Mendoza School of Business

“Quiet Period” adds to mystery surrounding Google auction

Published: July 14, 2004 / Author: Sam Service

Just about anyone can get in on the ground floor of popular search engine Google’s much-anticipated initial public offering, which could get rolling within days.

That is because co-founders Larry Page and Sergey Brin, along with Chief Executive Eric Schmidt, have designed Google’s planned $2.7 billion IPO as a Dutch auction, open to all investors, both big and small, in an effort to level the playing field.

That has created a lot of buzz on both Wall Street and Main Street, leaving many wannabe investors wondering how this all-inclusive IPO lovefest will work and whether they should try to get in on one of the most talked about deals in recent history.

And herein lies the problem.

Because the Dutch auction model is so unorthodox and so rare, there is a steep learning curve, especially for uninitiated mom-and-pop investors.

Bottom line: Many of the would-be investors Google hopes to attract aren’t sure what they are supposed to be doing.

Compounding the confusion, Google and its investment banking partners, including Morgan Stanley and Credit Suisse First Boston, the lead underwriters, are doing little to shine the spotlight on the mechanics of this auction process.

Google won’t comment on anything concerning its planned IPO, citing what is known as a “quiet period,” required by the Securities and Exchange Commission. This quiet period, which generally lasts until 25 days after a stock starts trading, prohibits the company or its bankers from promoting the IPO in any way, shape or form.

For the legions of clueless investors trying to bone up on their IPO know-how, not to mention Google, which is counting on the masses to help it raise capital, this lack of transparency could spell trouble.

“If investors are getting no information and if you are getting stonewalled by the investment bankers, how does that help the process?” asks Tom Taulli, a finance professor at the University of Southern California in Los Angeles and author of “Investing in IPOs.” “I’ve been saying this all along. There will be a lot of frustrated investors that expect something they aren’t going to get. I don’t think it will be a smooth process.”

From its amended prospectus filed with the SEC, a few things are pretty clear about the Mountain View, Calif., company:

— Google has indicated investors can bid for as few as five shares.

— Google’s founders intend to retain strong control, due to an unusual dual-class stock structure, in which public shareholders will get Class A shares with one vote while insiders get Class B shares with 10 votes each.

— And investors who wish to participate in the IPO will need to open an account at one of 30 investment banks it plans to use to sell its shares.

Beyond that, however, investors don’t have much to go on.

CSFB, one of the lead banks in the Google IPO, doesn’t even have a retail brokerage division.

But even smaller retail brokerages that cater to regular investors, including San Francisco investment bank W.R. Hambrecht, which pioneered the Dutch auction IPO method, don’t have much of anything to say.

“The irony of the SEC laws, in general, is they’re supposed to protect the investors, but then you have this quiet period and that means investors can’t get any information,” Taulli says. “This is a very complex process even for someone like me to understand. I can’t imagine what it must be like for someone who is new to the stock market.”

While investors may view Google as a rare chance to get in on some red-hot IPO action this summer, don’t expect the ludicrous hype and wild valuations lionized by the stock market of the late-1990s.

Remember back in March 1999, when, the online airline-ticket retailer, went public at $16 and soared to $69 on its first day — a 331 percent pop?

That isn’t going to happen here, experts say. In fact, Dutch auctions are designed to discourage this very type of behavior.

In a traditional IPO, a company hires an investment bank to estimate how much investors will pay for the shares. Typically, the stock is grossly underpriced in order to provide windfall profits for favored brokerage clients and wealthy investors who get first crack at the shares.

Meanwhile, ordinary investors are typically shut out from the process.

In a Dutch auction, the price is essentially determined by the investors who submit the highest price they are willing to pay and the number of shares they want at that price. The ultimate price everyone ends up paying is the lowest one submitted by the last bidder for whom shares are still remaining.

For example if there are 100 shares of stock to dole out, the one investor who bids on that final, 100th share is the one who ultimately sets the “clearing price” for the entire group. And everybody who bids the clearing price or higher gets the stock they bid for at this lower price.

While the notion of a “steady-as-she-goes” IPO may sound good on paper, some academics wonder if it will appeal to investors.

If Dutch auctions make good on their promise of reducing volatility and eliminating first-day pops, what is the point of getting in on the ground floor in the first place, some argue?

“As an investor, why go through all the headache and brain damage when the stock probably won’t go up the first day anyway?” Taulli asks.

There is historic precedent for investors boycotting Dutch auction IPOs for this very reason, says Ann Sherman, assistant finance professor at Notre Dame, who has written extensively on this subject.

“The mere prospect of being crowded out by thousands of free riders discourages serious investors from devoting time and effort to coming up with a reasonable bid,” Sherman says.

Another problem is buyers tend to overpay for stock in a Dutch auction, because those who place the highest bids have the best chance of getting shares.

Part of the problem with this strategy, according to critics, is it gives bidders a choice: work hard to come up with their own estimate of the value of the company, or else bid a really high price to be first in line, knowing they will likely to pay substantially less than they bid.

“If everyone else does their homework, these free riders save time and effort and are virtually guaranteed shares at a reasonable price,” Sherman says. “But if too many others take the same shortcut, the IPO will be overpriced.”

That is one reason why David Dietze, president of Summit, N.J.-based Point View Financial Services, is advising his clients to steer clear of the Google IPO.

“We are wary of IPOs generally,” he says. “The Dutch auction process can be a fairer system in so far as it gives a greater opportunity for the small investor to snap up shares, but I think that it increases the risk that the price paid at the IPO is too much.”

While most companies are reluctant to break ranks with Wall Street, and go Dutch, those few that have speak glowingly about the process. Two years ago, Patrick Byrne, chief executive of Salt Lake City-based, used the same “Dutch auction” process that Google has proposed to sell the first shares of his online company.

Like Google, Byrne — a former Wall Street banker — saw it as a way to let investors, rather than Wall Street bankers, set the price of his company’s first shares.

“In an auction, you find the right price for your stock right out of the gate,” he says. “The conventional system is unfair. It’s an insiders’ game, and I have yet to see a single person with microphone off who would disagree.”

But unlike Google, was small — its auction raised $40 million, a pittance compared with the $2.7 billion Google hopes to raise — and so it lacked the same clout and power to effect lasting change.

In fact, Byrne says his decision to use the Dutch auction model ultimately landed him in the penalty box.

Aside from Hambrecht, which took the firm public, not one Wall Street firm has issued a single research report about his company since went public in 2002.

“They told me they would never pick up coverage of our company if we did this and … essentially, we still have no Wall Street coverage,” he says.

Byrne hopes Google’s decision to launch an egalitarian IPO by the people, for the people, will help change the status quo on Wall Street.

“People were willing to walk away from us,” he says. “But no one can afford to walk away from Google, because they are so big and prominent.”


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