Traditional Ipo Vs. Auction-Based Ipo

Learn the difference between a traditional IPO and an auction-based IPO, and what the difference means for companies and investors.

Companies conduct initial public offerings (IPOs) of stock to raise capital for operations and growth. Auction-based IPOs are becoming an alternative to the traditional IPO. Auction-based IPOs offer several advantages to both the companies and individual investors, but also carry some additional risks.

Traditional IPO

In a traditional IPO, a company hires an investment bank to underwrite the IPO. The company and the investment bank research the likely market value of the company. Based on the research and the amount of capital the company wants to raise in the IPO, the company and the investment bank determine how many shares will be offered, as well as the price per share of the offering. This price is usually discounted from what the company and investment bank estimate the true market value will be.

After the number of shares and share price of the IPO are determined, the company and the investment bank conduct a road show, in which the present the offering to large investors. These investors are usually institutional investors or wealthy individuals who are among the investment bank's top clients. Interested investors will commit to buying a number of shares at the offered price. After the road show tour is complete, the company and investment bank will review the commitments, and allocate shares. Investors will not necessarily be allocated all the shares they committed to buy. The investment bank collects a percentage of the IPO sale as commission, in addition to other fees charged to underwrite the IPO. These investors can then start trading the stock on the first open trading day.

Because they are discounted from the estimated market value, stocks issued in traditional IPOs frequently trade significantly higher than the initial price as soon as trading begins. However, because access to the stock at the IPO price is limited, the profits from this appreciation go to a small group of investors.

Auction-based IPO

Auction-based IPOs use the Internet to open the purchase of IPO stock to a larger set of potential investors. Companies still need an investment bank to underwrite the IPO, but the costs are much lower. Companies will determine how many shares they are offering, as well as a reserve price. A road show may still be part of the process to educate large investors about the company, but there is no share allocation. Instead, when bidding opens, investors will enter a bid for the price and number of shares they want to buy.

A Dutch auction format is often used. The company sets a price well above what any investor is expected to bid, and then reduces the price incrementally someone bids. The bidder is sold the number of shares he or she bid, and then the price is lowered again incrementally, until all of the shares offered have been sold. All bidders pay the price bid by the final bidder.

Auction-based IPOs can be attractive to companies because of the lower fees. In addition, because auction-based IPOs are more likely to end with a share price close to market value, the first-day increase in stock price once open trading begins is often less, meaning those profits went to the company instead of to the investors. However, companies often get substantial positive press when their stock prices increase substantially on the first day of trading. This publicity has some value. In addition, if the company overestimated its value, there is also increased risk that it will raise less capital than expected.

For investors, auction-based IPOs allow many more people to participate, instead of limiting the opportunity to buy shares to a few large investors. However, the investment return is likely to be substantially less than it would be for a traditional IPO.

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