Dutch-auction IPOs: institutional development and underpricing performance

Abstract

The Dutch-auction method of bringing IPOs to market has been used sparingly since its initiation in 1999 despite the potential for this method to lead to more fully-priced issues. The development of Dutch-auctioned IPOs is documented here, and institutional details are reviewed. An empirical investigation of the characteristics of these IPOs is presented. The evidence indicates smaller magnitudes of underpricing of Dutch-auctioned IPOs relative to traditional IPOs. A multi-variate analysis indicates, however, that this smaller degree of underpricing is due to factors other than the Dutch-auction process. The evidence strongly reinforces the institutional rationing hypothesis for underpricing. It also contributes to the international evidence of the failure of auctioned IPOs to avoid underpricing.

Appendix

1.1 Institutional details of the Dutch auction process:

Table 6 lists the distributional details of the various processes used for the 21 Dutch-auctioned issues. Note that all utilize Hambrecht’s OpenIPO process even when other firms are the lead underwriters, as in Google and NetSuite. It also lists the individual issues for which the various processes apply. A summary of the most important provisions is presented below.

Table 6 This table summarizes the major characteristics of an OpenIPO issue, as described in the registration statement and/or the prospectus. The underlined headings are arbitrary, as registration statements and prospecti differ from one another in their composition and tend to be repetitive and chronologically disorganized

1.1.1 Underwriter compensation

As indicated in Table 2, underwriter compensation varies from 1.88 to 7% of the issue price. Provisions U1 and U2, listed in Table 6, indicate that the underwriter, or underwriter syndicate, purchases all of the IPO shares once the issue price is determined. These shares are purchased, most commonly, at a 2–7% discount, and then sold to the successful bidders at the issue price. A 7% discount is standard for traditional IPOs. [See Chen and Ritter (2000).]

1.1.2 Qualification process

Provisions Q1 through Q3 indicate that bidders must meet account requirements established by the underwriters and participating dealers. Account requirements may include a minimum account balance in a participating brokerage firm, and/or minimum number of transactions completed through a participating brokerage firm. As noted in Table 6, these requirements are typical for an OpenIPO issue. To date, however, only Google and NetSuite required bidders to obtain an ID number prior to placing a bid, and to consent to electronic communication from the underwriter.

1.1.3 Bidding process

Provisions B1 through B5b describe the bidding process for the OpenIPO. Bids include number of shares desired at a proposed price. Each firm’s registration statement (which, in the SEC’s Effectiveness Process, becomes the firm’s prospectus) provides an offering price range for the issue. Bids can be above, below, or within the range indicated. Nearly all of the firms using the OpenIPO process (20 of the 21 issues) specified a minimum bid of 100 shares. Google indicated that it would accept a minimum bid of 5 shares. [See Oster (2004).] In general, bidders have the right to withdraw a bid any time prior to the close of the auction. Underwriters may reject any bid based on eligibility or creditworthiness criteria, or any bid that the underwriter considers “manipulative or disruptive” to the auction process.

1.1.4 Confirmation process

Provisions C1 through C11 concern the “confirmation” process. This process requires that bids be “confirmed” just prior to the closing of the auction. “Confirmation” consists of electronic notification that the bidder stands behind their previous bid offers, or that they are revising their bids in some way by changing the price and/or the quantity demanded. Since any initial bid can be changed up to the time of closing, confirmation of final offers must be forthcoming in order to participate in the issue. In general, bids must be reconfirmed if either the number of shares offered changes or if the public offering price range is revised sufficiently so that the total value of the issue changes by 20% or more.

1.1.5 Closing (end-of-auction) process

Provisions E1 through E3 pertain to the closing of the auction. Over time, the description of this process has evolved. For the first two OpenIPO issues, the closing process was not referred to at all. For the next seven issues, the approximate closing date was published on Hambrecht’s website. For the last twelve issues, the prospecti state that reconfirmation of all bids are required if the auction is unable to close within 15 days after the registration statement becomes effective. Also, the prsopecti generally state that closing occurs within 1 to 4 h after the time the registration statement is declared “effective” by the SEC.

1.1.6 Pricing process

Provision P6 allows the firm to select an issue price that is below the market-clearing price. This assures excess demand, and therefore allows rationing of the shares as explained above. Most OpenIPO issues allow the public offering price to be set outside the initial or revised range set forth by the prospectus, as stated in P2. This has actually occurred for two issues to date. [See New River Pharmaceuticals Inc. and FortuNet, Inc. in Table 2.]

1.1.7 Distribution process

Provisions D1 through D9 refer to the actual distribution process. As shown in Table 6, some issuers refuse to recognize bids demanding more than 5% of the total shares offered. This assures wider distribution of shares, a more liquid aftermarket, and most importantly, that no institution or individual will obtain a controlling interest in the issuing company. Provision D2 assures that the issuer may use its discretion to reduce a large order. This certainly assures that the issuer can eliminate a large controlling interest.

Rationing the issue so as to prevent a controlling outside interest is not only a protection measure for the management entrepreneurs who retain the controlling interest, but it is also an assurance to the issue’s purchasers that management will not be readily changed, that they can rely on the continuity of the IPO management team.

1.1.8 Post-issue process

The post-issue process, described in PI1 through PI8, describes the overallotment, the lock-up period, and the aftermarket stabilization activity that may take place. Although 180-day lock-up periods are most common, shorter periods may be specified in each issue for certain classifications of the firm’s ownership, which would result in a shorter average lock-up period for the issue. The registration statements for five of the last OpenIPO issues address requests for early release from the lock-up period, as shown in PI6 and PI6a. This inclusion represents another step in the evolutionary process for IPOs brought to market using the OpenIPO process. PI7, which is included in most OpenIPO issues, indicates that the underwriter intends to act as market maker after the issue has been made public.