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How Google Mispriced Itself

An IPO researcher argues that Google left money on the table because it didn't divulge its growth outlook, not because it held a stock auction

On July 26, 2004, Google (GOOG) announced plans to sell 28.3 million shares at between $108 and $135 apiece, hoping to raise at least $3 billion in one of the most heralded initial public offerings of stock ever. Rather than use Wall Street's venerable "bookbuilding" method, the company and its underwriters planned to employ an auction to price the IPO and allocate the shares to investors.

An auction, in theory at least, should deliver the highest possible price for the company while giving individual investors, rather than just the fund managers who dominate the bookbuilding approach, the opportunity to buy shares.

Unexpectedly, in the face of weak demand, Google was forced to scale back the size of the stock sale and lower the offering price. On Aug. 19, 2004, Google went public at $85 per share, selling just 22.5 million shares and raising just $1.9 billion. Adding insult to injury, the stock rose 18% on the first day of trading to close at $100.34. Because that quick $345 million gain went to investors rather than Google's pockets, some would suggest the auction failed to achieve its purpose of setting a price close to the value investors would be willing to award the stock on the open market.

Part of the reason that the offering raised less money than expected was simply bad luck: In the weeks leading up to the IPO, both the technology-laden NASDAQ market (NDAQ) and shares of Yahoo! (YHOO), Google's top rival, had been drifting downward, sending a chill through the IPO market.

But because Google used an auction, some critics have blamed Google's decision to spurn Wall Street's tried-and-true procedure of bookbuilding.

The Secrecy Initiative

In my opinion, the failure to raise as much money as the company expected had nothing to do with the choice of an auction. Instead, it had everything to do with management's decision to pursue a policy of secretiveness about Google's business.

Let me explain. But first, a disclosure: In 2002, long before Google's IPO, I did advise the company on the advantages and disadvantages of an auction. I was one of many advisers Google consulted, and I was not involved in any of the final decisions, nor did I have any financial stake in the outcome.

Now, imagine a successful young company whose profits per share grew 135% over the prior year. Outsiders are trying to figure out whether profits will continue to grow at that 135% rate for the next few years, in which case a price-to-earnings ratio of 120 might be justified, or accelerate to a growth rate of 190% per year, in which case a PE ratio of 200 might be justified.

If management thinks the more optimistic scenario is realistic, and they're about to sell shares in an IPO, then they have every incentive to disclose that information. Furthermore, if outside investors are skeptical about the reliability of this information, management has an incentive to agree to a "lockup" on selling their personal shares until after they report at least a couple of quarters worth of operating results. This means an executive will suffer the same market consequences as any investor if the company's actual performance fails to justify the pre-IPO forecast.

Revealing Forecasts

Normally, if management has positive information about the company's earnings prospects, these forecasts will be voluntarily revealed to institutional investors during the "road show" marketing campaign that precedes an IPO. So if management is not voluntarily revealing better prospects, it is perfectly rational for an investor to assume that there are no better prospects to reveal. Furthermore, when most young companies hold an IPO, the top managers usually don't sell any personal shares. In fact, they almost always agree to a lockup period of 180 days before they can sell shares.

During Google's road show, management refused to divulge any earnings forecasts to institutional investors, pointing out that the prospectus clearly stated "we do not plan to give earnings guidance." Adding to the uncertainty about Google's growth prospects were two discouraging signals from top executives: Some were selling personal shares in the IPO itself, and management was agreeing to lockups of only 90 days after the IPO before they could sell more personal holdings.

In response to these actions, institutional investors decided not to grant Google the benefit of the doubt: They did not award the company a price reflecting a PE ratio of 200. Instead, they went with the more "conservative" PE suggested by the historic operating data disclosed in the IPO prospectus. With fully diluted earnings per share (EPS) in the 12 months before going public at 72¢ per share, the offer price of $85 still reflected a PE ratio of 118.

And so, by not tipping off institutional investors to how fast earnings were expected to grow, and by allowing top managers to sell personal shares from the outset, Google found itself with a lower IPO price than it might have.

An Unconventional Company

This predicament had nothing to do with the use of an auction rather than bookbuilding. Instead, it had everything to do with the prospectus' declaration that "Google is not a conventional company."

The goal of getting the highest offer price in the IPO conflicted with the goal of opening the process to individual investors, treating them as equals to the professional money that controls the bookbuilding approach. Unlike most companies, Google's management gave a higher priority to the second goal.

In the end, only those who were willing to give the company the benefit of the doubt were richly rewarded when Google subsequently began reporting its quarterly EPS figures.

Notably, Google's refusal to clarify its prospects also led to gyrations in its stock price once it started to trade as investors puzzled over the company's true worth. On the first day of trading, the stock price jumped by 18%. In the following weeks, there were intraday price swings of 8% from low to high on several occasions. On Oct. 22, 2004, the day after Google announced its first post-IPO EPS numbers, the stock jumped by 14% after fluctuating by 10% within the day.

On all of these days, the market was having a great deal of difficulty agreeing on what the appropriate value of Google should be. Given all this market disagreement after the IPO, it's not very surprising that the auction wasn't able to perfectly forecast the price one day in advance. There is no reason to think bookbuilding would have led to a more accurate forecast.

A "Hot IPO" Scenario

No, Google's IPO did not go as smoothly as the company hoped. Many pundits have blamed this on the use of an auction. In my view, the key feature of Google's IPO was not the auction, but the unwillingness to divulge information to institutional investors that was not contained in the prospectus. These institutions were left in the dark regarding how rapidly the company's profits were growing. They only discovered the truth, and bid up the stock price, when the rest of us did—after Google announced its quarterly earnings.

Most of the time, whether a company uses an auction or bookbuilding for its IPO makes little difference. Some of the time, however, it makes a big difference.

The scenario in which it matters is when a company is lucky enough to discover that its IPO is "hot," with investors willing to pay more for the shares than had been anticipated. With an auction, a company can react by setting an offer price close to what investors are willing to pay. With the bookbuilding method, by the time a company discovers there is strong demand, it has little bargaining power if the investment bankers don't want to raise the offering price. In Google's case, the weak demand for its shares made this a moot point.

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