's offering is being underwritten by Morgan Stanley (nyse: MWD - news - people) and Credit Suisse First Boston, a unit of Credit Suisse Group (nyse: CSR - news - people), these types of public offerings have been a specialty of San Francisco-based WR Hambrecht, which holds a patent on the process for its OpenIPO.

"It's definitely the biggest story here," says Ryan Jacob, manager of the $69 million Jacob Internet Fund (JAMFX). Jacob, whose fund has not yet participated in an OpenIPO, says investors must be mindful that "the auction process is designed for the seller to get the best price."

In a Dutch auction, a company reveals the maximum amount of shares being sold and sometimes a potential price for those shares. Investors then state the number of shares they want and at what price. Once a minimum clearing price is determined, investors who bid at least that price are awarded shares. If there are more bids than shares available, allotment is on a pro-rata basis--awarding a percent of actual shares available based on the percent bid for--or a maximum basis, which fills the maximum amount of smaller bids by setting an allocation for the largest bids.

This method of IPO allocation can create an instant windfall for insiders by encapsulating as much market demand into the offering price as possible. And for young and growing companies, an auction allows the company to raise as much cash as the market is willing to afford it. But if the initial market demand is not there, a company putting its faith in the auction could miss out on the support of a traditional offering.

"Bankers are out there actively marketing the offering," says David McAdams, an associate professor at the MIT Sloan School of Management. "Some institutions require more attention."

And for this reason, Hambrecht's OpenIPO process is not entirely unguided. Companies still embark on a banker-led road show for major institutional investors, but the bidding and price discovery is automated. A representative for Hambrecht would not comment on whether the company or its auction-technology will be used for Google's auction. Patrick Byrne, chairman and chief executive of Overstock.com (nasdaq: OSTK - news - people), selected the OpenIPO process for his company's May 2002 IPO.

"A lot of pressure was brought to bear by going with Hambrecht," says Byrne, who believes that competing banks shorted his company's stock prior to a July 31, 2002, Wall Street Journal article in order to sully the auction's effect. The company's stock, which now trades for $37, went from $14.50 to $7.80 during that month.

In early April of that year, the company's regulatory filing revealed an expected pricing between $12 and $16. Bids were accepted from May 6 to May 29, and the offering priced at $13, with bidders receiving 60% of their desired allocation. The only selling insider in that offering was Amazon (nasdaq: AMZN - news - people), which then owned 7%.

Byrne says the current row of investment bankers is "like a cartel trying to make sure all members stand shoulder to shoulder. We always knew it would take someone like Google to break it."

Goldman Sachs (nyse: GS - news - people), often looked to as the top underwriter for quality offerings, is believed to have refused association with Google's offering. But Goldman's stance and the unwillingness of other firms could help create a hybrid for IPOs--mixing an auction with dealer-supported pricing.

"There can always be a reserve price," says MIT's McAdams. "There's an important tradeoff in attracting enough investors and discovering what the price will be."

Jacob notes that Google's regulatory filing also gives the company and its bankers just this type of wiggle room. By noting that the bankers will consider the validity of certain bids and the prices bid by institutions, "they went out of their way to give themselves flexibility," says Jacob.

But whether it's what the market and investors really want, no one knows.

Source:

1