Google's Dutch auction initial public offering.

Robicheaux, Sara ; Herrington, Christopher

CASE DESCRIPTION

This case concerns the Initial Public Offering of Google, Inc. in August 2004. Instead of using the traditional best-efforts style IPO, Google used a Dutch Auction to allow small investors to buy in on the IPO. This case is intended to be used in an advanced corporate finance class. It can be taught in two hours of class time and should take about two to three hours of outside preparation by the students.

CASE SYNOPSIS

In August 2004, Google, Inc. took its firm's stock public for the first time using a Dutch auction process. This case study details the company's history as an Internet search engine company. Then it explains Google's initial public offering and the market environment in which Google was going public. The case concludes with questions for discussion.

INSTRUCTORS' NOTES

Overview

This case concerns the Initial Public Offering of Google, Inc. in August 2004. Instead of using the traditional best-efforts style IPO, Google used a Dutch Auction to allow small investors to buy in on the IPO. The case is intended to be used in an undergraduate corporate finance class. It can be taught in two hours of class time and should take about two hours of outside preparation by the students. The case concludes with nine questions students should address in analyzing this case. Below we will give some possible direction and answers to these questions although these are not meant to be the only "correct" solutions. Also, several of the questions involve the student doing research beyond what they read in the case.

Discussion Questions

1. Much controversy was centered on the whether or not both the IPO market and Google as a company were ready for the IPO. Did Google, Inc. make the correct decision by choosing to go public when it did? Explain why the move was or was not justified financially and circumstantially. Financial statements are provided in Tables 1, 2, and 3 for 2002-2004.

Even though the IPO market was not "hot" at the time Google chose to go public, it appears the market was ready to invest in Google. The post IPO performance of the company indicates that investors anticipate great things from Google. Nine months after the IPO the stock was trading at 2.7 times the offer price which is very unusual. Unlike many dotcom IPOs of the late 90's, Google actually was a profitable company with positive net income and cash flows.

2. One major complaint of potential investors was that Google was not specific enough in explaining how the money from the IPO would be used. Explain why this is or is not a justified grievance, and detail some of the options Google should consider for spending of the IPO capital. Which option is most promising?

Discuss why companies do not want excessive amounts of cash on hand. What are the advantages & disadvantages to cash? Also discuss why IPOs are beneficial to companies.

The Google IPO brought in 1.67 Billion dollars. This is a large amount of cash and the company needs to be able to explain how they plan to spend/invest this cash. Some of the cash was used to pay off $201 million in settlement disputes with Yahoo. In order for shareholders to buy shares in Google they must anticipate that Google will be able to generate the same or higher returns than they could earn elsewhere investing in a similar risk company. Google needs to be able to articulate to their investors how they are going to generate returns on their investments.

There are unlimited possibilities of what Google could do with the proceeds from their IPO. Some possibilities: they could acquire smaller technology companies, hire more employees, increase compensation of existing staff to retain the talent they currently have, develop new products (e.g. customized home pages which they released in May 2005).

3. One of Google's main intentions in using the Dutch auction process to price its stock was to get the most accurate price possible. Was the Dutch auction successful in achieving this goal? Would the price have been more representative of fair value if Google had let the underwriters set the price, as is traditional? Based on your calculations, what would you have considered to be a fair market value for Google stock?

Use this question to discuss the whole IPO process: underwriting, syndicates of investment banks, best effort, firm commitment, red herring, underpricing, book building, road show, and beauty contest. Students will need to understand the typical IPO process in order to understand why Google's use of a Dutch Auction was so unique.

The idea behind Google using a Dutch Auction IPO was to help prevent underpricing that traditionally occurs in hot IPOs and also allow small investors the ability to buy shares. A traditional IPO involves a syndicate of investment banks who underwrite the offer and set the offer price based upon the book building process which incorporates the demand for the new shares based on feedback from the road show. The syndicate then distributes these shares to their interested clients. When an IPO is in high demand, as was the case with Google, in a traditional underwriting environment shares typically go to high-end investors who invest in many IPOs and the average investor does not have the opportunity to buy shares.

