Google, the company that has become synonymous with Web search, is going public. This is not only a major event for the high-tech community, but it has become a bellwether for the investment banking industry, the markets and even the economy. Not too much pressure here?
But like Google itself, they are not going public through the normal run-of-the-mill underwriting and investment banking process. Google has announced its intention to go public through an electronic Dutch auction. For those unaware, a Dutch auction aligns bidders from highest to lowest price and allocates shares accordingly. At the point where all shares are assigned, all of the allocated shares are allotted at that lowest price (the order where the allotted shares ran out). For example if bids were received at prices ranging from $100 through $50 but the last share was allocated at a price of $80, all of the shares would be priced at $80, even if the top bidder was willing to pay $100.
The Dutch auction is a very fair auction process. It incents high bidders, as they are rewarded for their biding by receiving their allotment the lowest accepted price. It also reduces bidder's remorse, the act of bidding high, winning and feeling anxiety for overpaying. A feeling anyone with a winning bid on eBay has most certainly felt. This format is also fair for the seller, who uses it because they generally have significant product and are looking for bidders to push the price up.
Why a Dutch Auction?
While the Dutch auction is a preferred format for many fixed income products, very few equity offerings are underwritten in this manner. WR Hambrecht & Co. developed a Dutch auction format for Open IPO, an online underwriting technology developed in the height of the Internet boom and .com craze.
WR Hambrecht's Open IPO in 1999 was going to revolutionize the equity underwriting business. William Hambrecht was one of the two founders of Hambrecht & Quist (later acquired by Chase Manhattan), that created one of the major high technology investment banking boutiques that funded the Internet boom. After the Chase acquisition, Hambrecht left.
William Hambrecht believed that the underwriting process was inherently unfair. It was dominated by large investment banks and institutional investors who benefited from keep banking fees high, and distribution centralized. This had the impact of capping the amount of money raised by companies, and keeping shares out of the hands of individual investors.
Given these inherent problems, Hambrecht's' pedigree, and the largest underwriting boom of all time, if anyone was going to solve this challenge WR Hambrecht was and Open IPO was the product.
Never the success it was supposed to be
Open IPO by all accounts was an abject failure. During 1999 and 2000 not quite the height of the IPO boom " but certainly before the bust, Open IPO only managed to execute three IPOs in 1999 and one IPO in 2000 compared to the 1,028 IPOs of 1999 and the 884 IPOs of 2000.
Why was the Dutch auction failure? Was it the industry, a problem with the auction philosophy, a marketing problem, or an inherent problem with the underwriting process?
The problems with the Dutch auction was inherent in the process, the players, and the times. The first major problem was the era. It was the go-go 90s, a period of wealth " vast quantities of wealth, not just Mercedes, Porsche's, and Lexus's but Ferrari's, Maserati's and Lamborghini's. Everyone wanted wealth, and an IPO almost certainly guaranteed it. Almost daily we would see another IPO doubling, and founders walking away from the process with not just millions, but tens or hundreds of millions.
The auction process inherently challenged wealth creation. Company's don't get wealthy, people do. An auctioned IPO goes to the highest bidder, where supply meets demand. When stock is issued at equilibrium pricing, there is no price pop. The stock does not rise 100% on the first day of trading and while the company receives more for its offering, the people receiving the initial allocation pay more and receive less. This dissuades venture capitalists from taking risk, investors from funding IPOs, and investment banks from needing bankers. It was in everybody's interest to keep the cycle going.
However on one in March 2000 the game stopped. Morgan Stanley's Mary Meeker said the market was too high, and that was that. The market cooled off, IPOs evaporated, and investment banking dried up.
Why Google Why Dutch?
With all this bad history, why is Google proposing to use the Dutch auction format, especially for an offering hyped to be the resuscitator of the high-tech world after four years of fibrillation?
First, investment bankers and banks have been forced to clean up their act. Over the past four years, the banking industry has been raked over the coals by litigators and regulators for extremely poor underwriting and IPO practices. Besides the fines and the bad press, the bad publicity keep coming as just last week Frank Quattrone, a major figure of the 90s high tech boom was convicted of obstruction of justice in regards to investment banking practices.
Second, the Google offering is not a straightforward IPO. In Google's attempt to maintain control, they are offering multiple classes of stock, restricting voting rights, disclosing that they will not be managed to quarterly results, and are making some very investor-unfriendly statements.
While these statements may sound great to Google patrons, employees, and founders, it probably will not play particularly well with large, conservative, institutional investors, who especially after being burnt on many 90s dot-coms may not want to participate in the offering. This however, may not impact demand for the offering, as the hype and the ubiquitous nature of Google, will mean wide individual investor support.
A challenging environment
Low institutional and high individual turnout would create a challenging environment for a traditional underwriting. A traditional deal would force the investment bankers to price the issue low to incent intuitional investors, scared away by the prospectus and investor un-friendly covenants. Once released in the aftermarket, however the offering could very easily be pushed up by retail investors looking to buy the next Internet icon.
This would create a large price pop scenario, which in 1999 this would be great, however, in today's market is not. Investment banks do not want to get blamed for hyping another Internet stock, having it shoot through the roof and having it crash when institutional investors back away. And once the firm misses a few quarterly projections " because "they won't be managed quarter-by-quarter," it may get very dicey.
A Stroke of Genius
By moving toward an auction format, opening the underwriting to individuals, and allowing the market to price the stock instead of the investment bankers allows the investment bankers to take a more hands off approach and say "don't blame us, we just facilitated." This way the bankers put everything in the prospectus, force investors to be qualified, let investors set the price, and take a hands-off approach to both price setting and distribution.
Using the Dutch auction format the regulators and litigators will have a more difficult time charging that the bankers manipulated the price (either high or low), closing individual investors out, or in some way being responsible for having the price pop or crash. It is a very smart plan especially in this litigation / regulation-prone environment.
Will All Banking Go Dutch?
I believe that while the Dutch auction format may be well suited for this deal, that we will not see the collapse of the traditional investment banking process, format, or technology. Google, as its founders truly and freely admit is different, and while different and being a trendsetter in the search space is great, being different and a trendsetter through corporate governance many not. While the Dutch auction may be perfect for Google, if it were my more traditional company, I would be searching for a second opinion.