What Is a Dutch Auction IPO?

Answers to your questions about the news.
May 6 1999 5:39 PM

What Is a Dutch Auction IPO?

A new type of Initial Public Offering (IPO) is getting a lot of attention, partly because it uses the Internet, and partly because it claims to be a fairer way of selling stock. Some high-profile firms, including Salon, have chosen it. What is this new method? How does it work?

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It's a variant on the so-called Dutch auction. In traditional auctions, the price rises until one bidder is left. In a Dutch auction, the auctioneer sets an extraordinarily high price and lowers it until someone bids on the item.

Imagine the Dutch auction of a 100 share offering. The auctioneer begins by calling out a prohibitively high price per share that he knows will attract no bids. He then calls out lower and lower prices until someone decides to buy a few shares (eight, for example). The auctioneer continues to lower the price until someone agrees to buy more shares (12, for example). So far, bidders have bought 20 shares, one-fifth of the total IPO, and they've bid different prices.

The auctioneer continues to lower the price until all 100 shares are spoken for. At auction's end, bidders get the number of shares they agreed to buy, but at the price bid by the last bidder. If the first guy bid $100 per share for the eight shares, and the second guy bid $75 per share for the 12 shares, they only pay what the last guy bid--say, $50 per share. In the Salon IPO, for instance, bidders have a month or so to visit a Web site and enter 1) a price and 2) the number of shares they're willing to buy. A computer records the bids and, at the end of the specified period, simulates the auction described above.

In theory, buyers pay more for stock in Dutch auction IPOs than in ordinary IPOs, which means more money will go to the firm that's selling shares. How's this? In an ordinary IPO, the firm hires an investment bank to estimate how much investors will pay for the shares. Then the firm agrees to sell stock at a fixed price below this estimate. (Why sell below the estimate? Patience, Explainer will get to that.) Generally, the first in line to buy IPO stock can turn a quick profit by immediately selling it for a higher price on the market. For example, last September, the eBay IPO went out at $18 a share, and the price zoomed to $48 after one day of trading. This was an atypically large short-term run-up, but the average short term run-up of IPO stocks between 1960 and 1987 was still 16 percent--a nice profit for a few days' work

Naturally, there is great competition to be one of the lucky few buying shares at the low price. In an ordinary IPO, the investment bank decides who gets to buy these discounted shares, funneling them to its best clients, usually rich individuals or large institutions (pension funds, endowments, etc...). This is a good deal for the prized clients, who make easy money, and for the investment bank, which gets to impress clients. But it's a bad deal for the firm holding the IPO because they could have reaped that capital.

You may be wondering why firms agree to ordinary IPOs at all. There may, in fact, be no good reason besides tradition for the current system. The Dutch auction model--which promises more money up front--may push out the old model and become the industry standard.

On the other hand, there two reasons why the traditional model may be superior in the long run. The price spike associated with a traditional IPO imparts an aura of success to the stock, which may in itself boost the stock higher. This benefits the firm's executives, who own shares, and the company itself, which also owns shares that it may unload to satisfy its own capital needs. (IPOs usually involve selling only a small portion of a firm's outstanding stock. It's not unusual for firms to sell new stock several times in a decade.) Another advantage of selling IPO shares at a discount to wealthy individuals and large institutions is that these investors tend to hold assets for long periods, thereby decreasing chances the stock will tank if the firm has a mediocre quarter..

Finally, traditional IPOs also irritate the average investor, who feels wronged because "insiders" made easy money. Will the Dutch auction help "outsiders" who can't catch a break with the current model? This has been suggested--by the firm conducting the Dutch auctions, among others--but is simply not true. The money that once went to "insiders" now goes to the IPO firm, which is no help to "outsiders" at all.