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Google at $513

December 13th, 2006 by David Kronemyer · No Comments

Google went public in August 2004 with an initial offering price of $85 per share. When it started trading a few days later, it opened at $100 per share. On November 22, 2006, it hit a high of $513 per share. Google structured its IPO as a modified version of a “Dutch auction,” so-called because it was created in the early flower markets of the Netherlands to sell multiple identical items. As explained by the New York Times:

“In the classic Dutch auction, a seller indicates how many items are available for sale and sets the minimum bid price. Bidders indicate the number of items they want to buy and the price per item they are willing to pay. All winning bidders pay the same price per item — which is the lowest successful bid, called the clearing price. Those who bid above the clearing price, however, earn the right to buy the number of items they want, while those who bid at the clearing price have to divide the remainder. Google’s shares would be sold in a modified Dutch auction because it has reserved the right to set the final sale price, the allocation of shares and other auction terms. It said in its public offering statement that its goal was to eliminate the first day ‘pop’ in prices that was built into most initial stock offerings.”

Hansell, S., “For Google, Going Dutch Has Its Rewards And Its Risks,” New York Times (May 10, 2004). Adopting this approach is not without risk, even for the sophisticated investor. “The hardest part of the process, of course, is deciding how much to bid. There are myriad techniques that professional investors use in such decisions. A value investor, for example, might estimate how much cash the company will produce over the next several years and what the value of that cash flow might be. A growth investor might assess how well the company will be able to sustain its rapid revenue increases. But such analysis is difficult for anyone to conduct in isolation. Waiting until after the offering, when the shares begin trading, would allow an investor to see the consensus price of the entire market. Traditional underwriters reassure potential investors by setting the offering price lower than the expected market price, but this will not happen with Google,” Hansell, S., “Bored With EBay? Try Google’s Unusual Auction,” New York Times (Aug. 5, 2004). The reason why it would not happen, of course, is because of the way Google structured the IPO.

As matters transpire, Google’s procedure proved to be controversial, seemingly because it seldom was deployed. “Experts in such auctions, which are widely used internationally but are rare in the United States, cautioned, that a wealth of experience overseas suggested a real possibility that the Google offering could be dramatically overpriced. ‘What really disappoints me is that Google has chosen a method that has been in use for 20 years and has failed everywhere it has been tried,’ said Ann E. Sherman, an assistant professor in the department of finance at the University of Notre Dame and an expert on initial public offerings auctions. ‘A stock is not like a painting,’ she said. ‘You can’t just look at a company and know what the value is to you,’” Markoff, J., “Google’s Sale of Its Shares Will Defy Wall St. Tradition,” New York Times (Apr. 30, 2004).

In the same article, deploying a rather different metaphor, another pundit opined: “Google is not an icebreaker for other companies to follow. It’s a polka-dotted zebra.” Ms. Sherman later weighed in with some more helpful suggestions: “An auction is just too risky. There is no telling how many people will show up,” Hansell, S., “For Google, Going Dutch Has Its Rewards And Its Risks,” New York Times (May 10, 2004).

Evidently because of these factors, “Google, whose founders are academically inclined, acknowledges most of these auction risks in its prospectus. The document contains a section on the winner’s curse and how it could cause Google’s shares to decline sharply in the days after the offering. To ward off extreme share price fluctuations, the company has given its underwriters the ability to reject bids that they deem to be speculative (at an unreasonably high price) or manipulative (for an excessive quantity of shares),” Hansell, op. cit.

Winner’s curse? More likely, “Google’s curse.” Google initially believed the share price would be in the range of $108 – $135 dollars per share, Hansell, S. & Rivlin, G., “As It Goes Public, Google Says It Is Worth Up to $36 Billion,” New York Times (Jul. 27, 2004). “That would value the company at $29 billion to $36 billion, putting its market value just below the $38 billion value of Yahoo, a larger and far more mature Internet company. The most valuable Internet company, eBay, is worth $49 billion,” Hansell & Rivlin, op. cit.

