google ipo project

IPO Auctions: Case Study

Game Theory

Zachary Gentry

Bill Johnson

Katherine Peterson

Nikhil Vaswani

Table of Contents

Introduction..........................................................................................................................3

Book-Building vs. Auction IPOs.........................................................................................3

IPO Auctions and Revenue Equivalence.............................................................................6

Historical Experience with IPO Auctions............................................................................8

Google IPO Case Study.......................................................................................................9

Auction Design Flaws..........................................................................................................9

Investor Insult Value..........................................................................................................14

The Game of IPO Poisoning..............................................................................................14

What Could Google Have Done?......................................................................................17

Conclusion.........................................................................................................................19

IPO Auctions: Google Case Study

IntroductionThe 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

their attorneys hammer out complex negotiations on the eventual shape of the business.

While the process requires vast amounts of specialized expertise, connections and

patience, investment banks participate knowing that they will be handsomely rewarded

for their efforts.


Typically, 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 benefits

in 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 investors

to 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


management’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 in

the book build business. The basic formula for generalizing order statistics states that in

a uniform distribution of potential values for a good:

Where 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

has the option to take the clearing price or to take a slightly lower price with a partial

allocation scheme, a practice that is referred to as a “dirty Dutch” auction. (Sherman

2004) There have been 12 IPOs to date using the OpenIPO bidding system and

considerably more follow-on offerings.


IPO Auctions and Revenue EquivalenceIn analyzing IPO auctions, we evaluated the applicability of the “revenue equivalence

theory”. Revenue equivalence theorem states that a seller’s revenue will be equivalent

independent of the auction method used, as long as the following conditions are met:

(Milgrom and Weber 1982)

A single, indivisible object is to be sold Winning bidder has the highest value for object Values are independent, non-collusive and non-cooperative

A number of the above conditions do not hold true in the case of an IPO auction. Most

critically, in an IPO auction, there are multiple units for sale. Therefore, the seller must

determine how to efficiently allocate shares.

The two most common models are the “pay as bid” and “uniform-price” auctions. In a

pay-as-bid auction, bidders submit bids based on their localized demand at various prices.

Sellers aggregate the bids and set the clearing price, but each buyer pays their bid

amount. In a uniform-price auction, bidders again submit their demand curve, but

bidders essentially get the quantity demanded at the clearing price. Evidence from

Treasury auctions suggests uniform-price auctions yield higher revenue than do pay-as-


Uniform price auctionPay as Bid Auction

bid auctions. (Malvey et al. 2001) The primary reason stated was that pay-as-bid

purchasers are likely to bid their value, under normal rules of auction theory. Uniform

price auction participants on the other hand tend to submit bids “ahead of the market”

because there is no penalty for submitting bids above their value.

The second major divergence from revenue equivalence deals with the valuation of the

underlying asset. Revenue equivalence holds most strongly in a world of private values,

where each bidder has their own estimate of the good’s value, but IPO auctions are goods

that have a common value. Auction prices in a common good auction are not based on

one’s estimation of the inherent value of the good but on the level of return attributable to

the good. Assume a good with a common value of (x) with an error (), which is taken to

have a mean of 0. Since each participant in a common value auction has a similar

expectation of x and similar uncertainty around , bidders in sealed-bid auctions

rationally bid x. However, in a public outcry auction, buyers can get roused into

believing that their assessment of is incorrect and bid beyond their value of x. This is

classically referred to as the “winner’s curse” as the highest bidder receives the good but

might not be receiving it profitably. The curse is typically a function of the amplitude of

.

In summary, while revenue equivalence holds for single unit, privately valued goods, the

world for multi-unit goods with common values is a bit murkier. It does not invalidate

IPO auctions at all – it simply means that the choice of method could be deterministic in

explaining the level of buyer efficiency and seller revenue.


Historical Experience with IPO AuctionsIn the real world, IPO auctions are rare. Many countries have tried them and either

abandoned the option or practice. One researcher noted that Germany’s Neue Markt

provided the opportunity to auction IPOs, but of the three hundred companies that went

public on the market, only one actually used an auction format. (Christian Leuz quoted in

Discussion of Ausubel 2002) Historic data from international stock markets suggests that

even among countries that originally developed an auction methodology for IPOs, this

method was eventually abandoned in favor of a book-building methodology. IPO

auctions were tried in Italy, the Netherlands, Portugal, Sweden, Switzerland and the U.K.

in the 1980s, and in Argentina, Malaysia, Singapore, Taiwan and Turkey in the 1990s,

but they were abandoned in all of these countries years before book building became

popular. (Sherman 2004)

Some of the reasons posited for the historical lack of interest in IPO auctions are as

follows:

Valuation is difficult and expensive. If there are no economic rents commensurate with the level of the amount of cost, there is no reason to pay the reservation price.

