Understanding IPO Initial Price

Sometime in the next 12 months, Google, the massive search engine company, is going to hold its initial public offering, placing a portion of company stock into the public markets. A standard IPO this is not, however. It'll be a Dutch auction, which means that each bidding investor will get a chance to name his own price for Google shares. Let the cards land where they may.

Although the phenomenal amount of interest surrounding the impending Google IPO has cooled somewhat, we're talking about something that's gone from standing-on-the-sun hot to merely, say, standing-near-a-nuclear-reactor hot.

That's fine. Ideally, as the actual initial public offering (IPO) comes to pass, the level of interest will have dropped to "who's gonna win this spelling bee" hot. That's my hope, at least -- so people will keep from doing phenomenally bad things like paying way too high a price for shares of Google.

Not that I'm holding my breath.

One of the aspects that people are asking questions about is the nature of the IPO allocation, the "Dutch auction." It's a pretty neat approach that completely takes the judgment of investment bankers out of the pricing decision and places it in the hands of the market.

For those of you who are interested in participating in Google's IPO, or for those of you who are interested in just learning something about the process, below is a simplified version of how a Dutch auction works. This is likely to be old hat to people who have a lot of experience buying or selling goods on eBay (Nasdaq: EBAY), where Dutch auctions are quite common in instances where the seller is seeking to unload a large number of identical items.

The classic IPO

In a normal IPO, an investment bank will come in, do some evaluative work on how much a company is worth, survey the market to determine the interest of potential buyers of a company at X, Y, or Z price point, and then recommend a pricing formula to the management of the company. Once upon a time, this process was used to generate as much capital as possible for the company, but starting with IPOs such as Netscape, Yahoo! (Nasdaq: YHOO), theglobe.com, and so on in the mid-1990s, IPOs came to be measured by how much of a "pop" they generated on the first day of trading. Want a successful IPO? That's easy -- price your shares at about 35% of what they're actually worth, and watch the market swarm, driving the price sky high.

Of course, this greatly kneecapped the ability of the company to raise funds from the equity it sold. A survey of some of the biggest IPO pops of all time shows a list of companies that mostly no longer exist. Fat lot of good the positive vibes of a big IPO did 'em. I'm sure that when all was said and done they'd have preferred the cash from more reasonably valued IPOs rather than pricing them very low so that people they'd never met, who had nothing to do with the companies, could get rich by flipping IPO shares to the public the same day they got them. In fact, I would hope that some of those now-ex-CEOs of now-former high-flying IPO companies would look back and say "hmmmmm, I wonder to whose benefit that IPO "pop" really was? It wasn't the company, for certain.

But I digress. We're talking about Google's IPO here.

The Dutch auction

As a result of this chicanery, several companies that have IPO'ed in the recent past have elected to sell by Dutch auction, including Overstock.com (Nasdaq: OSTK), RedEnvelope (Nasdaq: REDE), and now Google. Overstock's CEO, Patrick Byrne, notes with some satisfaction that Google's decision to go the Dutch route "could be the thing that breaks a sleazy Wall Street system." Our 2002 coverage of the Overstock IPO -- a company that went on very quickly to become a TMF Select and then Hidden Gems recommendation, offers a good view into some of the more recent Dutch auction IPOs.

A Dutch auction curtails or removes the ability of the investment bank to influence the opening price of the shares and its ability to allocate IPO shares at all. It's share democracy at its finest. If you're willing to name an insane price for shares in a Dutch auction IPO, you're going to get 'em. (It should be noted here, though, that Google reserves the right to have "speculative bids" nulled, but the company doesn't define what that means. What's in question is the price you'll pay -- which isn't necessarily the one you commit to paying.)

What you (and everyone who gets shares) will end up paying is the price that the last person past the post has bid. Generically, if there are 1 million shares available, it will work like this:

Investor Bid Amount/share # of Shares Shares Remaining
A $10,000 1000 999,000
B $100 250,000 749,000
C $30.42 100,000 649,000
D $29 550,000 99,000
E $25 100,000 -1000
F $24.99 50,000 0

And so on.

It's important to note that no one who has bid can see anyone else's bid. So once the auction has closed, the shares are all allocated. As you can see, the lowest bidder for whom shares were remaining was Investor E, who offered to buy 100,000 shares at $25 apiece. Every investor who bid higher than Investor E is thus guaranteed shares, but they get them not at the price they bid, but at the one that Investor E bid, $25. So even though Investor A, clearly a delusional soul, offered to spend $10 million for 1000 shares, she will only have to pay $25,000 -- Investor E's price times 1,000 shares. In exchange for this phenomenal cosmic power, Investor E runs the risk of not receiving as many shares as he bid. In this case, though Investor E bid on 100,000 shares, there were only 99,000 left once all of the higher bidders' orders had been filled, so he only gets 99,000.

And what of Investor F, whose bid came in only a penny per share below Investor E's? You guessed it -- neither she nor anyone else with lower bids gets any shares at all in the IPO, and will have to buy them on the open market once they start trading. The total capital raise for the company, gross of fees, is $25 million.

There's one more catch to Google's IPO. At management's discretion, once the bidding is done, it has the right to adjust down the price that successful bidders are required to pay. Let's just say that management thinks that $25 per share is just kooky. It can say "OK, bidders, your price is actually $17." This only goes for the successful bidders though -- Investor F, even though her bid is now $7.99 higher than the price paid, is still out of luck. To pay you must first win.

The mechanics

Right now you might be asking just how the bidding takes place. Is some guy in bib overalls going to show up and break into an auctioneer's cadence? No, not quite. In order to participate, you must do the following:

1. If you don't have one already, open a brokerage account at one of the now 31 banks and brokerages underwriting the auction, including online pureplays E*Trade (NYSE: ET) and Ameritrade (Nasdaq: AMTD), and banking giants Citigroup (NYSE: C) and Wachovia (NYSE: WB). If you want to, you can actually open up an account with E*Trade or Ameritrade through the Fool's Broker Center and get commission-free trades. Credit Suisse, Morgan Stanley, Wachovia, Wells Fargo, Muriel Siebert & Co., Lehman Brothers, UBS, and Goldman Sachs are also part of the Google gaggle. If you do not have an account at one of the 31 underwriting companies, you will not be able to bid.

2. Ask for and receive the Google prospectus. Having gone this far, I highly suggest that you read it.

3. Request a bidder's identification number from the broker. These will not be issued once the bidding is opened.

4. Make your bid, stating the amount of shares desired and the amount per share you bid. If you really, really, really want the shares, bid high. (P.S.: This is a very silly thing to do. Bid what you think they're worth and not a penny more. If you fail to get shares because the investing world loses its collective mind, it could be the best failure you ever endure.)

5. Go make a sandwich. Wait for the results.

The folks at WR Hambrecht put together a pretty nifty slide show on the process of a Dutch auction.

If you go through this process, I wish you the best of luck! Remember, getting IPO shares isn't "winning;" making a good investment decision is. For more information, check out this special (registration required) on the Google IPO produced by the folks at the Wharton School at the University of Pennsylvania.

Finally, read Fool contributor Salim Haji's column today to find out what it will take for Google to succeed.