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‘Dutch’ Customs with Familiar Values Make For Unmatched Bedfellows


The act of “going Dutch” implies for one to pay for him/herself (or to provide for one’s own expenses) when in a group setting in order for financial cohesion to exist: The recent actions behind Facebook’s (NASDAQ: FB) less- than- stellar entrance into the market has brought forth the resurgence of a debate that involves the financial and strategic issues found in the traditional initial public offering (IPO) process versus a rather contemporary approach known as a Dutch auction.

Since the presence of online retail brokerages have broadened the ways that companies can raise capital, the need for private companies to go public has diminished.  This is evidenced by the fact that during the Internet Bubble (1996-2000), the average number of IPOs per year was 539 (the average pre-bubble was 520/year), and post-bubble (data from 2001-2008), the average number has dropped to 134 per year, a third of its former size.  This notion was also coupled on the basis of online brokerage firms experiencing tremendous growth in the number of new accounts in 2008, and, presently for companies such as Charles Schwab (NYSE: SCHW) who “were able to participate in 81 stock IPOs in the first ten months of 2010” when most of your average investors are not as lucky to get in on the deal. This helped in signaling a shift in the IPO market.  However -not to be misled- your “average” investor in most cases needs a minimum of $100,000 in assets just to participate in the secondary offerings and a minimum of $500,000 in certain assets to be a participant in the first round of offerings, as indicated by Fidelity’s(NYSE: FNF) investment requirements.

Nonetheless, when a company does decide to go public, the steps are fairly simple yet time-consuming.  Because of the ease of access to otherwise hard-to-reach investors, particularly if you’re a small company under $25 million, management now has the choice to either have an investment banking firm conduct the IPO or the company could decide to do it through direct means by way of an auction.  Thanks to the shift (or un-thanks, however you choose to view it), what was the key principle for any successful IPO was that a company had to have strong pre-IPO financial performance. However, in regards to those companies that were highly promoted as having strong valuations, the preceeding IPO follies have begun to dispel the theory.

With this in mind, the failure rate for IPOs stands out more than ever.  Therefore, the cause for scrutinizing the IPO process is valid; which brings us back to the discussion at hand.  The argument on whether the traditional or alternative IPO approach is best brings to the forefront which method will either most accurately generate a fair market valuation and –some will say this is the most important part- who will receive the shares and how much of those shares should be allocated.

Tradition Rules

The typical IPO process begins with an investment firm such as Goldman Sachs, for example, agreeing to sell shares on the behalf of the issuer by purchasing a certain number of shares and then reselling them to the public.  In doing so, the underwriter assumes the sale of the IPO; they also consequently assume the risk.  For their service, the issuer agrees to pay a fee, which is usually in the range of 5%-10%; however, most deals are made with a 7% charge.  Although in the case of Facebook’s IPO, lead underwriter Morgan Stanley accepted only a 1% fee.

The underwriter then establishes an initial price range, based on investor interest during the road show, in order to “build a book” of orders for the stock and to later determine a clearing (or initial) price for the sale of the shares.  Underwriters will more often than not under-price the shares because of the applied risk.  Under-pricing is done as a way to create a spread (aka, “money left on the table”) which is the amount between the stock’s initial offering price and its closing price after the first day multiplied by the number of shares sold.

Critics of the traditional method argue that the IPO process makes for an unfair playing ground for two reasons. The first is favored share allocation, both prior to the IPO and during the after-market sales through a technique known as laddering, “where customers who got allocations of hot IPOs were required to buy more in the aftermarket to help boost the stock price.” The second is by way of kickbacks- underwriters receiving customers’ profits.

Separate but Equal

The first online auction occurred in 1999 with Ravenswood Winery and through the Open IPO method, a system based on the Dutch auction process first developed by WR Hambrecht + Co., there has been a total of 28 IPO auctions to date.  And, “Just like a typical auction,” as explained on the company’s website, “the highest bidders win” however “the entire auction is private, and winning bidders all pay the same price per share – the public offering price.”

With a Dutch auction, the issuer announces the number of shares to be sold and at times a potential price for those shares.  Investors then state the number of shares they want and at what price. The market clearing price is determined from the submitted bids.  Investors who bid at least that price are awarded the shares.  One important point to make: In a Dutch auction, there may be an underwriter still involved; however, the underwriter’s due diligence does not involve determining a clearing price or the issuance of shares.

The Dutch auction method gained public awareness when Google (NASDAQ: GOOG) went public in 2004.  Being the first hot-ticketed Internet IPO since the Bubble era, Google was touted as the IPO to watch.  And even further inquisition came about when the company announced that it would be using a “new” IPO method.  After the preliminary examination from lead underwriters Morgan Stanley and Credit Suisse First Boston helped to decide a fair market price range of $108 to $135, Google reserved the right to set the final sale price at $85.00.  While Google’s intentions were to match supply with demand by decreasing the initial price and through the repurchasing of the shares, Google’s stock popped anyway to $100.34.  Because Google “lost” money on the IPO, many felt that this served as proof of the failure of the Dutch auction system.  Presently, Google’s stock price ranges from a 52-week low of $473.02 to a 52-week high of $670.25.

Critics of the Dutch auction say that it is susceptible to bidding rings and, without the proper assessment from well-established underwriters, the method is more exposed to bad-quality sellers.

Habits are Hard to Break

As the change in the need for private companies going public, so go the earnings.  Data according to noted IPO expert Jay Ritter shows that at the height of the Internet Bubble, from 1999-2000, the average gain generated from the first-day return from 856 IPOs were 64.5% with $66.63 billion left on the table.  From 2001-2011, the average first-day return from 1,093 IPOs were 11.8% and $32.67 billion left on the table.  As for IPO auctions, from 1999-2011, the average first-day return on WR Hambrecht’s 19 IPOs has been 14.1%.

Currently, the U.S. IPO market contains 75 IPOs having been filed, which is down 43.2% from last year. Proceeds are up 12.9% at $28 billion from last year and the average rate of return is 17.6%, according to Renaissance Capital.

Reasons as to the causes for the IPO debate range from various degrees of market efficiency to firm-specific behavioral factors.  Also, time sensitivity in regard to the long-term performance on whether or not (or how important of an issue) does the Internet bubble play has added to its complexity.  However, as the rate of businesses transitioning from private to public continue, so to does the need for further evaluation in the IPO process.


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