Loving the IPO Comeback
Few private companies ever create the hoopla that Google did in April, when founders Sergey Brin and Larry Page announced plans for an initial public offering. The search-engine company's IPO was hailed as proof that investor appetite for technology stocks had returned. And Google's most ardent fans were quick to claim that the unique offering -- a Dutch IPO auction -- would revolutionize the market, empowering entrepreneurs and individual investors at the expense of the big investment banks. But while there may be some truth to these assertions, Google's lasting impact could prove far different from the current hype.
First, it's important to note that the IPO market had rebounded well before Google's announcement. By late April, the volume of completed IPOs had increased tenfold over the same period in 2003, and 118 companies filed with the Securities and Exchange Commission to go public -- more than all of last year combined. (A chart of recent IPO activity appears on the next page.)
None of this is to suggest that the market has returned to boom-year levels; 900 companies went public between 1999 and 2000. But "momentum is building," says Renaissance Capital analyst Kathy Smith. And a healthy IPO market benefits all entrepreneurs because it typically prompts venture capitalists, private equity firms, and even angel investors to increase their activity too -- all of them in pursuit of the next big score.
The phenomenon could be especially strong this year. Small caps are in favor -- the Russell 2000 small-cap index has outperformed other top indices in the past year. And smaller, younger businesses make up the majority of the 2004 class. Companies that have IPO'd since January report median annual revenue of $56 million. Even if you exclude those with zero revenue (think biotech), nearly half of this year's IPOs had annual sales of less than $100 million.
So what impact will Google have? The blockbuster IPO has generated buzz for the entire market. And Brin and Page set an enviable example by going public while maintaining control. Following Google's IPO, the founders and their CEO will retain 92 million (or 40% of) Class B shares, each one with supervoting rights equal to 10 of the Class A shares sold to the public.
In a Dutch IPO auction, participants bid for how many shares they'd like at what price. The underwriters then set a "clearing price" -- the highest price at which all shares can be sold. While all winning bidders pay the same price per share, those who bid above the clearing price generally get all of the shares that they requested. Those who bid at the clearing price divvy up the remainder. And those who bid below that price are out of luck.
The virtue of the auction format is that it places individual investors on equal footing with institutional investors. It also channels more of the investment money to the company; less winds up in the hands of fat cats who flip the pre-IPO shares they get from investment banks. Democratizing the process appeals to entrepreneurs like Nick Lazaris of Keurig, a manufacturer of high-end coffeemakers based in Wakefield, Mass. "I always thought that the rapid growth on the first day of trading was strange and unfair," says the CEO, who hopes to take his company public by 2006. "Shouldn't the company get that money?"
Patrick Byrne, CEO of Overstock.com, agrees. The 2002 IPO of his Salt Lake City-based Internet retailer was underwritten by W.R. Hambrecht & Co., the San Francisco firm run by famed investment banker Bill Hambrecht. His bank has completed nine IPO auctions since 1999, including Byrne's, for a total of $309.2 million. "At the end of the day we counted the money with the lights on rather than with the lights off," says Byrne.
Still, some experts warn that auctions can be risky. Andrew Klein, whose former firm Wit Capital organized about 200 Internet IPO auctions in the late '90s, recalls that the model made pricing a hot IPO very tricky. What could happen at Google, he says, is that the auction creates "so much frenzy" among bidders that the clearing price blows past the company's true market value. The stock could then crash on the first day of trading. However, if Google exercises its right to limit the price of the offering, there might not be enough shares to fill successful bids.
Another concern: annoying the investment bankers. After an auction, "you make enemies, but that's good for a laugh," says Overstock.com's Byrne. "The corrupt cartel's been standing shoulder to shoulder to prevent Bill Hambrecht from doing this."
And yet, shunning the banks can backfire. As the novelty of the IPO auction wears off, smaller companies that rely on that model may find themselves overlooked and undersubscribed, says Ann Sherman, a Notre Dame professor who has studied IPO auctions overseas. At least under the current system "you are guaranteed that a certain number of investment banks and institutional investors will look at the company," Sherman explains. "They might not like what they see, but at least they'll look at it."
If Google's Dutch auction is to transform the way IPOs are done, it will have to overcome these concerns. But in the end, the lasting reform that Google has achieved may be something else entirely. According to Klein, the real news for entrepreneurs is that Google forced underwriters Credit Suisse First Boston and Morgan Stanley Dean Witter to slash their fees to roughly 3%, down from 7%. While the banks still stand to make as much as $81 million, "that 7% has never been negotiable," says Klein. "Now that the percentage is negotiable, it's a slippery slope." This is great for companies and small investors, he says: "Everyone benefits but the banks."