3SWM Final_Google IPO

May 10, 2010 3SWM & Oz Final

Google’s IPO – Game Theory Analysis

Introduction

In August of 2004, Google Inc. made its highly anticipated initial public offering after

nearly six years as a privately held company. Even under normal circumstances, the IPO of a

marquee company such as Google would have drawn considerable investor and media interest.

This IPO, however, would become one of the most talked about in recent history because Google

stayed true to its roots as an innovative company and chose to conduct an auction to sell its

shares.

This paper will analyze Google’s decision to shun the typical process of IPO via an

investment bank in favor of a modified Dutch auction. In doing so, we will provide an overview

of the typical IPO process and an analysis of its strengths and weaknesses, followed by a

discussion of Google’s auction and its results. Finally, we will analyze auction IPOs for the

industry as whole, discuss their infrequent use, and offer strategies for those involved in the

auctions.

Initial Public Offerings

Since the early 18th century, businesses have been offering shares of their ownership via

initial public offerings. Doing so allows companies to raise money to expand or pay off debts,

and their owners to sell some of their shares. It also gives employees and business partners the

opportunity to become partial owners of the company.


However, with these benefits come a number of burdens. The process of going public is

typically very expensive as a result of legal, accounting, and printing fees. Additionally,

companies usually hire an investment bank to act as an advisor throughout the process, in

exchange for lucrative fee arrangements. Once public, companies must also undertake the

significant effort and cost of complying with extensive SEC regulations.

A. Role of the Underwriter

Before going public, companies typically hire an investment bank (or multiple banks for

larger offerings) to act as an underwriter and assist with the initial sale of the shares. The goal in

hiring an underwriter is to find a partner with the contacts and distribution ability to sell the

shares to interested parties. In doing so, the investment bank helps the company set an initial

price for the shares and build up demand in the market.

To market the IPO, investment banks often leverage their relationships with institutional

investors – who make up a large percentage of the market – to arrange purchases. Through a

process known as a “road show,” bankers travel around the world meeting with potential

investors to promote their client companies. Based on the demand they foresee in the market,

and on various financial analyses, underwriters work with the issuing company to set an initial

price for the shares. In exchange for these services, investment banks typically earn

commissions based on the value of the shares they sell. These fees can become very expensive,

equalling as much as 8.0% of the IPO in some cases.

B. Under-pricing IPOs

A common goal in setting the price for an IPO is to ensure that demand for the shares

exceeds supply, so that there is a “pop” in the share price on the first day of trading. The purpose


of this initial under-pricing of an IPO is two-fold. First, the bank wants to generate additional

interest in the stock when it first becomes publicly traded, as positive news about a company’s

“increasing value” can create momentum for the stock going-forward. Second, banks have an

incentive to please institutional investors (many of whom are their clients) by giving them a

moderate investment gain in exchange for taking on the risk of owning the company before the

market. Of course, this can create significant gains for investors who have been allocated shares

of the IPO at the offering price. .

However, under-pricing an IPO also results in “money left on the table” – lost capital that

the issuing company could have raised had the stock been offered closer to the market price.

One extreme example of this occurred with the theglobe.com IPO. Underwritten by Bear Stearns

on November 13, 1998 the stock was initially priced at $9 per share. In normal conditions, the

opening should have been around $10 or $11 per share; yet the globe.comjumped 1,000% at the

opening of trading to $97, before closing at $63 after many investors took their quick (and large)

profit. Theglobe.com raised approximately $30 million from its IPO. Unfortunately, if it had

been priced correctly – that is, if the company captured the value that the market put on it – it

might have taken in $200m internally.1

While under-pricing may cost the issuing company some of its initial capital, the

inverse can be just as damaging. If a stock is offered to the public at a higher price than the

market will pay, the underwriters may have trouble meeting their commitments to sell shares.

Even if they sell all of the issued shares, if the stock falls in value on the first day of trading, it

may lose its marketability and thus even more of its value. Therefore, investment banks must

1 http://news.cnet.com/2100-1023-217913.html


strike a balance between offering a company at a low enough price to stimulate demand, while

also ensuring that the company generates sufficient capital.

Google’s IPO

Google broke with conventional wisdom in approaching its IPO, which was very

consistent with its history of attacking the status quo through its introduction of innovative

products and services. Instead of following the traditional route of having an investment bank

underwrite its shares, Google opted for what they termed a “modified Dutch auction.” In doing

so, they sought to deprive the Wall Street banks of their normal complete control over the sale,

and make it easier for individual investors to purchase the stock.

A. How Google’s “Modified Dutch Auction” Worked

Google, working with Morgan Stanley and Credit Suisse First Boston as its lead bankers,

used a modified version of a Dutch auction to sell its shares to the public. Investors (both retail

and institutional) interested in bidding on the stock could open accounts with banks working on

the IPO and submit orders outlining the number of shares they wanted to buy and at what price.