Although the Dutch Auction did allow small investors to buy shares in Google it did not eliminate the underpricing of Google. In fact, the underpricing on Google was (100.34-85) /85=18.05% on day 1. Studies actually show that IPO underpricing averages between 11% to 20%. One IPO that had an extremely large amount of publicity was Netscape which was underpriced by (54-28)/28=93%. Having shown that the underpricing as defined by the closing price on day 1 being above the offer price did occur with the Google IPO but was still in the range of being normal, the six month and nine month returns for Google are what makes the offer price appear too low. The reasons why the underpricing on day 1 was average but the returns 9 months later make the offer price appear way to low are addressed in the next question.

4. Google hit several speed bumps along the road to its initial public offering, many of which were exacerbated by Google's own actions (e.g. failing to register shares, losing major underwriters, Playboy article, etc.). Which ones, if any, hindered the successfulness of Google's IPO and why?

This question could be used to discuss Ethical Issues, SEC violations, SEC filings and quiet periods.

It appears that all these events hindered the success of the IPO in the sense that the offer price was lowered from its initially announced range. The offer price appears to be approximately set correctly for the time in which the stock went public due to the amount of underpricing that occurred. However, if they had waited until some of the bad press had ended, possibly several months later, the offer price might have been set higher. Failing to register shares was probably the most troublesome news that came out around the time of the IPO. This is an SEC violation and can have financial consequences.

5. Now that Google's IPO has come and gone somewhat successfully, what strategy should Google adopt for the coming years to avoid a fate like so many other Internet and technology companies? Are there any issues in Google's financial data that you feel are problematic and should be addressed by the company's management?

A good exercise for students would be to do a ratio analysis for Google and compare it to the industry average ratios and Yahoo.

Unlike many of the Internet and technology companies that failed when the dot com bubble bust in 2000, Google had been generating positive net income and cash flows for several years. In fact they had growth of net income in 2003 of 6% and in 2004 of 278%. Net cash from operating activities has also grown tremendously in the last three years. It appears that Google should not be concerned about its current financial status. However, they do need to focus on what they are going to do with the new cash they received from the IPO and determine how to generate the superior returns that their investors are predicting.

6. What has led to Google's success? What appears to be its strategy? Has their strategy changed since they went public? Do you see a need for their strategy to change in the future?

"Google's mission is to organize the world's information and make it universally accessible and useful." (http://www.google.com/intl/en/corporate/index.html) Their success has come from their ability to be the best at organizing the world's information and make it universally accessible and useful. Their strategy has not changed and there are no plans for it to change in the future. Their mission statement is broad enough that it is not time sensitive to changes in technology.

7. Did Google need to go public to satisfy its need for capital? What would you forecast their capital needs will be over the next few years? What sources other than common stock could be used to satisfy those capital needs?

In 2003 & 2004, approximately 96% of Google's total revenues came from fees they charge their advertisers. Based on Google's strategy the capital needs over the next few years will be driven by creating a larger employee base and infrastructure to handle their growth as well as acquiring other technology companies. Their plans at the time of the IPO involved spending $300 million on capital equipment in 2004. (http://investor.google.com/pdf/20040630_10-Q.pdf)

Other sources of potential capital could come from venture capital funds, bank loans, or private equity. Students should define each and discuss the pros and cons of each given Google's earnings history.

8. If you were a stock analyst hired by a mutual fund to make a buy, sell or hold recommendation on Google today, what would you recommend? Why? What characteristics of the company make it a risky investment?

This answer will depend on when the case is analyzed. Students should at a minimum consider: the current stock price, various analyst predictions of Google's future, Google's own earnings forecast, the industry outlook, the market outlook. The risky attributes of Google are largely related to them being a part of the technology industry which is constantly evolving.

9. In the context of agency theory, do you think Google's choice to go public in the form of a Dutch auction favored their insiders?

Not necessarily. The primary difference between book building (the traditional form of IPO offering) and an auction (Dutch or otherwise) is that book building allows discretion to the underwriter in allocating extra shares in the case of oversubscription (i.e. most offerings). It has been argued that this discretion allows the issue to shape its share structure to suit insiders. Some argue rationing favors large shareholders to improve monitoring; some argue rationing is against large shareholders to decrease monitoring. There is little empirical evidence supporting either idea. On the other hand, if you think that management wants a disperse ownership to reduce monitoring then the Dutch auction might give them that more so than book building. However, given that insiders bear the agency costs (as Jensen and Meckling suggest), then reduced monitoring increases agency costs and the shareholders should be indifferent.

Sara Robicheaux, Birmingham-Southern College

Christopher Herrington, Birmingham-Southern College