If you’ve spend some time researching types of IPOs, you’ve certainly stumbled upon traditional IPO paths such as the fixed price and book building methods, which involve serious collaboration with underwriters and investment banks to determine the opening stock price.
But some companies — notably Google — have started challenging the need for institutional involvement. Why not let real people decide the opening price of the stock in a bid, rather than big banks and institutional underwriters? The principle behind Dutch Auctions and Open IPOs, in other words, is the democratization of stock pricing.
So what do auctions and open IPOs actually do?
Dutch auctions and Open IPOs work on a bidding system that allows institutional investors and retail investors alike to bid blindly on the number of shares they want to buy and the price they’re willing to pay, a process that helps the company set its opening price at IPO.
But what are the differences between Dutch auctions and Open IPOs, and when is one more appropriate than the other? The answer is in the detail, explained in the paragraph below. See this article if you’re interested in traditional book building IPOs.
Dutch auction and Open IPO Differences
The key difference between Dutch auctions and Open IPOs is that Dutch auctions sell shares progressively starting with the highest bid and descending until all stocks are sold, whereas an Open IPO uses the same bidding methodology but sells all of the stocks at the lowest bid price, such that all bidders pay the same amount.
In addition, Dutch auctions are usually closed events for institutional investors and certain high net worth individuals, whereas Open IPOs are known for their transparency and “openness” to retail investors.
Finally, Dutch auctions often happen in person or in closed online bidding platform rooms, whereas Open IPOs by definition take place in open bids online. Of course, Open IPOs require some system of vetting to prevent non-serious investors from falsifying the lowest bid price, but the principle of accessibility remains.
Dutch auction and Open IPO Similarities
While they have some differences, Dutch auctions and Open IPOs should not be interpreted as entirely different from IPO stock pricing methodologies. On the contrary, compared to traditional fixed price and book building methodologies, they’re very similar.
- Dutch auctions and Open IPOs both use a digital bidding system. This allows them to ensure the integrity and independence of the bids.
- They both use the same tiered bidding system, which I’ll explain below.
- They both rely on the principle of blind bidding, which allows them to prevent communal knowledge to thwart the real value of the stock in the retail market.
In addition, compared to radical alternatives such as reverse mergers and direct public offerings, Dutch auctions and Open IPOs are reasonable, actionable alternatives to the traditional paths.
Whereas reverse mergers and direct offerings seek to undercut the entire IPO process, Dutch auctions and Open IPOs simply democratize the stock valuation step.
Dutch Auction Explained in Detail
Imagine you work for a wholesale watch brand that wants to go public with 10,000 shares. You have been approached by big banks who would like to underwrite and value your stock at $35. You think this is too low, and decide to go with a Dutch auction. You invite 10 investors to the auction. They bid the following amounts and number of shares, and are therefore placed in the positions below.
Bidders:
- Investor 1: 2,000 shares at $3,500
- Investor 2: 500 shares at $1,000
- Investor 3: 300 shares at $300
- Investor 4: 200 shares at $750
- Investor 5: 500 shares at $1,200
- Investor 6: 1,000 shares at $3,000
- Investor 7: 1,000 shares at $3,500
- Investor 8: 2,500 shares at $4,000
- Investor 9 1,500 shares at $1,500
- Investor 10: 2,000 shares at $500
Position:
- Investor 8: 2,500 shares at $4,000 (10,000 – 2,500 = 7,500)
- Investor 1: 2,000 shares at $3,500 (7,500 – 2,000 = 5,500)
- Investor 7: 1,000 shares at $3,500 (5,500 – 1,000 = 4,500)
- Investor 6: 1,000 shares at $3,000 (4,500 – 1,000 = 3,500)
- Investor 9 1,500 shares at $1,500 (3,500 – 1,500 = 2,000)
- Investor 5: 500 shares at $1,200 (2,000 – 500 = 1,500)
- Investor 2: 500 shares at $1,000 (1,500 – 500 = 1,000)
- Investor 4: 200 shares at $750 (1,000 – 200 = 800)
- Investor 10: 2,000 shares at $500 (800 – 800 = 0)
- Investor 3: 300 shares at $300
As you can see, investor 3 does not get any shares, since his bid was too low. On the other hand, investor ten will only get a portion of his shares — 800/2,000 to be exact, or 40% of his desired shares. Keep in mind that this spread of prices and amounts is unlikely. Most bids will be much closer.
