Going Public: Is a Dutch Auction IPO More Efficient than Traditional “Book Building”?
Companies require capital to operate. For some companies, “going public” is a solution for raising additional capital through tapping into the resources of the general public. One critical question raised during the initial public offering (IPO) process is: how much are the company’s shares worth? In a traditional IPO process, the pricing is determined through a process called “book building.” Essentially, the lead underwriter of the deal determines a price range of the offering through frequent contacts with investors as well as their own valuations. Then during the road show process, orders for the shares are taken—investors invited to the road show can state the quantity of shares they are interested in acquiring, and the price they are willing to pay per share. These orders are compiled to “build a book” and eventually used to determine the final offering price and allocations. However, as the article suggests, determining the final offering price and how the shares are to be allocated is often a highly biased process, as investment banks have an incentive to make decisions to maximize the underwriting fees they collect from the deal. As a result, the final offering price determined by traditional “book building” often inaccurately reflects the true public demand for the shares.
Instead of traditional “book building,” the article recommends companies to consider going public through a Dutch Auction IPO. In this process, the company will consult investment banks to determine its valuation range, and then pass on this information to potential investors. The investors will consider this valuation along with their own opinions of how much the company is worth, and submit their bids specifying how many shares they want and how much they are willing to pay per share. The market-clearing price is the highest price at which the company can sell all of its allotted shares. As a result, the company can go public on an investor-friendly note, assuming that investors succeeded in determining a fair value for the shares through the bidding process.
This article touches on the topics of Dutch Auctions and market clearing prices. While the Dutch Auction IPO process is not a true Dutch Auction, it does resemble a Vickrey auction. The dominant strategy for investors is to bid their true values. If the investor is part of the group of winners, he will pay, at most, his true value. In addition, there is a chance that he will pay a price lower than his true value and realize a positive payoff. The price that all winning investors pay is the market-clearing price, as previously discussed. Yet, despite the potentially increased pricing efficiency in a Dutch Auction IPO relative to a traditional IPO, it is not a very popular method for various reasons, one of which is the resistance of investment banks to support this strategy, as it has a high probability of cutting into their underwriting fees. However, the pursuance of this strategy by prominent companies such as Google may influence private companies in the IPO process to strongly consider a Dutch Auction IPO as opposed to a traditional IPO.
Source: http://www.fool.com/investing/general/2012/09/25/lets-re-think-the-ipo.aspx
-CW