Silicon Valley Legal Bible（5）IPO Pricing Methods How are shares priced

The Silicon Valley Legal Bible with Forty-Two Chapters, a legal encyclopedia customized for founders. I am American lawyer Liu Xiaoxiao.

I. Three Common IPO Pricing Methods

Traditional IPO pricing methods include the Fixed Price Method, Inquiry Pricing Method, and Book-Building Method.

Fixed Price Method

Fixed Price Method (FPM) is actually a method whereby the investment bank, as an underwriter, directly analyzes and values the company's finances and determines a fixed issue price. The advantage of this method is that it is simple and straightforward, and the price has already been determined and placed there. However, the disadvantage of this method is that it lacks flexibility, and it is very likely that the estimation is inaccurate and cannot be changed. Tesla adopted the fixed price method for its IPO in 2010, which was evaluated by underwriters such as Goldman Sachs and Morgan Stanley before the IPO and set the issue price at $17 per share, but because it did not fully consider the company's innovative ability and growth potential, it led to the failure of the company's financial analysis. innovation and growth potential of the company, which led to a huge surge on the first day.

Inquiry Pricing Method

Inquiry Pricing Method is a method in which the company and the underwriters do not determine the price in advance, and the underwriters ask some of the potential investors about their willingness to pay the price, and then based on the information collected, determine an offering price range within which the shares will be offered to the public investors. There is also a cumulative bid and ask method, the ordinary method of inquiry is a one-stage inquiry, cumulative bid and ask is a two-stage inquiry, that is, to provide investors with a second opportunity to choose, which is conducive to adjusting a more appropriate price. Über's (Uber) IPO in 2019 used the inquiry method by underwriters, such as Goldman Sachs and Morgan Stanley, to determine the price of the IPO. Uber's 2019 IPO used the RFQ method, with underwriters such as Goldman Sachs and Morgan Stanley, to set a price range of $44-$50 per share, successfully raising $8.2 billion, making it one of the largest IPOs of the year.

Book-Building Method

Unlike the RFQ method, which is aimed at institutional investors, the Book-Building Method solicits interest from a broader public to determine a final offering price based on aggregated data. However, there is a risk of information leakage and market manipulation by the underwriters, as Facebook used the bookbuilding method in its 2012 IPO on the Nasdaq stock exchange. It opened at $42.05 on the first day of trading and closed at $38.23, the same as the offering price.

The following are the pricing methods used in the IPOs of well-known companies in the past 20 years, from which it can be seen that all three pricing methods are used quite frequently, with the request-for-quotations (RFQ) method being slightly more frequent than the other two. But we are more familiar is often another IPO pricing method, called "Dutch auction", and the actual frequency of this method is very low, basically can be said to be the level of once in a hundred years, the most recent use of Dutch auction pricing is the 2004 Google, and then back to the use of Dutch auctions are The last time a Dutch auction was used for pricing was Google in 2004, and then Ford half a century ago.

So what exactly is a Dutch auction, and why is it so prestigious and used so infrequently?

2. Dutch vs. English Auctions

Before introducing the application of Dutch auction in IPO, let's make it easier for you to understand by comparing the Dutch auction with the English auction.

(1)English Auction

An English auction is the kind of auction we usually see in movies, where the bids for the subject matter of the auction increase from low to high, with the highest bidder becoming the buyer, and the auctioneer confirming three times before determining the highest bid.

The auctioneer stands there and says, "The starting bid for this blue and white porcelain tea set is $10,000, so let's start the bidding.

Here's $12,000. $12,000.

There's another one there for $16,000, $16,000, $16,000 once, $16,000 twice.

There's another one over there for $18,000. $18,000. Is there anything higher? $18,000 once, $18,000 twice, $18,000 three times, sold!

This is actually a very typical English auction.

(2)Dutch Auction

In contrast, a Dutch auction is a reduced-price auction, in which the bids for the subject matter of the auction decrease from highest to lowest, and once any bidder responds, the first respondent becomes the buyer, with no requirement for three confirmations.

For example, a $100 flower will be sold at a reduced price of $10 for every hour that passes.