The Dutch auction is obviously favorable to the company, who will sell it’s shares at the above prices to these initial investors before offering them to the public in the IPO at the lowest bid price ($500 in our example). However, it’s not exactly fair to the high bidders in the auction.
Investor 4, for example, walks away with 200 shares that s/he purchased at $750 each. This means s/he will will be able to sell the stock post-IPO if the price increases by at least 51%. However, investor 8 walks away with 2,500 shares at $4,000 each. This means s/he will have to wait for the stock to raise by 400% before it is even breakeven. Not such a good deal for investor 8.
This inequality may appear aggressive at first glance, but it’s much safer than the traditional path in which one (sometimes two) investment bank tries to determine the optimal price alone. If they overshoot the price, they will loose a lot of money at opening when retail investors buy for less (i.e the Uber IPO).
However, if they undershoot the price, they will look very bad in the eyes of the company, who could have made much more money had the offering price been higher. And unfortunately, the banks make mistakes far more often than they would like.
However, there is an alternative to the Dutch auction approach. Open IPOs may be the future of stock pricing since they avoid the uncertainty of investment bank underwriting, and because they avoid the inequality among initial investors in a Dutch auction. Let’s see how it works.
Open IPO Explained in Detail
Open IPOs operate the same way as Dutch auctions, except the highest bidders don’t get ripped off. The whole auction takes place via an online platform that allows a fixed number of bidders to participate.
Once these bidders place their “# and purchase price” bids, a simple calculation, such as the one shown above for Dutch auctions, shows what the minimal price must be to sell all of the shares. At that point, every investor above the threshold receives a proportional number of available shares based on their original offer.
For example, imagine the offering price is determined at 100 and there are 1000 available shares. One investor puts in a bid for 200 shares at $800 each. Another investor puts in a request for 300 shares at 100$. A third investor puts in a bid for 500 shares at $50 each. In this case, the maximum price each investor will pay for a share is $50, since this is the lowest bid.
However, the first investor valued the shares at $800, which means he took more risk in the bid. A simple way to solve this is using a weighted number of shares. We take the product of each investor’s price and # bid, add them up, and take the percent of total for each. Here, it would be 800 x 200 = 160,000, 300 x 100= 30,000, and 500 x 50 = 25,000. The total is 160,000 + 30,000 + 25,000 = 215,000. In other words, our investors would each take this portion of the shares:
- Investor 1: 160,000 / 215,000 = 74%
- Investor 2: 30,000 / 215,000 = 14%
- Investor 3: 25,000 / 215,000 = 12%
Each investor takes this respective percent of shares at the lowest bid price: $50. In some sense this is a better setup than the Dutch auction. Investors prefer it because none of them overpay and risk losing cash with high bids. On the other hand, the company loses the money from competitive dynamics in the bid. This is the key factor to consider for companies looking for an auction-based price discovery.
Advantages and Disadvantages
The advantages of Dutch auctions and Open IPOs depend on who you want to win the most. In short, Dutch auctions have the potential to benefit companies, whereas Open IPOs tend to benefit initial investors more.
The advantage of a Dutch auction is that it optimizes up-front earnings for the company by taking open blinds from investors without adjusting for the minimum price bid. However, it’s obviously not good for investors who find themselves with overpriced stocks in a company whose IPO price doesn’t take off.
Open IPOs, on the other hand, are great for investors, as nobody finds themselves with unprofitable shares. However, companies may find that they loose out on potential gains from high-bidding investors. Still, most companies recognize that “ripping off” high bidders can create negative press, so they may choose to disregard it entirely.
Costs of Dutch Auction vs Open IPO
While the costs of any IPO depend on the company’s specific advisory needs, it’s clear that Dutch auctions and Open IPOs are more cost effective than traditional routes. In general, you can break down IPO costs into these categories:
- Accounting – $1.1M
- Legal – $15.8M
- Printing – $300k
- Registration – <$100k
- FINRA and other miscellaneous fees – $700k, and
- Underwriter fees – $12.8M
As you can see, whether you go the traditional route or not, legal fees will always put a hefty dent in your wallet. However, you can eliminate the huge underwriter fees using and auction-based pricing methods such as Dutch auction and Open IPO..
Between the two of them, however, neither Open IPOs nor Dutch auctions are dramatically different in terms of cost. It’s best to decide if you want to favor investors or the company itself in the bid process, and handle costs from there.