However, at the last minute, Google’s investment bankers invoked the clause permitting Google to lower the IPO price, which was established at $85 per share, Norris, F., “Ouch! Insiders Feel an Unexpected Pinch,” New York Times (Aug. 19, 2004). “Google was able to sell the 14.1 million shares that it had planned, but existing shareholders are selling only 5.5 million shares in the offering, less than half the 11.6 million shares they had expected to sell.” The reason why? Alleged soft demand for the shares, Sorkin, A., “Google Says It’s Set to End Stock Auction,” New York Times (Aug. 17, 2004). Many apparently wanted even a lower price, in the range of $50 – $60 per share, Rivlin, G., “After Months Of Hoopla, Google Debut Fits the Norm,” New York Times (Aug. 20, 2004).

It’s important to understand just where the money goes. In an initial public offering, the usual template is, the company gets the money. After all, the company is the one selling the shares. However, existing stockholders (which then mainly would be employees and venture capitalists) also have the prerogative to “piggy-back” on the company’s offering, and sell shares they own, as well. In such an instance, the selling shareholder gets the money – not the company. In fact, of the 24.6 million shares Google intended to sell, 10.4 million were held by current shareholders – far more than is typical, Hansell & Rivlin, op. cit. – an amount later was increased to 25.7 million, Hansell, S., “Google’s Slow Search for a Good Share Price,” New York Times (Aug. 14, 2004).

Let’s see, 14.1 million shares at $85/share is around $1.2 billion. And 5.5 million shares at $85/share is $467.5 million. Alas! for Sergey Brin and Larry Page, Google’s co-founders. Alas! also for the poor investment bankers and institutional shareholders. But, wait a minute – because less than a week later, when Google’s stock started trading the price had jumped to $100/share. Hurray for Sergey and Larry! Hurray for whomever else it was who didn’t sell!

But now, Alas! for poor Google, because in the space of a week it had left $211.5 million on the table – gains now reaped by marketplace traders, who had bought the shares in the IPO. This was, in other words, “[E]verything the company’s founders … had sought to avoid with their unconventional approach of using an online auction to determine the price and distribute the shares ahead of public trading,” Rivlin, G., “After Months Of Hoopla, Google Debut Fits the Norm,” op. cit.

Thus, like a latter-day John Kerry, the flippers prevailed. “More than 22 million shares of Google traded hands yesterday. … Theoretically, that meant that every share changed hands at least once in yesterday’s trading. ‘Obviously a lot of people decided one day was long enough to hold it,’ said John Tinker, managing director at ThinkEquity Partners, a boutique investment bank based in San Francisco,” Rivlin, op. cit. “‘Clearly this auction didn’t do what it was supposed to do,’ said Matthew Rhodes-Kropf, a finance professor at the Columbia Business School who studies financial auctions. ‘It was supposed to give them a price that did not have a first-day pop. Instead all they accomplished was alienating the standard group that would buy their I.P.O.’s,’” Rivlin, op. cit. A lot of “thinking outside the box,” to borrow a Silicon Valley neologism, indeed.

Even so, the opening price gave Google a market valuation of more than $27 billion, “higher than not only an Internet company like Amazon.com, but also industrial giants like Lockheed Martin and General Motors. And on paper, at least, Mr. Brin and Mr. Page are now worth $3.9 billion each, and among Google’s 2,300 employees there are now an estimated 1,000 millionaires,” Rivlin, op. cit.

Under rules promulgated by the Securities & Exchange Comm’n, “insiders” are not permitted to sell their shares until the end of a so-called “lockup period,” typically six months. Google’s actually was phased, thus different amounts of shares came out of embargo at different times following the IPO. The risk, of course, is the shares will plummet in the meantime. So, there must have been a lot of nervous Googelites nibbling on their fingernails.

But now, of course, it’s a different story. Now, it’s a case of seller’s remorse. Because if Google had (theoretically, of course) priced each share at $513, instead of $85, those 14.1 million shares would have fetched $7.2 billion. I’m not saying it shouldn’t have gone public when it did, or there was any scenario under which $513 would have been a realistic IPO price. What I am saying, though, is, both Google and its initial selling shareholders would have been better off to ignore the advice of those pesky investment bankers, and to have stuck with their original plan. Which even in retrospect valued the company at 1/4th of where it’s ended up a little over two years later.