When all was said and done, Google Inc.’s now-infamous “Dutch auction” came down to a simple irony.
The company’s young co-founders, Sergey Brin and Larry Page, may have fancied themselves champions of a system designed to loosen Wall Street’s grip on the market for initial public offerings of stock. But their own missteps delivered a blow to reform that many experts say was unnecessary.
For fans of the controversial Dutch auction system, there was still plenty to cheer about. Despite the controversy that unfolded last week, it’s hard to argue that Google’s offering was anything but a success.
“The company got a good price, and investors got a good deal,” said Jay Ritter, an expert on initial public offerings at the University of Florida. “You can validly criticize management for being arrogant. But that’s a whole separate issue.”
In evaluating a financial deal, the bottom line is always a good place to start.
In a dreadful market for IPOs, Google, the 6-year-old Internet company raised $1.67 billion and valued its outstanding stock at $29 billion. That’s less than Motorola Inc.’s market value of $38 billion but more than the $23 billion commanded by General Motors Corp.
Brin, Page and Google CEO Eric Schmidt became billionaires, and hundreds of their employees became millionaires. By the close of business Friday, outside investors had seen their shares jump in price 27 percent, to $108.31 from the $85 offering price.
That windfall provided a stark contrast to the rest of the market. Amid a rocky period for technology stocks, promoters have canceled 19 conventional IPOs over the past month.
But if Brin and Page set out to reform Wall Street, they became their own worst enemies.
A Dutch auction is designed to cure many of the ills that plague the clubby business of taking companies public. In a traditional offering, a company hires investment banks that set about finding customers for its stock. Once the bankers have gauged demand, they set a price for the shares.
The problem is, investment bankers tend to line up their most favored clients as customers, locking out everyone else. Often, they also set the stock price lower than the true market value, guaranteeing a nice “pop” for clients when the stock starts trading–money the company never sees.
For years, this system has drawn complaints. But recent charges against Frank Quattrone, an investment banker with Credit Suisse First Boston, have focused increased attention on the issue. Last year, the National Association of Securities Dealers detailed how a group run by the highly respected Wall Street figure regularly doled out IPO shares to clients in return for lucrative banking business. In May of this year, a jury convicted Quattrone of obstructing justice when he hindered a federal investigation into the issue. Quattrone is appealing the conviction. (This paragraph as published has been corrected in this text.)
In their offering prospectus, Page and Brin made clear their disdain for the system–and for Wall Street in general. They proposed an auction as an antidote.
In a Dutch auction, a company solicits bids for a set quantity of stock. The idea is to open bidding to the large institutions that typically get IPO shares and individuals who don’t.
Once the bids are in, the company sets the price at the highest level it can to sell the number of shares it wants. If it wants to sell 1 million shares, for example, and investors bid for 2 million, then the company will sell the 1 million at the highest price that clears those shares. If the threshold price is $100 a share, that’s the price everyone pays, even if they bid higher. Anyone who made a lower bid doesn’t get any shares.
In theory, that should match supply and demand, and the company should get the highest price. The system is supposed to level the playing field for investors and eliminate the “pop” for favored bank clients.
Google’s offering netted $85 a share when the stock began trading Thursday. But the 27 percent gain by Friday was similar to a conventional pop. It proved that the deal could have produced more, which some cited in criticizing auctions.
But others said the company could have captured that gain if the auction had not been intimidating to many investors and if Google’s management and their underwriters hadn’t made several mistakes.
Those mistakes began with Brin and Page.
Google’s founders thumbed their noses at investor concerns, many of them legitimate. They set up two tiers of stock, giving the founders voting control of the company. They refused to say what they planned to do with the IPO proceeds.
One passage from the offering prospectus, written by Page, sums up the co-founders’ posture: “By investing in Google, you are placing an unusual long-term bet on the team–especially Sergey and me–and on our innovative approach.”
For that reason, he added, “We have set up a corporate structure that will make it harder for outside parties to take over or influence Google.”
On the day the prospectus came out, some observers said it was blind to well-founded concerns about corporate transparency. Mel Bergstein, chairman of DiamondCluster International Inc., a Chicago consulting firm, said Google needed to face reality.
“I think it’s naive and foolish to put demands on the public markets when you’re asking for money,” he said.
If Google’s lack of disclosure didn’t scare away buyers, the confusion surrounding the offering likely did.
Brin and Page insisted on having only two investment banks–Morgan Stanley and Credit Suisse First Boston–and paid them well below market rates to set up the auction. More than two dozen other banks participated, but they stood to profit even less from the deal.
Given that the entire concept of an auction posed a threat to Wall Street’s status quo, the upshot of this structure was predictable. Several banks, industry giant Merrill Lynch among them, bailed out. And one banker involved in the transaction, who asked that his name be withheld because the offering is still in a quiet period mandated by regulators, said the others lacked enthusiasm for selling the deal.
“One thing that’s important in an auction is open distribution,” he said. “It created a hostile atmosphere. … Usually, whoever brings in an order gets the credit. But in this case, the lead underwriters got the most of the economics. It’s like asking a used-car salesman to sell cars without a commission.”
Morgan Stanley didn’t return telephone calls seeking comment. A CSFB spokeswoman, citing the quiet period, declined to comment.
All of this was the backdrop for other problems. Earlier, Google had said the Securities and Exchange Commission was investigating the company for issuing unregistered shares. And then days before the offering, Playboy magazine published an interview with Page and Brin that threatened to violate the quiet period.
The SEC allowed the offering to proceed. But then signs of weak demand caused Google to back off from its initial price estimate of $108 to $135 a share. It set the new estimated range at $85 to $95, but that added a new level of confusion.
Even before the price drop, many large brokers required potential investors to jump through numerous hoops to qualify for the auction. And even when they did qualify, individual brokers were sometimes ill-prepared to advise them.
Vasu Krishnamurthy, a management consultant who lives on New York’s Long Island, was excited when he heard about Google’s stock offering. He thought the original price estimate of $108 seemed high, but he bid anyway.
When the price estimate dropped to the lower range, however, his broker canceled his order. Even if the price was set at $85, the broker told him, Krishnamurthy would have to pony up $108.
“If that is the case, take me out of the auction,” Krishnamurthy said. “That is too risky. I don’t want to bid.”
But his broker was wrong. In a Dutch auction, any bid above the final price is accepted at the final price. Krishnamurthy realized his broker’s mistake, re-bid at $85 before Wednesday’s deadline and received 70 percent of the shares he requested.
By Friday, of course, Google’s stock had closed within the original price range, at $108.31 a share, suggesting that there was plenty of pent-up demand stymied by the process.
The question is, was that an indictment of the auction or the way it was transacted by Google and its investment bankers?
The Playboy interview, the arrogance, the unregistered shares, “none of those things have anything to do with auction versus [the traditional method],” argues the University of Florida’s Ritter.
But Jeff Stacey, co-founder of IPO Monitor, an Internet service that tracks IPOs, thinks the jury’s still out.
While Google can be happy with its take, he said, the Dutch auction IPO won’t gain real credibility until several dozen large companies choose the auction approach.
“Google is a once-in-a-decade kind of deal,” he said.
Patrick Byrne, chairman of Overstock.com, disagrees. He acknowledges that Google and its bankers made mistakes. But he said they also validated a concept he’s been championing since 2002, when he used an auction to take his retailer public.
“Now that it’s been tested, [directors] can’t say that it hasn’t,” he said. “So when they use the conventional system and the stock pops and they leave a bunch of money on the table, they’re gonna get sued.”
Byrne thinks Google hasn’t hurt the IPO reform movement.
“I think they did more good than harm,” he said.