Number of potential participants is large so the opportunity as measured in shares per investor is exceedingly small.


Google IPO Case StudyIn theory, the uniform price auction was chosen to eliminate “leaving money on the

table,” yet on August 19, 2004 Google’s stock opened 18% above where it had priced

the night before. This initial increase rewarded early investors and represents value

not captured by Google. Further, after the first day pop, the stock price has

continued to climb, topping $225 in May 2005 (see Chart 1 below). There are three

potential game theoretic explanations for this.

Chart 1: Google Historic Stock Price and Trading Volume (need citation)

August 19, 2004

Opened @ $100.00 (17.6%)

Closed @ $100.34 (18.0%)

September. 20, 2004

Closed @ $119.36 (40.4%)

Auction Design FlawsThe first imperfection in the Google auction was the investor qualification process.

Investors were required to visit a Google website in order to receive a bidder

identification number. Once the auction began, investors were not allowed to obtain

bidder identifications. Thus, there may have been a population of interested

investors excluded from the offering. Once the offering priced, these investors were


happy to bid the price up. By making the process difficult for all investors to

participate, Google may have left some value on the table.

This flaw was exposed because of circumstances unique to the Google situation.

Market conditions worked against Google. In the weeks prior to the auction Yahoo!

And Amazon, two comparables, both reported earnings misses for the second quarter

of 2004. The Morgan Stanley Internet Index dropped 10%. In addition, the Company

encountered difficulty with the Securities and Exchange Commission (“SEC”). There

was concern that an interview of Google’s founders appearing in Playboy’s August

issue violated the SEC’s IPO quiet period restrictions. Investors assumed that this

investigation would take a significant amount of time because a similar investigation

of Salesforce.com’s IPO in early 2004 had resulted in a three month delay.

Therefore, many investors put off diligence of Google and were caught off guard

when the delay turned out to be only ten days.

These delays exposed Google to another auction flaw – the reconfirmation of bids.

The auction rules stipulated by the SEC, and set forth in the prospectus, state that

the underwriters must reconfirm any bids if there is a material change to the

prospectus, or if fifteen days pass. This occurred because of the Playboy delay, as

well as the 25% decrease in the price range that occurred on August 18. This came

at an inopportune time because many institutional investors take holiday in the

second half of August and may have been unavailable to reconfirm bids. If so, their

prior bids were erased from the order book, thereby lowering the number of bidders.

The auction design also precluded significant international participation. Due to

regulatory hurdles related to the design of Google’s auction process, the Company

decided against registering to offer shares in foreign jurisdictions as is common

practice with most large IPOs. Again, this limited the population of investors

participating in the auction.


In addition, although this auction system is designed to increase the number of

bidders by being open to all investors thus leading to higher revenues for the

company, it may actually have had the opposite effect on the Google IPO. Take the

following game where an investor must decide whether to bid or not for Google

shares:

I

IEnter

Don’tEnter

Bid-$305K

Don’t BId<$0

$0

I

Many OtherBidders Enter

$0Not ManyOther BiddersEnter

<$0

If the investor decides to enter the auction (i.e. register for the bidding process) then

they can decide to bid or not bid. We assume that there is a negative value

marginally lower than zero associated with an enter, no bid strategy. Not bidding

implies that the investor does not perform any due diligence. However, in the Google

IPO, investors did have to register with Google before submitting a bid to a broker.

We assume that the time associated with the registration process is small but

significant when compared to a breakeven alternative.

Conceivably, someone who did not perform due diligence may bid, but this is always

a sub-optimal strategy. By definition, an investor who neglects due diligence does

not know his willingness to pay. He can bid low, hoping to win shares at a cheap

price. However, if there are many competing investors, he will likely get no


allocation. If there are few competitors, and he does win, there is a winner’s curse.

He owns shares that no one else wants and should not expect a pop. Thus, we

collapse this branch of the tree to one node with a marginally negative outcome.

If they decide to bid they would bear the cost of doing due diligence. This has been

estimated by assuming that the mean first day return for early investors (18%) is

compensation for their due diligence efforts. Thus, using an average IPO value of

$254mn (www.iporesource.com 2004) and assuming an average investor receives an

allocation of 0.67% (on average a 20K share allotment in a 3mn share offering) then

their initial investment is $1.7mn. Therefore the first day return of 18% equates to

$305K, which we assume to be an estimate for the cost of due diligence to the

average institutional investor. After deciding to bid there are two possible outcomes:

One where there are not many other bidders, therefore forcing the expected value

further below the intrinsic value, resulting in a first day pop (assumed to be 18%),

thus compensating the investors for their due diligence and leaving them as happy

owners of the stock (we assume that given indifferent payoffs, investors would prefer

to own the stock). The other possibility, of many other bidders entering the auction,

would subsequently increase the expected value towards the intrinsic value therefore

negating the pop and resulting in overall negative returns for the investor (after

taking into account the due diligence costs). This outcome is contingent on the

number of other bidders entering the auction. If there were perceived to be too

many bidders, then through backward induction, the average investor would assume

losses if they entered (as even entering without bidding has some cost) and would

thus prefer not to enter.

