- A Dutch auction is a means of selling securities where the seller sets an opening price, which decreases until bids are made, and it is most commonly used in IPOs.
- At the end of a Dutch auction, all securities are sold at the lowest accepted bid price.
- Google famously used a modified Dutch auction for its 2004 IPO.
- Dutch auctions democratize the IPO process, allowing individual investors to participate in a process that’s often reserved for institutional and high-net-worth investors.
Definition and Example of a Dutch Auction
A Dutch auction is a means of selling an asset by setting a maximum price. During the auction process, the price is gradually lowered until someone makes a bid.
Note
Dutch auctions can be used to sell a variety of types of securities, including Treasury securities, floating-rate debt instruments, IPOs, and more.
Perhaps the most well-known example of a Dutch auction occurred in 2004 when Google went through an IPO. In a traditional IPO, the investment banks managing the IPO communicate with mutual funds, preferred clients, and other investors to determine an appropriate IPO price. But in the case of Google’s IPO, the company decided to use a Dutch auction. While Google ultimately managed to raise more than $1 billion of capital during its IPO, there’s some debate as to whether it was the most efficient pricing mechanism.
The initial target range for the IPO was $108 to $135. Ultimately, the investment banks ended up pricing the IPO at just $85. And by the time the offering opened, the price was $100.
In another example, GameStop used a Dutch auction in 2019 when it offered to purchase up to 12,000,000 of its Class A common stock in a tender offer. The company announced it would purchase the shares for up to $6, but no less than $5.20.
Note
In addition to IPOs, Dutch auctions are used by the U.S. Treasury Department. In the past, specifically with preferred stock Capital Purchase Program investments, the Treasury Department has used a modified Dutch auction method. This established a market price by allowing investors to submit bids at specific increments.
How Does a Dutch Auction Work?
One of the most common uses of a Dutch auction in securities is during IPOs. In a traditional IPO, the investment banks underwriting the IPO do what is called a roadshow.
During this roadshow, they set up meetings with financial analysts, institutional investors, brokers, and more. Not only do they use these meetings to market the securities that will soon be for sale, but they also use the information they gather to appropriately price the securities.
Note
One distinct feature of the traditional IPO process is that not everyone is invited to participate. Often, these IPO securities are open to favored investors of the underwriting banks.
A Dutch auction works a bit differently in that theoretically, anyone can bid on the securities. In the case of Dutch auctions, the IPO process is democratized, in that it allows individual investors to participate, rather than just the institutional and high-net-worth investors invited to participate in traditional IPOs.
Additionally, the auction process, rather than the roadshow, is used to determine the IPO price. In a Dutch auction IPO, investors submit a bid of the highest amount they’re willing to pay for the securities. As is the case in most auctions, the goal is to sell the shares for the highest price.
Suppose that a company planned to sell its IPO shares for as high as $100 per share using a Dutch auction. It opens the bid for 1,000 shares. The highest initial bid is $95, and that highest bidder will get first priority on the shares. The bidding continues until the final shares have accepted bids.
But that bidder won’t actually buy the shares for $95. In a Dutch auction, all bidders receive the same price. The bidding continues until all of the shares have been bid on, and all bidders pay the lowest accepted bid. So if the last of those shares sold to a bidder offering $70, then all buyers would ultimately pay $70 for their shares.
Pros and Cons of Dutch Auctions
Pros
Reduced transaction costs
Democratization of public offerings
Increased transparency
Cons
Less price control
Possible price inefficiencies
Increased investor risk
Pros Explained
- Reduced transaction costs: In a traditional IPO, the investment banks have more involvement as they perform the roadshow and set the IPO price. A Dutch auction IPO can reduce the involvement of the underwriters, and therefore reduce transaction costs.
- Democratization of public offerings: In a traditional IPO, shares are generally sold to favored investors. But in the case of a Dutch auction, shares go to the highest bidder whether it’s a large mutual fund or an individual investor.
- Increased transparency: In a traditional IPO, the price is usually set behind closed doors based on underwriters’ conversations with institutional investors. But because the price in a Dutch auction is based on the public’s bids, there is more transparency in the process.
Cons Explained
- Less price control: A potential downside for the company going public is that a Dutch auction gives them less control over their IPO price. It will always depend on the auction process.
- Possible price inefficiencies: In some cases, a Dutch auction may lead to shares being inappropriately priced. For example, in the case of Google’s IPO, investment banks initially priced the shares at just $85, while the shares quickly increased to more than $216 in the following months. This inefficiency could have been due to a lack of sufficient information on the part of investors, public uncertainty about the Dutch auction process, and more.
- Increased investor risk: Dutch auctions can democratize IPOs, but that isn’t necessarily a good thing. Many individual investors aren’t well-versed in the IPO process and may not understand the risk.
What It Means for Individual Investors
Dutch auctions in the IPO process can be incredibly impactful for individual investors. Often, IPO shares are offered only to clients of the underwriting investment banks. But in the case of a Dutch auction, anyone can bid on shares.
But this benefit also comes with significant risk. The Securities and Exchange Commission (SEC) considers IPOs to be risky and speculative investments. Institutional investors may be well-versed in IPOs, but many individuals have never participated in one. As a result, they may not fully understand what they’re getting themselves into.
Before participating in IPO via a Dutch auction, be sure to inform yourself about the auction process and the company. Companies that are going public are required to file registration statements with the SEC, which individuals can look up on EDGAR. As with any investment, don’t participate unless you really understand what you’re investing in
