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Imagine the Dutch auction of a 100 share offering.
The auctioneer begins by calling out a prohibitively
high price per share that he knows will attract no
bids. He then calls out lower and lower prices until
someone decides to buy a few shares (eight, for
example). The auctioneer continues to lower the
price until someone agrees to buy more shares (12,
for example). So far, bidders have bought 20 shares,
one-fifth of the total IPO, and they've bid
different prices.
The auctioneer continues to lower the price until
all 100 shares are spoken for. At auction's end,
bidders get the number of shares they agreed to buy,
but at the price bid by the last bidder. If
the first guy bid $100 per share for the eight
shares, and the second guy bid $75 per share for the
12 shares, they only pay what the last guy bid--say,
$50 per share. In the Salon
IPO, for instance, bidders have a month or so to
visit a Web site and enter 1) a price and 2) the
number of shares they're willing to buy. A computer
records the bids and, at the end of the specified
period, simulates the auction described above.
In theory, buyers pay more for stock in Dutch
auction IPOs than in ordinary IPOs, which means more
money will go to the firm that's selling shares.
How's this? In an ordinary IPO, the firm hires an
investment bank to estimate how much investors will
pay for the shares. Then the firm agrees to sell
stock at a fixed price below
this estimate. (Why sell below the estimate?
Patience, Explainer will get to that.) Generally,
the first in line to buy IPO stock can turn a quick
profit by immediately selling it for a higher price
on the market. For example, last September, the eBay
IPO went out at $18 a share, and the price zoomed to
$48 after one day of trading. This was an atypically
large short-term run-up, but the average short term
run-up of IPO stocks between 1960 and 1987 was still
16 percent--a nice profit for a few days' work
Naturally, there is great competition to be one
of the lucky few buying shares at the low price. In
an ordinary IPO, the investment bank decides who
gets to buy these discounted shares, funneling them
to its best clients, usually rich individuals or
large institutions (pension funds, endowments,
etc...). This is a good deal for the prized clients,
who make easy money, and for the investment bank,
which gets to impress clients. But it's a bad deal
for the firm holding the IPO because they could have
reaped that capital.
You may be wondering why firms agree to ordinary
IPOs at all. There may, in fact, be no good reason
besides tradition for the current system. The Dutch
auction model--which promises more money up
front--may push out the old model and become the
industry standard.
On the other hand, there two reasons why the
traditional model may be superior in the long run.
The price spike associated with a traditional IPO
imparts an aura of success to the stock, which may
in itself boost the stock higher. This benefits the
firm's executives, who own shares, and the company
itself, which also owns shares that it may unload to
satisfy its own capital needs. (IPOs usually involve
selling only a small portion of a firm's outstanding
stock. It's not unusual for firms to sell new stock
several times in a decade.) Another advantage of
selling IPO shares at a discount to wealthy
individuals and large institutions is that these
investors tend to hold assets for long periods,
thereby decreasing chances the stock will tank if
the firm has a mediocre quarter..
Finally, traditional IPOs also irritate the
average investor, who feels wronged because
"insiders" made easy money. Will the Dutch auction
help "outsiders" who can't catch a break with the
current model? This has been suggested--by the firm
conducting the Dutch auctions, among others--but is
simply not true. The money that once went to
"insiders" now goes to the IPO firm, which is no
help to "outsiders" at all. |