Online Auction IPOs: Morningstar, Google, and Capital Raising

Introduction: The Auction Route to Capital

Morningstar's announcement that it would take the online auction route to raise capital in its Initial Public Offering (IPO) did not raise many eyebrows, given the company's long record of vigilance on behalf of the individual investor. Under a normal IPO, it is the investment bank that allocates shares directly to institutional and other preferred clients. In Morningstar's case, however, the lead underwriter — W.R. Hambrecht, in place of Morgan Stanley — would hold an auction to determine the price band and the manner in which shares would be divided. The primary advantage of this method is that even small investors are able to participate in the process.

In the opinion of Tom Taulli, an IPO specialist at www.currentofferings.com, the approach aligned with Morningstar's culture that everyone deserves a fair share. The auction method is a transparent system from an allocation standpoint: shares are not given to favored funds or individuals, but rather to those who bid correctly, regardless of whether they represent a small fund or a large one. (Carter 2005)

However, this method of raising capital through online auctions has not found widespread favor in the market. Google adopted a similar approach, with Morgan Stanley and Credit Suisse First Boston serving as lead underwriters, yet conventional investment banks continue to disregard the auction process. The reason is straightforward: if shares are sold through auction, investment banks lose billions of dollars in underwriting fees and, more importantly, lose control over the allotment of IPO shares. This may explain why Morgan Stanley, Deutsche Bank Securities, and William Blair all kept their distance from the Morningstar deal. Nevertheless, the exercise was a timely initiative for Morningstar, whose integrity in the investment world had come under scrutiny after regulators began investigating its dealings. (Carter 2005)

The Securities and Exchange Commission had opened an investigation related to inaccurate data Morningstar released concerning a mutual fund. Morningstar first declared its intention to offer shares through an IPO as far back as May 2004, but the process was delayed — possibly because of the company's interest in pursuing the unorthodox auction method. Regardless of the reasons for the delay, selling shares through the auction route represented an important public relations victory for Morningstar and a significant win for Hambrecht, which had long championed the auction process but had previously been involved only in smaller deals such as the IPOs of Redenvelope (REDE) and Overstock.com. The Morningstar deal was a marquee transaction for Hambrecht, one with the potential to bring the auction process to center stage. (Carter 2005)

How the Auction IPO Works Versus the Traditional IPO

A conventional IPO is managed by a team of investment bankers who gather interested institutional investors and determine the share price. Under an auction IPO, investors are required to submit bids, and the company sells shares at a single clearing price to a list of investors ranked by the size of their bids. The benefit of the auction route is that a conventional IPO can be an expensive proposition and may create a windfall profit if the stock commands a high price from the moment it begins trading publicly. The auction process, by contrast, aims to set a price that more accurately reflects true market demand.

The risk, however, is that some companies fear they may not be able to attract sufficient interest through an auction — that large institutional investors will decline to bid for their stock, and that analysts at investment banks who were bypassed in the IPO process will subsequently ignore them as a public company. Other companies that have filed auction IPO paperwork include small firms operating in diverse fields. After Dover Saddlery, both Traffic.com — which provides reports to radio and television — and IDT Spectrum Inc., which holds licenses for wireless spectrum, registered auction IPO filings. (Syre 2005)

Risks and Benefits of the Auction IPO Model

Avalon Pharmaceuticals Inc. also filed an auction IPO. The managers of these four companies watched the Morningstar IPO closely while evaluating the prospects of their own auctions. Morningstar's executives had deliberated their decision with many people, including investment bankers, prior to the actual offering. The early experience of auction IPO companies is generally encouraging. One notable exception was CyroCor Inc., which offered shares through the auction route at $11 per share in a July auction and subsequently lost 50% of its value. This demonstrates that the auction route does not suit every company. Nevertheless, there are positive aspects to the model, and companies should weigh the option seriously, recognizing that all companies face a continuous auction for their stock from the moment they begin trading publicly. (Syre 2005)

The benefits of the auction model include its transparency and its cost-effectiveness. Because the price is determined by competitive bidding rather than by negotiation between the issuing company and its underwriters, the resulting price better reflects genuine market demand. This reduces the likelihood of the dramatic first-day price surges that characterize many conventional IPOs — surges that benefit institutional investors at the expense of the issuing company. At the same time, the reduced role of traditional investment banks means that companies pay lower underwriting fees, leaving more capital with the issuer.

Conclusion: Should Corporations Follow the Auction Model?

Detractors of the conventional IPO allocation process argue that institutional investors benefit the most from first-day price increases, at the expense of the issuing company. To address this problem, the Dutch-auction process embodied in OpenIPO — developed by W.R. Hambrecht — represents one of the latest efforts to price IPOs more efficiently, so that the issuer obtains a more accurate reflection of the company's true financial standing. (Hensel)

In summary, the auction IPO model offers meaningful advantages in terms of transparency, cost, and pricing efficiency. While it is not suitable for every company — as the CyroCor example illustrates — the successes of Morningstar, Google, and New River Pharmaceuticals suggest that corporations with strong brand recognition and a committed retail investor base have sound reasons to consider the auction route seriously. The continued resistance of traditional investment banks reflects their financial self-interest rather than any inherent flaw in the auction mechanism itself.

References

Carter, Adrienne. "Morningstar Follows Google's Lead." Business Week, 10 January 2005.

Carney, Beth. "IPOs: Going, Going… Not So Fast." Business Week, 16 August 2005.

Hensel, Nayantara. "An Empirical Analysis of Online Auction IPO Processes and Traditional IPO Processes." Graduate School of Business and Public Policy, U.S. Naval Postgraduate School.

Syre, Steven. "The IPO Path Less Taken." The Boston Globe, 1 September 2005.