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IPO Auctions: Case StudyGame TheoryZachary GentryBill JohnsonKatherine PetersonNikhil VaswaniTable of ContentsIntroductionBook-Building vs. Auction IPOsIPO Auctions and Revenue EquivalenceHistorical Experience with IPO AuctionsGoogle IPO Case StudyAuction Design FlawsInvestor Insult ValueThe Game of IPO PoisoningWhat Could Google Have Done?ConclusionIPO Auctions: Case StudyGame TheoryZachary GentryBill JohnsonKatherine PetersonNikhil VaswaniTable of ContentsIntroduction..........................................................................................................................3Book-Building vs. Auction IPOs.........................................................................................3IPO Auctions and Revenue Equivalence.............................................................................6Historical Experience with IPO Auctions............................................................................8Google IPO Case Study.......................................................................................................9Auction Design Flaws..........................................................................................................9Investor Insult Value..........................................................................................................14The Game of IPO Poisoning..............................................................................................14What Could Google Have Done?......................................................................................17Conclusion.........................................................................................................................19IPO Auctions: Google Case Study Page 2IntroductionThe goal of most aspiring entrepreneurs and their venture capital backers is to “go public.” This process showers a company with much needed growth capital. Although there is incredible wealth transferred in initial public offerings, some companies feel cheated in the bargain. Since 1980, the first day price increase after an initial offer has averaged 18.8%. (Ritter 2002) The increase in price benefits early investors but represents market value not captured by the firm. Some companies have fought against the traditional IPO system. One alternative method currently gaining in popularity is IPO auctions. Most IPO auctions had been small offerings until Google, the leader in the online search industry, announced its intention in April 2004 to auction its shares to the public. This paper explores the economics of IPO auctions and the practical realities faced by companies. Given this framework, we then analyze Google’s IPO as a case study.Book-Building vs. Auction IPOsThe IPO process in the United States is very well developed. After a company develops its first audited financial statements, it takes approximately 4-5 months until closing. In that time, an army of individuals from the company, its investment bank, and both of theirattorneys hammer out complex negotiations on the eventual shape of the business. Whilethe process requires vast amounts of specialized expertise, connections and patience, investment banks participate knowing that they will be handsomely rewarded for their efforts.IPO Auctions: Google Case Study Page 3Typically, an investment bank makes about 7% of the total capital raised for conducting due diligence on a company and coordinating its public sale. Banks can also profit from the upside of the stock. When demand for a new issue outstrips number of shares allotted, the bank can issue a “greenshoe” option to allocate an additional 15% of shares. Profits on these shares go directly to the investment bank. Since most IPOs are oversubscribed 2X to 10X, the bank almost always issues a greenshoe option and benefitsin the upside of the stock.As mentioned, the average amount of the first day price appreciation from 1980-2001 was 18.8%, although in the late 1990s first day price appreciation could be as high as 200%. (Ritter 2002) During that period, $488 billion of capital transferred from investorsto companies (Ritter 2002) and therefore $92 billion in extra wealth was transferred to investment banks through the process. This $92 billion represents market value not captured by firms in the IPO process. In addition, growth companies achieve high multiples on cash employed, so this additional profit earned by banks represents a high opportunity cost to firms who could greatly benefit from investing the cash in the firm’s operations.In practice, these shares tend to fall into the hands of a bank’s most valued clients including friends, family and institutional purchasers who might provide additional business opportunities. While this is not a financial concern of the new public company, it does concentrate the ownership constitution of the entity post-IPO. This concentration makes it easier for the owners to force the new public company to be more focused on short-term, quarter-to-quarter earnings estimates rather than the core business and IPO Auctions: Google Case Study Page 4management’s long-term vision. This short-term focus to benefit investors is often contrary to the basic values of many entrepreneurs.It was during the period of speculative excess in the IPO market that Bill Hambrecht, legendary Silicon Valley banking pioneer, first started actively considering ways to use the Internet to enable stock auctions. The basic economics behind auction theory posit that there is greater buyer efficiency and higher seller revenue (capital) in auctions than inthe book build business. The basic formula for generalizing order statistics states that in a uniform distribution of potential values for a good:   11*)(nknVVEknWhere E[V] = expected value, V = intrinsic value and n = number of bidders. Since the pool of potential investors n determines the closeness of E[V] to V, a larger n increases E[V], ceteris paribus. Furthermore, because there is no intermediary between sellers and buyers, the entire surplus should accrue to the company. WR+Hambrecht markets this service under the name OpenIPO. In an OpenIPO auction, buyers have one week to submit their bids. Their bids are independent of other investors and are sealed. At the end of the week all of the bids are aggregated by the seller who hasthe option to take the clearing price or to take a slightly lower price with a partial


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