IPO Auctions:

Game Theory Zachary Gentry Bill Johnson Katherine Peterson Nikhil Vaswani

Case Study

Table of Contents
IPO Auctions: Case Study........................................................................................................1 Game Theory.......................................................................................................................1 Zachary Gentry....................................................................................................................1 Bill Johnson.........................................................................................................................1 Katherine Peterson...............................................................................................................1 Nikhil Vaswani....................................................................................................................1 Table of Contents.....................................................................................................................2 Introduction..............................................................................................................................4 Book-Building vs. Auction IPOs.............................................................................................4 IPO Auctions and Revenue Equivalence.................................................................................7 Historical Experience with IPO Auctions................................................................................9 Google IPO Case Study.........................................................................................................10 Auction Design Flaws............................................................................................................10 Investor Insult Value..............................................................................................................15 The Game of IPO Poisoning..................................................................................................15 What Could Google Have Done?..........................................................................................18 Conclusion..............................................................................................................................20

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IPO Auctions: Google Case Study

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Introduction
The 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 Googles IPO as a case study.

Book-Building vs. Auction IPOs

The 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.

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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 firms operations. In practice, these shares tend to fall into the hands of a banks 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 managements long-

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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:

E V(k ) = V * n

[ ]

( n k + 1) ( n + 1)

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.

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IPO Auctions and Revenue Equivalence

In analyzing IPO auctions, we evaluated the applicability of the revenue equivalence theory. Revenue equivalence theorem states that a sellers 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.

Pay as Bid Auction

Uniform price auction

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-bid auctions.

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(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 goods value, but IPO auctions are goods that have a common value. Auction prices in a common good auction are not based on ones 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 winners 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.

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Historical Experience with IPO Auctions

In the real world, IPO auctions are rare. Many countries have tried them and either abandoned the option or practice. One researcher noted that Germanys 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.

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Google IPO Case Study

In theory, the uniform price auction was chosen to eliminate leaving money on the table, yet on August 19, 2004 Googles 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)

September. 20, 2004 Closed @ $119.36 (40.4%)

August 19, 2004 Opened @ $100.00 (17.6%) Closed @ $100.34 (18.0%)

Auction Design Flaws

The 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

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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 Googles founders appearing in Playboys August issue violated the SECs IPO quiet period restrictions. Investors assumed that this investigation would take a significant amount of time because a similar investigation of Salesforce.coms 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 Googles auction process, the Company decided against registering to offer shares in foreign jurisdictions as is common

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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:

Many Other Bidders Enter Bid -$305K I Dont BId Dont Enter

<$0

I Not Many Other Bidders Enter <$0

Enter I

$0

$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.

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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 winners 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

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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 investors 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 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 Googles 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

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

Investor Insult Value

Throughout 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 longterm goals. At the same time, Googles choice of dual class stock was seen as a negative corporate governance indicator. Wall Streets interpretation of Googles actions was that Googles management was vague, naive and stuck in an ivory tower. (Add citation here?) Money managers could have seen Googles 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 Poisoning

Putting aside Googles missteps discussed above, some of Googles venture capital investors, namely 2005 commencement speaker John Doerr, have complained that

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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.

Play

$29,631M, $97M

Auction

U Poison $21,387M, $54M

G Play Book Build U Poison $21,368M, $73M $29,597M, $131M

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

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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 Googles 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)

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U.S. Initial Public Offerings1

$50 250 200 150 $30 100 $20 50 0 2001 2002
Total Proceeds

$ billions Offered

$40

$10 2003
# Deals

2004

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 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
1

www.ipohome.com, 2004 Annual Review.

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# of Offerings

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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, Googles attempts to include more potential investors by expanding the syndicate hindered the auction process. The syndicate represented most of the

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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 Googles missteps led to the under pricing while Googles 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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