This analysis is contingent upon the investor’s perception of how many other bidders

would enter the auction. For example, if they believed that the average of all bidders

in terms of size were the same as the average bidder then they would require an

allotment of 14,000 shares to cover their due diligence costs ($305K/(18% x $121


http://www.iporesource.com/

which was the initially announced mid point giving the expected $ rise in the share

price by the end of the first day). This equates to 0.07% of the offered shares

(14,000 / 19.6mn). Therefore they would enter, only if they believed that less than

1,405 bidders would enter the auction in total (100% / 0.07%).

It was extremely unlikely at that time that so few investors would actually bid in the

auction, as the IPO was widely hyped and it was one of the most anticipated IPOs in

2004. In fact, as of October 2004 Google had 2,739 stockholders of record (SEC filing

424-B3). Although this would have been affected by post IPO trading, it gives us

comfort to believe that there were many more bidders than the required maximum

during the auction, especially since many investors may have exited after taking

early gains and personal brokerage accounts are typically aggregated by the broker

for filing purposes, Therefore it was rational for the average investor to not bid in the

auction at all. In addition, one of Google’s stated aims was to use the auction

mechanism to avoid the one day pop altogether, thus dissuading investors from

entering even further.

All these various factors resulted in fewer bidders in the auction. Game theory

suggests that in this type of auction, fewer bids leads to less captured value by the

seller. Indeed, the fact that investors were willing to bid up the stock in the after

market (first day pop) indicates that Google failed to capture the full willingness to

pay of the market.

Investor Insult ValueThroughout the IPO process, Google displayed disdain for Wall Street and established

practices in the financial community. Not only did Google seek to eliminate excess

gain from the IPO pricing, they attacked established practices with regard to

institutional access and forward guidance. Google did not provide incremental

insight into the business during its roadshow as is customary. In fact Google CEO,


Eric Schmidt, did not attend the roadshow meetings. (Brewster and Waters 2004)

Additionally, Google stated that it would not provide future guidance to analysts, as is

standard Wall Street practice, because it did not want to lose focus on its long-term

goals. At the same time, Google’s choice of dual class stock was seen as a negative

corporate governance indicator. Wall Street’s interpretation of Google’s actions was

that Google’s management was vague, naive and stuck in an ivory tower. (Add

citation here?)

Money managers could have seen Google’s attitude and dismissal of their traditions

as an insult. Out of spite, they declined to participate in the initial public offering.

This may have been a rational strategy if their insult value was greater than

estimated profits. Though the banks missed out on potential profits, they did succeed

in embarrassing Google to some extent. After the stock performed well in its first few

days of trading, these institutions saw the need to own the stock. (Kedrowsky 2004)

The Game of IPO PoisoningPutting aside Google’s missteps discussed above, some of Google’s venture capital

investors, namely 2005 commencement speaker John Doerr, have complained that

Wall Street investment banks “poisoned” the Google IPO in order to protect their

vested interests. By poisoning we mean that the banks undertook non-public efforts

to undermine a successful offering. This could include not marketing the transaction

as aggressively as other transaction and using back channels to persuade

institutional investors not to bid. For this to be plausible, the banks must make more

profits through the poisoning strategy than through a cooperating strategy. This can

be modeled as a sequential game, with Google (“G”) acting first and the underwriters

(“U”) acting second.


G

U

U

$29,631M, $97M

Auction

BookBuild

Play

Poison

Play

Poison

$21,387M, $54M

$29,597M, $131M

$21,368M, $73M

We measured the outcome for Google in terms of the value realized by existing

shareholders through the offering. This is calculated as:

(total post-offering shares – primary shares offered) * offering price – fees

The banks’ outcome is a straightforward fee calculated as a percentage of the total

offering size. The agreed fees for the Google auction were 2.8%. Based on

discussions with Dr. Ann Sherman, Notre Dame University, we believe that a

traditional book build would receive an additional 100bp in fees. This does not match

up with the oft-quoted 7% IPO fee. However, such large fees are not charged on

equity offerings in excess of $200 million. Given an initial offering size approaching

$4 billion, a fee of 3.8% is not an unreasonable assumption.

To test the hypothesis that the banks poisoned the Google offering, we first assume

that they did in fact poison the offering. The “play” outcomes reflect data from

Google’s amended S-1 filing of July 26, 2004 (one day prior to the roadshow launch.)

