Judging the Google IPO

Economist Gregory L. Rosston sees merit in Google's auction-style approach but says the offering will likely be judged on the wrong criteria.

3 min read
Google loves to use market forces to set its course.

It is not well known by the public, but Google uses a sophisticated auction technique to price the ads that generate 95 percent of its revenue. The success and seamlessness of this auction approach probably had something to do with the company's decision to eschew the traditional investment-banker-led IPO. Instead, the company has opted for what may be a substantially more efficient approach, one that benefits existing Google owners.

All of this sounds great, and it should be. But the success of the Google IPO is bound to be judged on the wrong criteria.

If things are done correctly, neither Google nor its investment bankers will pick the IPO price.

Press reports on the day of the IPO will focus on the offering price and the bounce that "lucky" IPO buyers get. If the bounce is close to zero, that would be bad, according to the popular press. But the press is wrong. In fact, a bounce of zero would signify a resounding success, because it would mean the shares have been priced correctly.

If there is a large immediate bounce, then Google and its investment bankers did not do their job in designing an efficient auction mechanism. The profits gained by IPO shareholders would cost existing Google shareholders dollar for dollar.

If things are done correctly, neither Google nor its investment bankers will pick the IPO price. Instead, using a Dutch auction, the company will be able to read the IPO price from solid commitments that individuals, money managers and pension funds have made to buy the stock.

In the traditional-model IPO, investment bankers spend countless hours wrangling expressions of interest from their favored clients and later allocating shares based on past and expected future business. But Google is using the order process to get people to put their money where their mouth is. A potential investor has to make a commitment to buy.

An additional benefit is that if the pricing process is a good one, potential investors don't need to get in on the IPO. The secondary market, which will open minutes later, should give buyers the same price. This way, small investors will not have to spend time trying to understand the rules of the IPO and figuring out how to have a bid selected; they can focus on understanding what they think is the intrinsic value of the company and making a straightforward, informed investment choice, as they should.

So what does Google need to do to get to this happy outcome? First, it needs to make sure that the rules of the auction are clear, fair and well understood. Second, it needs to make sure that buyers have the ability to participate easily and at low cost. Third, the company needs to make sure it sticks by the rules.

By including the rules in its SEC filings and working with brokerage firms to get the information to clients, the first two requirements should be satisfied. Potential liability, not to mention ethics, should ensure the company respects the rules. Because of its brand name and the widespread public interest in the offering, Google has been able to get lots of free publicity for its offering from newspapers across the country (and throughout the world). Several factors, including this media attention, easy access to the SEC Web site with all of the offering documents, and consumer familiarity with Google provide a great opportunity to satisfy all of these criteria for a successful IPO.

And success should be measured by how small the bounce is, not by how large it is.