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IPO

A Dutch auction is a price discovery method where the auctioneer lowers the asking price until bids cover the desired quantity, commonly used in IPOs and government securities. In this process, bidders submit offers, and the final price is set at the last bid that meets the total quantity needed, ensuring all successful bidders pay the same price. This method aims to minimize underpricing and volatility, as demonstrated by Google's IPO in 2004, which utilized a Dutch auction to achieve a fair market price.

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IPO

A Dutch auction is a price discovery method where the auctioneer lowers the asking price until bids cover the desired quantity, commonly used in IPOs and government securities. In this process, bidders submit offers, and the final price is set at the last bid that meets the total quantity needed, ensuring all successful bidders pay the same price. This method aims to minimize underpricing and volatility, as demonstrated by Google's IPO in 2004, which utilized a Dutch auction to achieve a fair market price.

Uploaded by

sheikh.doody
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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What is a Dutch Auction?

A Dutch auction is a price discovery process in which the auctioneer starts with the
highest asking price and lowers it until it reaches a price level where the bids
received will cover the entire offer quantity. Alternatively, a Dutch auction is known
as a descending price auction or a uniform price auction. Dutch auctions are
appropriate for instances where a large quantity of an item is being offered for sale,
as opposed to just a single item.

A Dutch auction can be used in an IPO to figure out the optimum price for a stock
offering. They are also used by government agencies for the public offering
of Treasury bills, notes, and bonds.

Dutch Auction Process

In the Dutch auction process for an IPO, the underwriter does not set a fixed price
for the shares to be sold. The company decides on the number of shares they would
like to sell and the price is determined by the bidders. Buyers submit a bid with the
number of shares they would like to purchase at a specified bid price. A list is
created, with the highest bid at the top. The company works down the list of bidders
until the total desired number of shares is sold.

The price of the offering is determined from the last price covering the full offer
quantity. All bidders pay the same price per share. A Dutch auction encourages
aggressive bidding because the nature of the auction process means the bidder is
protected from bidding a price that is too high.

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Example of a Dutch Auction

Assume that the company, Compu Inc., is using a Dutch auction to price its shares
for an IPO. The company is looking to sell a total of 400 shares in its IPO.

Bidders:

 Investor A places a bid for 200 shares at $300


 Investor B places a bid for 25 shares at $450
 Investor C places a bid for 500 shares at $100
 Investor D places a bid for 60 shares at $200
 Investor E places a bid for 100 shares at $150
 Investor F places a bid for 15 shares at $120

Placement:

 Investor B: 25 shares at $450 (400 – 25 = 375 shares remaining)


 Investor A: 200 shares at $300 (375 – 200 = 175 shares remaining)
 Investor D: 60 shares at $200 (175 – 60 = 115 shares remaining)
 Investor E: 100 shares at $150 (115 – 100 = 15 shares remaining)
 Investor F: 15 shares at $120 (15 – 15 = 0 shares remaining)
 Investor C: 500 shares at $100

In this example, the IPO would be priced at $120 per share because the last bid of
15 shares at $120 filled out the total number of shares that Compu Inc. is looking to
offer. Investors B, A, D, and E would be able to purchase shares for $120 instead of
their initial bids of $450, $300, $200, and $150, respectively. Investor C would be
out because the number of shares is already filled.

Consider the same example but with different bid prices:


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 Investor A places a bid for 100 shares at $300
 Investor B places a bid for 200 shares at $200
 Investor C places a bid for 200 shares at $200

Placement:

 Investor A: 100 shares at $300 (400 – 100 = 300 shares remaining)


 Investor B and C: 200 shares at $200 (300 – 400 shares total = -100 shares
remaining)

Note that Investors B and C both placed a bid for 200 shares at $200 (400 shares in
total). Therefore, at a price of $200, there is a demand for 500 shares (100+200+200).
However, the company only wants to sell 400 shares. In this case, the company must
figure out a way to allocate these shares. One way to resolve this problem is to take
the percentage:

400 shares available / 500 shares demanded = 80%. Investors A, B and C would
receive 80% of their requested shares:

 Investor A receives 80 shares at $200


 Investor B receives 160 shares at $200
 Investor C receives 160 shares at $200

Total shares issued: 400

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Traditional IPOs and Underpricing

Setting a price for an IPO can be difficult. Traditionally, investment bankers


(underwriters) would take the top management of the company on “roadshows” to
meet with institutional investors and assess their interest in the IPO. These
roadshows offered the underwriter an opportunity to market the stock in advance,
thereby hopefully increasing demand for it, and also the opportunity to learn how
much per share large, institutional investors were initially willing to pay for the
stock.

However, setting a price for an IPO through roadshows is sometimes unreliable. For
example, Twitter was priced at $26 for its IPO, based on gauging public interest at
roadshows, but traded as high as $45 on the first day of trading. This is called
mispricing, where the IPO is priced too low. The feedback the underwriter received
from the roadshows was obviously misleading in terms of public interest in acquiring
the stock.

A Dutch auction is used to minimize the increase between the offer price and the
opening price of the offering (therefore minimizing underpricing). While it usually
results in some bidders paying less for the stock than they were willing to, it at least
protects the underwriter and the company from having to sell hundreds, or perhaps
thousands, of shares at a ridiculously low price.

Google’s IPO: A Dutch Auction

In 2004, Google (NASDAQ: GOOG), now Alphabet Inc., decided to go with a


Dutch auction IPO process. In its regulatory filings, Google’s documents stated:

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“Many companies going public have suffered from unreasonable speculation, small
initial share float, and stock price volatility that hurt them and their investors in the
long run,” and “we believe that our auction-based IPO will minimize these problems,
though there is no guarantee that it will.”

Google (Alphabet Inc.) relied on a Dutch auction to minimize underpricing and to


earn a fair price on its IPO. Although Google went public at $85 a share and climbed
nearly 30% in two days to close at $108 a share, the IPO was considered a success
due to the initial uncertainty in the effectiveness of a Dutch auction. At that time,
many market analysts criticized the Dutch auction process. Many of them were
afraid that investors would collectively submit a low bid and cause Google to open
at an unfavorably low price. In hindsight, there is speculation on whether Google
would have been able to set a higher opening price if it had gone the more traditional
IPO route.

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