If this were to be a pure Dutch auction IPO, the IPO would be set at a “clearing price”, or the

highest price that sells all of the shares being offered. Investors who bid at or above the clearing

price would get their shares at the lowest winning price.

To illustrate this, consider the following simplified example, where a fictional company

is looking to offer 2,300 shares in its auction:


Bid Price Shares

Requested Cumulative

Total Investor 1 $100 / share 1,000 1,000 Investor 2 $90 / share 500 1,500 Investor 3 $80 / share 600 2,100 Investor 4 $70 / share 400 2,500 Investor 5 $60 / share 800 3,300

Investors receive shares in order until the cumulative total of the shares distributed

exceeds the actual number of shares that the company is offering. In this case, Investors one,

two, three would be granted all of their requested shares at $70 / share, and Investor four would

receive 200 of their requested 400 shares at $70 / share. Savvy readers will note that in its purest

form, this Dutch auction functions in the exact same manner as a Vickrey auction. The authors

suspect Sir John Morgan, esq. helped consult on this IPO.

Google modified this approach though. They held a traditional Dutch auction, with

investors submitting bids on the stock along with how many shares they were willing to

purchase, but instead of letting this determine the market price, Google then used the information

gained in this auction to then decide (with their Investment Bank’s input) what price the shares

would actually be offered at. Although the Dutch auction would act as an input into the selling

price decision, it would not be the sole determinant of the offering price2.

B. Why Google Chose This Approach

Google’s approach to its IPO very much resembled a populist struggle, attempting to

wrestle the power away from the closed and chummy Investment Bank / Institutional Investor

circle and give it back to the individual investor. By using a Vickrey auction, they had two

specific goals in mind: 2 Google Made Splash, But Didn’t Start IPO Wave, http://www.marketwatch.com/story/google-made-splash-but-didnt-start-ipo-wave

http://www.marketwatch.com/story/google-made-splash-but-didnt-start-ipo-wave

http://www.marketwatch.com/story/google-made-splash-but-didnt-start-ipo-wave


1. Accurate price discovery. By relying on the forces of supply (i.e., the number of shares

being offered) and demand (i.e., a market with equal access and free will bidding on the

shares), Google sought to eliminate the first day surge of its share price that was so often

experienced during the dot-com era. By generating a demand curve for the IPO from the

small investor and allowing him / her to receive allocations and participate in the pricing,

the actual release price should be a more accurate representation of the underlying value

of the stock (given that the dominant strategy in a Vickrey auction is to bid your value).

This should also ensure that the full value of the IPO goes to the company that is going

public, rather than the favoured clients of the Investment Bank underwriting the IPO.

2. Equal access to shares for all investors. The Dutch auction reduces the corruption in

the IPO process, whereby under the traditional method, Investment Banks provide their

most profitable clients with the greatest portion of the shares of IPO, reducing the

likelihood that small investors will be able to gain access to these shares. By allowing

both institutional and retail investors to bid in the auction, and by placing them both on

equal ground (by not requiring a minimum number of shares purchased), it democratizes

the process.

Google’s Results

Many watchers view Google’s IPO results as evidence that the online auction process did

not serve as an efficient pricing mechanism, as it did not minimize Google’s first day price surge.

Google’s offer price ended up being $85/share, and it closed on the first day of trading at


$100/share, an 18% increase. GOOG subsequently continued to surge in its first week of

trading, further illustrating pent-up demand that was not captured by the initial offer price3:

$80

$85

$90

$95

$100

$105

$110

$115

Open 19-Aug-04 20-Aug-04 23-Aug-04 24-Aug-04 25-Aug-04 26-Aug-04

Closing Price / Share Google's Stock Price - First Week Performance

Opening Day Surge

18%

There is a great deal of controversy, however, of whether the resulting surge is evidence

of a failure of the Dutch auction as an IPO methodology, or whether it was the implementation of

the “modified” aspect of this particular auction that enabled the opening day surge. Most

analysts agree that Google’s actual execution of the IPO was not pretty4:

They slashed the opening price the day before the offer went public. Although it is a

closely guarded secret what the actual clearing price was resulting from the Dutch

auction, up until the day before the offer Google was publicly predicting an offering price

range of $108-$135/share. This drastic drop in actual price, and the resulting price surge,

may indicate that Google would have been better served following the actual clearing

3 GOOG: Historical Prices for Google Inc., http://finance.yahoo.com/q/hp?s=GOOG+Historical+Prices 4 Google Goes Public, http://www.nytimes.com/2004/08/20/opinion/20fri1.html

http://www.nytimes.com/2004/08/20/opinion/20fri1.html

http://finance.yahoo.com/q/hp?s=GOOG+Historical+Prices


price, instead of arbitrarily deciding on $85/share (although without knowing the actual

clearing price from the auction, we cannot verify this).

