To put things in perspective: The concept of publicly owned business is nearly as old as business itself. As Edward Chancellor points out in A History of Financial Speculation, "Cicero referred to partes carissimas (most expensive shares), and claimed that buying shares in public companies was seen as a gamble which conservative men avoided." And while the public company is alive and well, today's Forum is troubled by a relatively new phenomenon: the modern IPO.
Built around the concept of "book building," the process of going public in 2012 involves not just a company and its eventual investors, but also a cadre of intermediating investment banks. Headed up by one or two banks in particular (the "lead underwriters"), the "underwriting syndicate" performs a number of crucial tasks for the company in question, including valuing the company, deciding how many shares it should issue, and perhaps most importantly, finding buyers for those shares prior to the offering. Of course, along the way, the banks also manage to do a little something for themselves; on average, an underwriter holds onto 6%-8% of the value of the shares it sells.
Getting to know the status quo
A quick survey of the last 50-plus years of American offerings demonstrates that the book building method is, overwhelmingly, the route of choice for companies looking to go public. But like a good many other practices that have achieved status quo in modern business, the "traditional" IPO is far from perfect.
In a piece last summer for the New York Times, Steven Davidoff, a professor of Finance and Law at the Ohio State University, identifies two major "cracks" in the current IPO process. He described the first as a breakdown in "gatekeeping," in which banks neglect their implicit role as the judges of whether a not a company should go public, and bring bad businesses to market for the sake of that 6%-8%.
A prime example of this would be Zynga (Nasdaq: ZNGA): Despite an obvious over-dependence on Facebook (Nasdaq: FB) and a business plan that banked heavily on releasing a steady stream of "hit" games, Zynga was ushered onto the NASDAQ this past December. For those investors lucky enough to get hold of some shares at the $38 offering price, their investment has now fallen by over 90%. Morgan Stanley and Goldman Sach's combined $29 million in underwriting fees, on the other hand, remains safe and sound.
The second problem Davidoff examines lies in the sales process by which orders for a new offering are filled. Eager to both ensure that the entire issuance is sold and upkeep their long-standing (and long profitable) industry relationships, underwriters generally offer their institutional and high-worth individual clients first dibs -- and second dibs, and third dibs -- on an offering. The results of this are twofold, as it not only effectively locks the retail investor out of the offering, but also keeps the company in the dark as to what retail demand for, and thus fair value of, its business might actually be.
To illustrate the latter, consider the case of LinkedIn (NYSE: LNKD), which issued shares for $45 in May of 2011 only to see them close well over $90 after the first day of trading. Had the company better known the extent of public demand for a piece of its business beforehand, it might have placed a significantly larger price tag on its offering, thus avoiding the perennial IPO pitfall of "leaving money on the table." Money that went, not coincidentally, to the satisfied clients of the well-commissioned syndicate.
Filling in the cracks
In both of the scenarios described above, the shortcoming of the IPO process is inextricably linked to the presence of investment banking. And to be perfectly blunt: Therein lies the case for removing banks from the public offering. Or at the very least, for drastically lessening the role the banks play.
By marginalizing the middle-man, public offerings could very well become a more mutually beneficial experience for companies and investors alike. Fully informed of the investing public's demand for its stock, a company, let's call it New2Market, could issue its initial offering at a price reflecting that demand; fully informed of the prospects and financial well-being of New2Market, the investing public could calmly consider, along with millionaires and managers of hedge funds, whether or not to buy.
Alas, you cry, if only such a system were to exist! If only the current way weren't the only way!
Here's the thing: It isn't.
Going Dutch
Through what is referred to as a "Dutch Auction" IPO, companies can gain access to the public markets in a way that both accommodates regular investors and significantly reduces that 6%-8%. Named after an auctioneering method that was famously employed during the 17th-century tulip craze in the Netherlands, the Dutch Auction is as simple as it is elegant. It works as follows:
In order to get the capital it needs to execute its expansion strategy, New2Market decides that it's time to go public. After consulting with one or two investment banks, whom it will eventually pay an aggregate fee of roughly 2%, the company arrives at two conclusions:
- Its business is most likely worth between $8,000 and $10,000.
- It would like to issue 1,000 shares in the upcoming offering.
On a website that includes both its prospectus and other informational material, the company informs potential investors that, in consideration of those dual conclusions, it thinks a share of its business is worth $8-$10.
The investors weigh that suggestion against their own opinion of the business and its value. Then comes offering day: All of the investors who have decided they want in log on to that website, where they place a bid that specifies how many shares they want. More importantly, each investor also specifies how much they are willing to pay per share. Let's say five investors place bids:
After receiving all of the bids, New2Market discovers that the highest price (or, in industry parlance, "clearing price") at which it could sell its full, 1,000-share issuance is $9 -- so it issues shares at $9, affording investors A-C their requested allotment, and giving the remaining 290 to investor D.
Aside from the benefits already enumerated, a broader positive of the Dutch Auction is that it allows the company to enter the public markets on an extremely shareholder-friendly note; in entrusting its investors with the job of arriving at a fair value, the company also gives them the right to speak first in what will, hopefully, be a long, fruitful conversation.
It's not all tulips
Granted, the Dutch Auction method comes with its fair share of baggage. Because it banks on companies being able to sell their business directly to investors, it is an especially difficult route for companies with complex models, or resource-strapped smaller companies, to take. Conversely, it is also open to exploitation by companies who have no business going public in the first place -- those that otherwise would have (or rather, should have) been turned down by the "gatekeepers."
There is also something to be said for the incongruous simplicity of the model relative to the complexity of its components. After all, business, investment, and the dynamic interplay between risk and reward are by no means cut-and-dry subjects. To that end, it is important to note that, of the select few companies that do decide to go public in this manner, most opt to modify the process in some way. Google, for instance, decided to treat the bids placed by hopeful investors as a data pool. Then, true to its roots, it combined an analysis of that data with a number of other factors before arriving at its ultimate offering price.
If it ain't fixed, don't say it ain't broke
When it comes to discussing the Dutch Auction IPO, or indeed, any "alternative" entrance into the public market, your friendly neighborhood investment banker will almost certainly point to the staggering majority of companies that opt to use the book building system as proof that the book building system works. If there's one thing I might ask you to take away from this article, it's this: The IPO status quo might indeed be a working option, but it is almost definitely not the best option.
Yes, the widespread use and success of something akin to the Dutch Auction is unlikely at best. And yes, the marginalization of investment banks within the world of public offerings would require a level of societal financial literacy that our country simply does not possess... but just because something would be tough to fix, doesn't mean we can't admit that it's broken. So the next time you're at a cocktail party, and someone tells you they stay away from IPOs because of some new listing that is terrorizing the headlines, hit them with this:
"You're right... that company did it all wrong. Now tell me: How would you do it?"
Nota Bene: In general, The Motley Fool recommends that investors steer clear of companies that have recently gone public; if it’s a good company right out of the gate, there’s no harm in waiting for it to be a good company that is one year (or even six-eight months) out of the gate. The purpose of this article is to encourage increased discussion around the pitfalls of and potential revisions to the IPO process—not to encourage increased IPO participation from everyday investors.
