Salon.com (which, need it be said, is something like a competitor to Slate) went public yesterday to a general yawn from the marketplace. Salon went public at $10.50 a share, fell to close at $10 a share, and was up a mere 1/16 of a point today. Not exactly what dreams of Internet fortunes are made of.
On the other hand, Salon was able to raise $25 million for its coffers by selling 2.5 million shares, which is not too shabby for a company with huge losses relative to its revenues, a dependence on a small number of advertisers, and a history of being, well, loose with the facts about its business (as our own Michael Kinsley documented). Even if Salon’s stock never rises from here, it’s still remarkable that an Internet magazine could have a market cap of $107 million.
What’s important about Salon’s debut, though, is that the company did not go public via the traditional route, whereby underwriters buy the company’s shares and then sell them to lucky investors, who are generally able to sell them immediately to less lucky investors. Instead, Salon used what’s called a modified Dutch auction process, which is being pioneered by W.R. Hambrecht & Company. In a Dutch auction, anyone interested in buying the stock bids. The bids are then ranked, and shares are distributed, beginning with the highest bidders and going down the list until all the shares are gone. But no one pays more than the lowest bidder who actually gets shares. (For more on Dutch auctions, click here .)
It sounds a bit confusing, but in truth the principle isn’t that different from a typical IPO, where all of those who get shares in the IPO pay the exact same price. The crucial difference is that instead of the underwriter setting the offering price, the market sets the offering price. And that’s a terrific innovation, because it means that companies will go public at prices much closer to what the market will bear than they currently are.
As I’ve argued here before, the IPO process is distorted because the company going public generally wants its offering price to be as high as possible (so it raises as much money as possible), while the underwriters want the price to be high but not so high that their favored clients don’t have a chance to make some easy cash. The Internet market is clearly frothy. But it’s not so frothy that first-day price jumps of 200 percent, 300 percent, and even 600 percent (which we’ve seen with companies like iVillage, Marketwatch.com, and theglobe.com) can be justified. Those are simply examples of mispricing.
Now, we have heard in recent months the idea that an IPO is not just about raising money, that it’s an exercise in branding, and that the publicity a company gets when its stock explodes on that first day is worth whatever money it leaves on the table. In the case of small, feeble companies like theglobe.com, you can see the argument for this. But then again, who needs an extra $50 million more than these small, feeble companies? In any case, the Dutch auction circumvents these problems, along with the more annoying reality that IPOs have become a simple way for the rich to get richer. As such, Dutch auctions are going to have a hard time penetrating Wall Street. But there’s an excellent chance that eventually they will.
Now, if you say this to anyone who’s actually on Wall Street, they’ll laugh in your face. Companies want a real investment bank behind them, not a startup like Hambrecht. Companies want that big jump on the first day. More important, investors want it. They’re not going to invest in IPOs if there’s not a real chance of making a lot of money quickly. And so on.
These are good reasons to believe that things will go on as they have been. But remember that brokerage houses and investment banks said very similar things about discount brokers and online trading, and only now are they realizing how wrong they were. Dutch auctions are cheaper (Hambrecht is charging 5 percent, not 7 percent as other investment banks do), fairer, and more efficient in determining price. It will be a long time before they make a material difference in the way most companies go public, but eventually they will.
The one thing that will hinder the diffusion of the Dutch auction IPO, though, is the mediocrity of the companies that use it to go public. If it’s only companies with financials like Salon’s (or Ravenswood Winery, the first company to go public with Hambrecht) that use the Dutch auction, then investors will identify the process with mediocre returns. But there’s nothing wrong with the process, and the first time a company with real growth prospects uses it to go public, that will become clear.