Google did not explain its business model or plans to sceptical investors. Unlike

most IPOs, Google did not feel the need to publicly disclose details of how it was going

to add value to its shareholders. Left feeling confused and uncertain, many investors,

both retail and institutional, chose to remain on the sidelines and not participate in the

IPO.

There was a great deal of “friction”, preventing some potential bidders from

entering the auction. To enter a bid in the Dutch auction, one first had to register online

to become an “approved bidder”, and then had to re-register with a broker. Google

purposely made the registration process onerous with the goal of limiting demand, hoping

to reduce any over-exuberant bids. Google also took the unusual step of not marketing

their shares in Europe or Asia, which is unusual for an IPO of this scale. By adding this

“friction” into the process, it pent up some of the overall demand, which may have been

released during the opening day of trading.

The market was rapidly declining during the period between the completion of the

auction and the actual IPO. This shook Google’s and its advisors’ confidence that the

demand information they received from the auction was still going to hold true in the

actual offer. Given the choice of pricing too high (and having a demoralizing price drop

on the opening day of trading) or too low, they opted for the conservative price. Instead

of offering 25.7MM shares at $135/share, they slashed their opening offer to 19.6MM

shares at $85/share.


The founders broke the SEC’s “silent period” rule with the publishing of an

interview in Playboy containing details not disclosed in their original SEC IPO

filing. This further shook Google’s confidence in their opening price, as investors were

becoming wary that that Google was ready to become a public entity5.

Although the success of the Vickrey style of auction for offering shares is inconclusive

based on Google’s results alone, most analysts agree that the publicity and media attention that

the process brought to the company was well worth its costs. It also focused the attention of the

public on online auctions, and forced companies to begin taking it seriously as a viable

alternative to the issuance process.

Analysis of Auction IPOs

As the Google IPO illustrates, auction IPOs may not always produce the optimal outcome

for the company issuing shares. In fact, the relatively tiny number of auction IPOs since Google

went public indicates that for the vast majority of companies, auction IPOs are less appealing

than traditional IPOs. While there are a number of possible explanations for this, the most

widely acknowledged reasons are that investment banks actually provide a valuable service to

both issuing companies and investors; that auction IPOs lack transparency and information; and

that auction IPOs may attract companies that would not otherwise be successful with traditional

IPOs.

A. The Value of Investment Banks

As discussed earlier, investment banks perform a number of services on behalf of the

companies that they take public. Perhaps the most important of these are the role banks play in

5 Google’s IPO, Five Years Later, http://dealbook.blogs.nytimes.com/2009/08/19/googles-ipo-5-years-later/

http://dealbook.blogs.nytimes.com/2009/08/19/googles-ipo-5-years-later/


valuing the company, and in marketing its shares to investors. By pricing the shares of

companies going public, investment banks perform the financial analyses necessary to

determine projected prices. These pricing models used by the banks are also helpful in selling

the company to institutional investors, who will likely perform similar analyses of their own. In

addition to these analyses, by meeting with potential investors, banks are able to gauge interest

in a company and better set the IPO price.

Aside from pricing, investment banks also put considerable effort into marketing the

company that is about to go public. Throughout the road-show process, investment banks meet

with potential investors and promote their client. The strong relationships that many banks have

with investors can have a significant impact on the demand for a company, and is a service that

is sorely missed by companies using auction IPOs. A company’s core competency is building

its product or service; in most cases, companies that are going through the IPO process do not

know the language of the market; investment banks serve as the “translator” between company

and investor.

These pricing and marketing services are particularly important for companies that have

complex business models, or that may not be well known. According to Notre Dame professor

Ann Sherman, an auction IPO researcher, the main problem with IPO auctions is “the idea that

there’s this automated ‘untouched by human hands’ method that prices shares perfectly every

time. Auctions may be a useful way to collect information, but for such complicated securities,

there will always be a role for an underwriter.”6

6 Taulli, Tom “Bidding Online for Hot IPOs” May 8, 2007 http://www.fool.com/investing/general/2007/05/08/bidding-online-for-hot-ipos.aspx


In light of these services provided by investment banks, it is not difficult to understand

why companies may feel that they will have more success with a traditional IPO than with an

auction IPO.

B. Lack of Information

In addition to the lack of services provided by investment banks, a general lack of

information on companies using auction IPOs may be deterring interest from investors.

Compounding the problem is the fact that the small investor, who is supposed to be a primary

participant in auctions, may lack access to sufficiently detailed information sources to accurately

price the company’s shares based on fundamentals, rather than on name recognition.. This

potential problem is made worse by the lack of information that the online auction process

requires to be disclosed. Of course, they almost certainly lack the skill to do a detailed financial

analysis assuming that they had the information.

