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Monday, April 21, 2008

Dutch Auction IPOs

I liked this article on Techdirt about Dutch Auction IPOs.

In a traditional IPO, the IPO price is arbitrarily chosen by the investment bank. The investment bank typically get an option to buy additional shares at the IPO price.

As is typical for the financial industry, this places the investment bank in a "conflict of interest" situation. The investment bank is supposed to be raising as much money as possible for its client. However, the investment bank also wants to make money for the clients to whom it sells the shares.

If a newly issued stock "pops" 2x or 3x on the day of the IPO, this is usually lauded as a "good thing". This really is a disaster for the pre-IPO shareholders. It means that they sold a huge chunk of the company for only 1/2 or 1/3 of its actual fair market value.

Since the dutch auction cuts out the investment bank middleman, dutch auction IPOs are roundly decried as being stupid. It actually is a very smart decision by the pre-IPO shareholders.

In a dutch auction, suppose the IPO corporation decides it is going to auction 10M shares to the public. It accepts bids. It chooses the largest bid such that the 10M shares are actually sold. People who bid more than the actual IPO price wind up paying only the IPO price. For example, if you place a buy limit $40 order for a stock that opens at $30, you only pay $30.

The daily opening price for stocks is chosen via a "dutch auction" process. The opening stock price is the price where the # of shares bought equals the # of shares sold.

Google's IPO was handled via a dutch auction. The shares did still run up after the IPO. Also, Google only auctioned off a small slice of the company at the initial IPO. They later sold additional shares after Google's price had run up. Notably, when Google was added to the S&P 500, Google sold a large chunk of new shares to index funds on the day Google was added to the index.

If a corporation holding an IPO holds a dutch auction AND only auctions off a small slice of the corporation, this maximizes the value for the pre-IPO shareholders. After a public market for its shares is established, the corporation can issue additional shares at the fair market price.

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