Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.On April 29, Google filed a registration statement with the Securities and Exchange Commission, indicating its plans to sell shares in an initial public offering. As mentioned in my June 2 Local Tech Wire article “Google’s Unusual IPO Plans Raise Questions”, the filing created a huge buzz on Wall Street and beyond. One of the reasons for this buzz, as alluded to in my earlier article, is that the offering is being sold and priced using a “Dutch auction.”
On June 21, Google amended its filings with the SEC. A major feature of the revised filings is the addition of much more direct and specific warnings to investors about the risks to them of the auction process. The added warnings — and the issues they raise for investors — impact not only Google but every technology or other company hoping to follow in its footsteps by conducting its IPO using an auction process.
Why an Auction Process? And what is the Auction Process?
The purpose of Google’s auction process is to determine both the price and the allocation to investors of the shares being sold in its IPO. By doing so, Google hopes to avoid two perceived flaws of traditional IPOs. The first is the “pop” in the trading price of the shares from the initial offering price through the first day or two of trading. If this rise is large — such as the 56% opening-day rise in Salesforce.com’s recent IPO — then it means that the company left a lot of money on the table, money that went to speculative traders rather than to the company’s coffers. One of the purposes of Google’s auction process is to set the opening price pretty much as high as the market will bear. The second perceived flaw in the traditional IPO process is the allocation of IPO shares among favored clients of the underwriters or other parties from whom the underwriters hope to gain business; these favored parties are able to buy at the IPO price and profit from any “pop” in the beginning of trading. In the Internet boom of the late 90’s, this led to widespread abuses of the allocation process, to the disadvantage of ordinary investors.
Google’s registration statement divides the auction process into five steps. The first is qualification, where potential bidders in the auction register to qualify to bid; this is done by setting up an account with one of Google’s underwriters (there are about 30 of them currently), meeting the underwriter’s suitability standards, and obtaining a bidder id. The second is bidding, where qualified investors bid both what price they are willing to purchase shares at, and how many shares they are willing to purchase at that price. (Investors may make multiple bids, so, for example, could bid to purchase both more shares at a lower price and fewer shares at a higher price.) The third is closing, where Google and its underwriters will close the auction; although Google reserves the right to close the auction at any time, it appears that it plans to close the auction in connection with the SEC declaring the registration statement effective.
Once the auction is closed, the fourth step is for Google and the underwriters to use the information from the bids to price the shares. Google intends to set the IPO price at a price that is at or near the “clearing price” — the highest price at which all of the shares offered may be sold to potential investors, based on the bids received in the auction process (thus maximizing the proceeds to Google and to its stockholders who are selling shares in the offering). Finally, once the shares are priced, Google will allocate them among investors, with the objective being to ensure that each successful bidder receives at least 80% of the number of shares for which he bid. Google will either allocate the shares pro rata among all successful bidders, or will use a more complex algorithm that fills all small bids and has a maximum share allocation, or cap, for larger bids.
Amendments to IPO filings highlight risks of auction process
The auctioning off of IPO shares — at least as planned by Google, where the aim is to set the highest price at which there are sufficient buyers for the shares — has some different risks for investors than the traditional IPO process. Google’s recent amendments to its IPO filings, presumably at the urging of the SEC as part of its comment process, highlight these risks in significant detail. These warnings start on the very front page of the prospectus, which now says that, as a result of the intent of the auction process (i.e., setting the highest possible price) “buyers should not expect to be able to sell their shares for a profit shortly after our [stock] begins trading.” This warning is echoed throughout the prospectus and the remainder of the registration statement, highlighting a very significant consequence of Google’s plans — because the offering will be sold to those who are willing to pay the most for the shares, there will likely not be much demand in the market to push the price higher. On the contrary, there are a number of factors that suggest that the price could well drop from the offering price.
The first of these risks, which was pointed out by Google in its initial filing, is the so-called “winner’s curse,” a form of buyer’s remorse. Google notes in the risk factors section of the prospectus that successful bidders may infer that there is little demand for Google’s shares above the offering price, and may thus conclude that they paid too much. If this conclusion leads these investors to immediately sell their shares, there will be downward pressure on the stock and so Google cautions investors “that submitting successful bids and receiving allocations may be followed by a significant decline in the value of their investment” shortly after the offering.
A second risk is that the offering is going to be priced based on the demand from the entire universe of potential investors, from fully-informed ones to people who hear the name Google and want to buy, with little or no ability to determine what a fair price for the shares might be. As Google notes in a newly inserted risk factor, this is very different from the typical IPO process, where most of the shares are purchased by professional investors “with significant experience in determining valuations for companies” who “typically have access to, or conduct their own independent research and analysis” regarding investments in IPOs. Google warns that the participation in the bidding process of investors who are less price sensitive than professional investors may result in IPO price higher than that most professional investors are willing to pay — which most likely would lead to a decrease in the price in subsequent trading. A recent Washington Post article (“Google Gives IPO Details, Warnings”) quotes one analyst who suggests that some major institutional investors may choose to boycott Google’s IPO, which, if true, would mean that the risk from the lack of professional participation in the auction process is a significant one, both because it removes their participation from the price setting process, and because it significantly decreases the pool of buyers.
A third risk is that the offering is being priced in a manner that has no relation to traditional valuation methods, such as multiples of earnings or cash flow, sales, revenues, market prices of competitors, etc. Research analysts, applying traditional valuation methods, will come up with target prices for Google’s stock that may bear no relation to the offering price and that may well be below the offering price. This too would create significant downward pressure on the stock, and is addressed by Google both in newly-inserted risk factors and elsewhere in its registration statement.
After the offering
These newly-highlighted risks in the auction process are real and significant. It will take some time after Google’s IPO occurs to see how these risks play out and whether the auction process — which is almost certainly good for Google in the short term, since it will maximize the offering proceeds — is positive in the longer term. If the risks are manageable, and Google’s stock price rises or remains relatively stable for a period after its IPO, then it is likely that the auction process will become a more and more important part of the IPO and capital raising process. If Google’s shares decline significantly, then it is likely that the auction process, at least in the form used by Google, will not be considered a viable path for most companies looking to go public.
Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based businesses, focusing on corporate, taxation and securities matters. Questions or comments can be sent to email@example.com