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Auctioning its way to a more 'inclusive' IPO

Think you have no chance of scoring Google Inc. IPO shares? Think again. The Internet search firm plans to use an auction system infrequently used in the U.S. to allocate most of its initial public stock offering.
/ Source: a href="" linktype="External" resizable="true" status="true" scrollbars="true"><p>The Washington Post</p></a

Think you have no chance of scoring Google Inc. IPO shares?

Think again.

The Internet search firm plans to use an auction system infrequently used in the United States to allocate most of its initial public stock offering. It is an attempt, the company said, to make the IPO "inclusive of both large and small investors."

Essentially, Google will allow qualifying investors with brokerage accounts at its two underwriters, Morgan Stanley and Credit Suisse First Boston, to submit bids listing how many shares they want and what price they are willing to pay. The bids will create a "master order book" that only Google and the underwriters will be able to see. Individuals who are interested in making bids for Google need to open accounts at the underwriting firms before the IPO. The Wall Street firms will determine who is a "qualified investor," which could limit the ability of small investors to participate.

Google and the underwriters will use information in the master order book to determine a "clearing price," the highest price at which all the shares can be sold to potential investors. Those submitting bids at or above the clearing price will be eligible to receive IPO shares. Those with bids below the price will be out of luck.

This method often is called a "Dutch auction," said to have been modeled on a system used in Amsterdam to sell tulips. But Google's approach is slightly different from the usual model. In its filing with the Securities and Exchange Commission on Thursday, the firm promised to use the clearing price as only the "principal" factor in setting the IPO price. The actual IPO price could be lower than the clearing price, Google said. Google said in its filing that the allocation will be done "primarily" through the auction, without commenting on what else might be involved.

Google also said it may decide to increase the number of shares sold during the IPO if the price rises during the auction. This means bidders will not know the total size of the offering when they submit what prices they are willing to pay.

That is a drawback, said Alexander Ljungqvist, an IPO expert and professor at New York University's Stern School of Business.

"That's like [auction house] Christie's saying they are selling one" expensive work of art, only to see the price go up and say it is selling two.

Ljungqvist also criticized Google for not settling on a process for dealing with a situation in which there could be more successful bids for shares than there are shares available. In its filing, Google said it would use one of two methods to deal with such a situation. Both are complex.

Under one method, the total number of shares offered would be divided by the number of shares represented in successful bids. That calculation would determine a "pro rata allocation percentage." Successful bidders would receive shares based on the pro rata allocation percentage multiplied by the number of shares they requested.

Under the second method, described as "maximum share allocation," successful bidders would receive shares based on an algorithm designed do give those with small share requests the full amount and those with larger bids no more than a certain number.

"This is designed in quite a complicated way," Ljungqvist said. If it fails because investors are confused or leaves investors dissatisfied with the way in which shares are allocated, it will be a long time before anyone else attempts the auction approach to IPOs, Ljungqvist predicted. Auction sales of IPO shares have not caught on in the past, he said.

But overall, Ljungqvist praised Google for employing the auction, saying if successful it could reduce the advantages major investors have had and single-handedly sweep away many of the IPO abuses seen on Wall Street in recent years.

Those abuses included Wall Street firms setting IPO share prices artificially low and allocating them to favored executives at firms that steer other business their way.

The low prices then allowed for big one-day price "pops" for hot IPOs. Wall Street insiders could then sell their IPO shares on the open market, netting big profits and leaving the larger investing public holding the bag if the share price dropped.

While the auction is designed to open up the IPO to individual investors, Google went to great lengths in its filing to warn of potential risks. The company noted that the share price could drop significantly on the open market and said only those interested in owning Google shares over the long term should attempt to invest in the IPO.

Others were also mainly positive about Google's attempt. "The jury is still out on all the details, and we will see how it plays out in the next few months," said Peter Thiel, co-founder and former chief executive of PayPal Inc., which had one of the last big Internet IPOs. "But we currently have a process that is massively inequitable between big institutions and small investors ... I think it's great that Google is doing what it can to weaken the power of the Wall Street mafia."