C. Appeal to Unappealing Companies

A third explanation for the lack of popularity with auction IPOs is that, due to the less

rigorous scrutiny by investment banks and the consequent reduction in information provided by

the issuing firm, the auction process could be used more by companies that may not have a clear

idea of how they would use the funds generated by the IPO. Intelligent investors are

undoubtedly aware of this possibility, and consequently discount the initial offer price.

Morningstar's decision in January to use the IPO auction process is seen by some as consistent

with this theory. Before its IPO, Morningstar was the subject of an SEC investigation concerning


inaccurate data,.7 In light of this phenomenon, issuing companies may feel that their IPO will be

viewed as less attractive to investors if they utilize an auction.

Recommended Strategies for Auction IPOs

In spite of these deterrents, auction IPOs are still a factor when companies determine how

best to issue shares. As such, those in the industry need to formulate strategies for dealing with

auction IPOs. This section discusses recommendations for companies going public, auction

companies, investment banks, and institutional investors.

A. Issuing Companies

First and foremost, companies that plan to go public need to decide if an auction IPO is

the right choice for the company. While certain disadvantages are not inherent to auction IPOs –

like the limited marketing effort –, the only major auction IPO platform, WR Hambrecht+Co’s

OpenIPO, offers limited support in exchange for reduced fees. Thus, certain companies may be

more likely to have poor results. In particular, companies that are not well known may have

considerable difficulty garnering demand for their shares from smaller investors. Additionally,

companies that have especially complex business models may be hurt by the lack of marketing

support from an investment bank that could help explain the company’s value to investors.

If an issuing company decides to use an auction, one of the most important things it can

do is to provide as much information as possible. Because an investment bank will not be

disseminating information on its behalf, and because investors will be sceptical about the lack of

information, it is critical that the company proactively do so. First, the company needs to be

7 Hensel, Nayantara “Are Dutch Auctions Right for Your IPO?” April 11, 2005 Harvard Business School Working Knowledge


clear about how it intends to use the capital it plans on raising (e.g. growth capital, paying down

debts, etc.). Additionally, it needs to provide details on the corporate governance structure of the

company and specify how it will address any challenges facing the company in the future.

Finally, it needs to clarify why it chose to use an auction for its IPO, as many investors will be

sceptical of the choice to avoid investment banks and will assume the company is guilty of

hiding some negative news.

In addition to providing information, it is critical that the company market itself to

investors. As previously discussed, investment banks have strong relationships with institutional

investors and are excellent at marketing companies to them. Because issuing companies that use

auction IPOs are at a disadvantage without this service, it is important that they actively pursue

institutional investors. Of similar importance, companies that use auction IPOs need to market to

small investors. If a company is not already well known to consumers, it will be very difficult to

drum up any demand from smaller investors without aggressive marketing.

B. Auctioneers

One of the biggest challenges facing IPO auction sites is a lack of credibility. In many

cases, both issuing companies and investors likely perceive IPO auctions as less effective or as

higher risk investments. To a large extent, this can be attributed to a lack of familiarity with

auctions and the lack of a proven track record of successful IPOs. This could be combated with

a significant investment in marketing – at least for a few IPOs until momentum swings – which

would result in increased awareness and bidding, and ultimately higher share prices for client

companies. In addition to investing in marketing capabilities, auction companies could pursue

more high-profile companies (e.g., Facebook or Zynga) which would automatically generate


considerable publicity and likely draw more bids from smaller investors. The auction houses

need to create a “Fear of missing out” in institutional investors who might otherwise shun an

auction IPO; if the investors know that the shares will be purchased immediately (because the

IPO is perceived to be of the “can’t miss” variety, like Facebook), then they will be more likely

to bid at their personal valuations, which will help the auction system hit the market price

correctly.

C. Investment Banks

For investment banks, the possibility of commonplace auction IPOs poses a potentially

serious threat. The most effective way for banks to mitigate this threat is to do everything they

can to maintain the status quo. This would likely involve strengthening relationships with

institutional investors, and building as many barriers as possible to prevent auction companies

from gaining credibility with investors. Similarly, investment banks would be wise to emphasize

past auction disappointments with potential issuing companies.

D. Institutional Investors

For institutional investors, auction IPOs present both a danger and an opportunity. The

risk with investing in companies that auction their shares is the potential that they are avoiding

investment banks because they will not stand up well to the scrutiny of a traditional IPO.

However, auction IPOs may also present an opportunity to purchase shares at a significantly

discounted rate. With auction IPOs it may be possible for larger investors to coordinate in

keeping prices down by withholding bids, or bidding low. This would be more difficult to do

with traditional IPOs, as the investment banks would be more likely to detect it and take

measures to protect their clients.

3SWM Final_Google IPO

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