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By: Wilmington Trust
The 2004 IPO of search-engine company Google Inc. caused quite a stir in the investment world. The company announced its intention to go public just as the IPO market began heating up again after a long lull. Because of the size and popularity of the firm - and its controversial decision to list its shares via a Dutch auction - investors and the media alike closely followed the Google IPO.
Google chose a Dutch auction in order to offer shares to as many individual investors as possible as well as let those investors set the price of the company's initial shares. That may have been a revolutionary concept in some circles, but not as different from the traditional IPO process as many think.
A private company "goes public" through an initial public offering, or IPO, which involves selling its stock on the open market for the first time. Companies become publicly traded in order to raise capital to expand the business, make acquisitions, and pay down debt.
The IPO process, called underwriting, involves hiring an investment bank to handle the offering, registering with the SEC, issuing a preliminary prospectus, and marketing the IPO to institutional investors in what is known as a "road show."
After the SEC approves the offering and an "effective date" - when the stock will be offered - is set, the investment bank and company management negotiate the stock price depending on market conditions and institutional investor interest.
Most of the IPO shares are allocated to large institutions, but individual investors can sometimes get shares if they have an account with one of the investment banks that is underwriting the IPO.
It is only in these last two steps - pricing and allocating the shares - that the Dutch auction differs.
The term comes from the auction method used to sell tulip bulbs in Holland in the 17th century. A Nobel prize-winning economist devised the actual pricing system. U.S. Treasury bills are also sold using this method.
Basically, a bidding process arrives at the lowest price at which the company can sell all the IPO shares. For example, Google investors submitted bids for a certain number of shares at the price they believed the shares were worth. After all the bids were made, Google used software to set the share price at the level investors were willing to pay for all 25.7 million shares and allocated those shares accordingly.
A Dutch auction usually prevents a first-day pop in the stock price, which is characteristic of IPOs that are priced in the traditional manner. While traditional IPO shares are often priced at a discount, the nature of a Dutch auction prices the stock close to its market value immediately. For example, shares of Google closed up 18% on its first day of trading - a modest increase compared to many past tech IPOs. The company made $1.8 billion from the sale.
Whether investors gain access to IPOs through traditional channels or via Dutch auctions, they should remember that initial shares carry more risk than stocks with a track record. Shares can be extremely volatile after an IPO as many investors immediately sell, or "flip," their shares to make a quick profit. Also, there is no stock research or Wall Street consensus on companies prior to an IPO, so conducting due diligence on an investment can be difficult.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.