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Dutch Auction IPO vs. Traditional Book Building

In today’s business world, there are many ways for a company to raise capital. From issuing bonds, taking out a loan, and even issuing debt. Currently, when most companies issue an equity stake in their company to raise capital – or “go public” – they value their shares through a process called book building. In this process, the lead underwriter on the deal uses models to value the company and creates a range at which the shares could be issued for. They then “go on a road show”, where they meet with investors and see how many shares, and for what price, the investors are willing to purchase. Unfortunately, this process can contain bias from the investment banks that both hope to maximize their underwriting fees and maintain good relationships with institutional investors who may buy shares in multiple IPOs.

An alternative to this approach is the Dutch Auction IPO. The Dutch Auction IPO is based on the Dutch Auction system developed for the tulip market in Amsterdam centuries ago. If there are 3 tulips to be sold and a group of potential buyers, each buyer bids how much they are willing to pay per tulip, and how many tulips they want. If the first person bids $5 for a tulip, the second person bids $5.50 for a tulip, the third $6 for a tulip, and the fourth bids $4 for a tulip. This would lead to a clearing price of $5, so the first three people would each get a tulip for $5, while the fourth person would not get any tulips. This idea can work for IPOs as well, and was recently used by Google in October 2007. There are many benefits of the Dutch Auction system – the strategy-proofness of the auction makes bidders bid their true value for a share of the company and it allows more potential investors because anyone can issue a bid. By allowing more potential investors companies are able to raise their true capital valuation and not “leave funding on the table”. This refers to when share prices jump initially after IPO so the company misses out on capital they could have gotten if they were correctly valued.

A downside that is mentioned in the article linked to below is that investors are only able to enter one bid instead of multiple bids at different share prices. In theory this would allow people to more accurately express their demand yielding a higher market-clearing price – which results in more capital raised for the company. Ultimately, although there are flaws with the Dutch Auction IPO system, it is better for both the company and investors than the traditional book building approach.

– cfs76

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