The “poison” outcomes reflect data from the final Google prospectus. Because it is

unclear what the outcome of a book build IPO would have been, we assume that

expectations at the roadshow launch would have been met. However, there are

significant external factors (SEC disclosure, dual class structure, roadshow missteps


and vagueness of future business plan) that may have altered the outcome.

Nonetheless, for purposes of simplification we assume that Google would have been

able to price the original number of shares at the midpoint of its filing range $121.50.

Using backward induction on this game, we see that the underwriters have a

dominant strategy of playing along. In this case, Google is marginally better off with

an auction, so the outcome is an auction in which underwriters play along.

However, this simple game does not factor in the future benefits at stake. We see

that if the banks can gain more than $43 million of future profits from poisoning an

auction, we should expect them to do so. The future benefit is the present value of

the 100bp difference in IPO fees on future offerings less negative reputation effects

of an unsatisfactory underwriting. To calculate the future IPO fees, we assume that

initial public offerings will continue at or near historical levels. The average annual

issuance over the past 4 years is $30 billion, as shown in Chart 2 below.

Chart 2: U.S. Annual Initial Public Offerings (www.ipohome.com 2004)

U.S. Initial Public Offerings1

$10

$20

$30

$40

$50

2001 2002 2003 2004

$ b

illi

ons

Off

ered

0

50

100

150

200

250

# of

Off

erin

gs

Total Proceeds # Deals

Thus, we estimate that the investment banking industry stands to lose approximately

$300 million annually if IPO auctions were instituted across the board. The Google

1 www.ipohome.com, 2004 Annual Review.


http://www.ipohome.com/

underwriting syndicate included most of the major investment banks (noticeably

absent was Merrill Lynch.) In any case, the benefit to the Google underwriters was

far in excess of $43 million, even if only evaluating one year. It is harder to pin down

the reputation effects on the banks. There are many parties involved and the blame

can be easily spread. We assume that these effects, though possibly substantial,

would still not outweigh the increase in IPO fees. Adding these factors into the

sequential game, Google should have foreseen that the investment banks would

poison and should have instead chosen the traditional book build.

What Could Google Have Done?A traditional book build would have been unacceptable to Google, since they saw

eliminating secretive Wall Street practices as part of their “Be Good” mantra. What

alternatives should Google have considered?

The first option would have been to demand a more transparent book building

process. Traditionally, investment banks have allocated shares at their discretion

based on who they felt would be the best shareholders. Though they are paid to

make the best allocation possible, they do disclose the data to back up their

conclusions – the complete order book. In practice, this led to abuses as favored

clients were always deemed to be the best shareholders. Google could have required

its underwriters to share the order information in the book before final allocations.

This would allow Google to ensure that investors who expressed high willingness to

pay got allocations, rather than being passed over by the syndicate. One potential

issue with this option is that individual investors have limited access to book build

IPOs, even if they are transparent, due to lack of brokerage accounts at the major

investment banks.

The second option would be to choose an underwriting syndicate with less to lose.

While we showed that as a group the syndicate was better off poisoning the offering,


an individual underwriter may have more aligned interests. Choosing one lead

underwriter instead of two may have tilted the scales in favor of the auction.

Assuming that a successful offering would establish the lead underwriter as the

preferred investment bank for initial public offerings, the underwriter would have

much greater incentives to ensure a successful offering. The size of the fee “pie”

would decrease, but by taking a larger share, one bank (or a small group) could

benefit. Taking this to an extreme, Google could have chosen an underwriter without

much history in traditional IPOs, WR Hambrecht. Bill Hambrecht is a well respected

banker in Silicon Valley. His firm had little to lose from traditional IPO underwriting

and it was arguably the most experienced at IPO auctions. As a minor participant in

the Google syndicate, Hambrecht could not influence the process much, but as lead

underwriter it is virtually certain they would play along.

Ironically, Google’s attempts to include more potential investors by expanding the

syndicate hindered the auction process. The syndicate represented most of the

traditional powers in IPO underwriting and provided an easy means to collude on

poisoning the offering.

Conclusion

It is difficult to say which of these ideas explain the “underpricing” of the Google IPO.

The investment banks argue that Google’s missteps led to the under pricing while

Google’s shareholders claim a nefarious plot on behalf of the underwriters. In truth it is

probably some combination. It would appear that Google tried to bake its cake and eat it

too. They tried to take the best of auctions (investor access and transparency), as well as

the best from book building (investment banks’ relationships and distribution) and ended

up getting neither. Although they did not escape the first day pop, they did achieve two


of their stated aims; that of wider distribution of share ownership and lower fees paid to

banks.


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