On August 19, 2004, Google issued 19.6 million shares using a modified Dutch auction. The use of a Dutch auction to float such a large number of shares in the United States is completely unprecedented. Professor Laurie Simon Hodrick, who has done extensive research on Dutch auctions, analyzes the lessons learned from the Google Dutch auction initial public offering (IPO).
|
HOW A DUTCH AUCTION IPO WORKS The term Dutch auction refers to the price determination mechanism developed more than a century ago to trade flowers in the Netherlands. The key difference between a Dutch auction IPO and a typical firm commitment underwriting is that in a Dutch auction the clearing price is determined by investor demand, as revealed through the bidding process, rather than set in advance by the underwriters. Once the bids are collected, they are aggregated to create a demand curve for the shares. In a standard Dutch auction, the clearing price is determined as the highest price at which the firm can sell the prespecified number of shares. This clearing price is then paid by all who submitted bids at or above the clearing price. If there is excess demand at the clearing price, the shares are sold pro rata (in equal proportion to the bidding) to all investors who bid at or above the clearing price. |
Much of the analysis throughout the Google IPO process has concluded that the Dutch auction is a flawed way to float shares. I strongly disagree. Executed correctly, the Dutch auction provides an efficient and effective mechanism that endogenously determines a share price where supply equals demand. So why is criticism of the Google Dutch auction rampant?
Regulatory and Market Challenges
Critics of the Dutch auction argue that it is flawed because Google encountered regulatory and market challenges during the IPO process. It is important to note that many of the hurdles faced in the Google IPO would still have been problematic had Google instead chosen to use a standard firm commitment underwriting. Specific missteps, such as the failure to register employee share distributions with the SEC and the Playboy magazine interview, as well as a deteriorating equity market, as evidenced by both numerous canceled IPOs and a decline in technology stock valuations, would all have detracted from the Google IPO irrespective of the auction mechanism chosen. These challenges, and not the Dutch auction, were sources of downward pressure on the offer’s demand.
The Offer Price
Critics also argue that the Dutch auction is flawed because Google reset its offer range from $108–$135 per share to $85–$95 per share. I consider the fact that Google reset its price range to be a strength of the Dutch auction, not a weakness. Rather than forcing Google to commit to a clearing price, the Dutch auction provided Google with the ability to set a price such that supply equaled demand, based on investor demand as revealed through the bidding process.
If a Dutch auction allows firms to set a market clearing price, why did the Google price pop from $85 per share to $100.34 per share on the first day of trading on the Nasdaq? Although the Dutch auction gave Google the ability to set a market clearing price for its shares, the modified Dutch auction as described in the prospectus did not require Google to do so. Google chose to go public at a price with unsatisfied demand. Further, if Google had been willing to commit to how its clearing price was to be determined, investor uncertainty would have been reduced.
Small-Investor Participation
Critics further argue that the Dutch auction is flawed because it failed to democratize the IPO process, denying promised access to the smaller investor. These critics blame the complexity of the Dutch auction. In fact, many investors that historically had been precluded from participating in hot IPOs did have the possibility of buying into the Google IPO. While the offer was not accessible to everyone, the limitation on small-investor participation arose at the underwriter level and was based on the underwriters’ interpretation of SEC restrictions that protect small investors from making unsuitable investments. The barrier to entry was not the auction’s complexity: small investors who were provided with access typically did not find the bidding complicated. Further, the fact that many of the trades on the first day were small lots contradicts the assertion that all small investors were denied access.
A Lesson from Stock Buybacks
Firms in the United States have successfully used Dutch auctions to repurchase their shares since the early 1980s. The firms pioneering this method of repurchase also faced investor confusion about the auction at first. My research shows that, over time, the auction design was improved and the market learned to appreciate the advantages of the mechanism so much that the Dutch auction has actually supplanted the fixed-price tender offer, which parallels a standard IPO offer, as the most common way that firms buy back significant blocks of shares in the United States.
The Future of Dutch Auction IPOs
Had the Google IPO been viewed as an unambiguous success, there is no doubt that it would have been followed by a flood of additional Dutch auction IPOs. Given the controversy now surrounding its outcome, what can we expect in the future? I expect to see noteworthy Dutch auction IPOs executed in the future, though at a slower rate of adoption than if the outcome had been an indisputable triumph. In my opinion, the future use of the Dutch auction for IPOs was never predicated on the success of this particular deal. A lesson from the history of firms using Dutch auctions for stock buybacks is that improvements will be made in the execution of future Dutch auction IPOs. What potential issuers should learn from the Google IPO, most of all, is that a Dutch auction works, if you let it.
Laurie Simon Hodrick, professor of finance and economics, is known for her groundbreaking research on corporate finance, which earned her the National Science Foundation Presidential Young Investigator Award. She has also received many awards for teaching excellence, including the Singhvi Prize for Scholarship in the Classroom at the School. Her commentaries about the Google IPO appeared in such media outlets as the Financial Times, the Washington Post, USA Today, PBS’s Nightly Business Report, CNBC’s Street Signs, the BBC’s World Business Report, NPR’s Your Money and Bloomberg’s Big Picture.