You may wonder why there is such a mode of transaction as the Dutch auction. The reason lies in the characteristics of the subject matter of the auction. The subject matter of an English-style auction is often bought and sold with little time urgency, such as common antiques and paintings, which cannot be sold today and will be sold tomorrow, or even next year, and the more years that pass, the more valuable the lot is. The subject matter of the Dutch auction is trading time urgency is high, often fresh and perishable commodities, such as fruits, flowers and so on.

a.Dutch auction in the flower market: Dutch auction originated in the flower market in the Netherlands, in 1887, the Dutch tulip harvest, showing the situation of supply exceeds demand. In order to get rid of them as soon as possible, a grower invented a price reduction auction, which is different from the traditional price increase auction.

b.Dutch Auction of Fruit on Trains: In the days of the green train, fruit on the train was sold at $20 a box, and as the train went on, the price would drop to $18, $16 a box or even lower. If you bought fruit when you first boarded the green train, the price would be very high, but when you were about to arrive at the station, the price of fruit was cheaper than at the fruit store, because the fruit vendors wanted to sell out before the train arrived. This is a kind of Dutch auction.

3. Special Dutch Auctions in IPO Stock Pricing

So the point is, the same Dutch auction, in stock trading and flower trading in the specific operation is not the same:

a.Flowers in the application of Dutch auction transactions: in the bid price of $ 100, a group of consumers to buy a batch of flowers; bid price of $ 90, another group of consumers to buy another batch of flowers, until the consumer to buy all the flowers.

b.Application of Dutch Auction in IPO stock pricing: stock pricing occurs only at the moment of IPO opening, note that we are still talking about the moment of IPO opening day, not the next long decades of stock trading one after another, subsequent transactions occur one after another, and the price of this second and the next second are different, but the opening of the market all the stocks are all sold in this moment, and all the stocks are not sold in this moment, and all the stocks are sold in this moment. There can't be two prices for a stock at the same time. So the result is that in stock trading, the Dutch auction is actually like this:

there are 100 shares in total, the stock is just released at $100 a share, someone subscribes for 10 shares at $100, then the price drops to $90 a share when someone subscribes for 40 shares, and then the price drops to $80 a share when someone subscribes for 50 shares, and so on, the 100 shares have all been subscribed for. However, the actual transaction price is not $100, $90, or $80, but all of them are sold at $80 a share. The reason for this is that the nature of the stock exchange requires that all the shares be sold at the moment of the IPO, and the exchange will sell them at the lowest price in the subscription. If they were all priced at $100, then the people who bought at $90 and $80 behind them would certainly be reluctant to do so. Conversely, the $100 and $90 bidders will be happy to buy at $80, thus ensuring that all shares are also ensured to be sold at the opening of the market.

4. The Dutch auction of Google's 2004 IPO

A particularly high-profile example of Dutch auction IPO pricing is the 2004 IPO of Google. Google used a Dutch auction and sold for $85. Google raised $1.84 billion and became the largest Internet company at the time, while avoiding the spike and fall and underwriter manipulation common in traditional IPOs.

The Dutch auction method used in Google's IPO is not universally applicable to most companies, and it turns out that in the last 100 years, the only other IPOs that have been priced using the Dutch method were Google's in 2004 and Ford's more than half a century ago. Because you want to use a good Dutch auction, or need to be the right place, the right time and the right person:

(1)Investors: to have enough knowledge and judgment to bid reasonably, and enough patience and information to wait for the results of the issue. Unlike England is the auction of multiple rounds of bidding, the Dutch auction is the first person to accept in the price reduction is sold, and because the Dutch auction in stock trading is the last person's price is also the lowest price to determine the price of all, then assume that the previous 99 shares are rational investors to sell at a normal price, but that leaves the last share of the reduction of the price of many rounds of no one wants it, until it comes down to a ridiculously low price before it sells, and all the shares are then sold at that last price, and eventually the company issuing the shares is going to be forced to sell them at a far lower result than the market.

(2)The issuer: because the Dutch-style selling auction greatly gets rid of the role of the underwriters, the underwriters can't get the benefits, and then it's impossible to help the company build momentum, so it has to rely on the influence of the company itself. Google's hegemonic position in the Internet, and Ford will allow every family in the United States to drive a car, in addition to companies like this have enough reputation and awareness of the company, most of the company to the time of the IPO is not yet known, the successful issuance of shares or to a large extent rely on the underwriters.

The Silicon Valley Legal Bible with Forty-Two Chapters, a legal encyclopedia customized for founders. I am Xiaoxiao Liu, a U.S. attorney.