A Revolution in the Making, Preparing for the Google IPO

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Google’s business

Google Inc. is an international technology company that deals in internet search and advertising. The core of Google’s revenues lies within advertizing, from programs such as Google AdWords and Google AdSense. In 2003, 97 percent of Google’s revenue was attributed towards advertizing, in which AdWords and AdSense made up 56 percent and 44 percent respectively (IMD, 2003). The AdWords feature allows advertisers to pay every time their link is clicked, while AdSense allows websites on the Google network to host links to AdWords advertisers and share the revenues with the (exhibit 3).

Although the search engine feature is notably web giant’s most successful program, Google has developed new products and services, acquired small technology companies or partnered with them in an effort to expand its revenue base.

Strategic threats to Google

The search engine industry does not have any long run entry barriers, which means new or established internet companies can enter the domain, thereby creating competition for Google. Internet portals such as yahoo and MSN offer more products and services than Google’s search engine. Like Google, MSN and Yahoo both provide links to other sites, but go a step further by displaying more information and solutions. This feature could attract more internet users, which might lead to a decrease in market share for Google. Google’s strategic alliance with portals, such as AOL, T-Online and LA Times (exhibit 3), may cause a significant lose in revenue if the contracts were to come to be terminated.

Costs and benefits of going public

Advantages

The main advantage of going public, especially for start-ups and small companies, is the provision of the large amount capital, which could be used to facilitate expansion and growth, or even pay off debts. The capital comes at a low cost, since no interest is required to repay the investors, and the amount raised need not be refunded back to investors, unless there is a case of liquidation or bankruptcy. Another monetary advantage is the capital gains made by the founders of the company, in case they decide to sell a proportion of their holdings. The company will also be able to source for more equity at lower costs in the future, through the use of rights issues (Draho 2004).

A company going public will be in a better position to assess its value since share prices reflect the financial soundness of the company. Consequently, it will be easier for a public company to use stock-for-stock options in acquisition practices, than a private company. Non-monetary benefits can also be derived, such as the publicity the company gets in the market due to the IPO, which could help the company increase its market share. The company will also be in a better position to attract and retain qualified staff and management, due to its increased size.

Disadvantages

Several disadvantages can be experienced by companies that go public, such as disclosure requirements. It’s compulsory for public companies to publish their financial statements for the public, quarterly and annual results, as well as details of the company’s directors. Companies are also required by law to allow for auditing, which comes at a cost, a feature that is not binding for private companies.

There is added pressure from the market for the company to report profits in its financial statements, which may influence management to act in ways that ensure short term profitability, rather than long term goals. The decision making process becomes slower, since important decisions require approval from the board of directors. The floatation process is quite costly, since investment bankers charge high fees, usually expressed as a proportion of the proceeds.

IPO under-pricing cost to Google

Google’s shares closed higher in the stock exchange market as compared with the IPO price of $85, thereby causing Google to “leave money on the table”.

Role of banks in IPOs

Investment banks assist companies in stock floatation, a process termed as underwriting. Underwriters evaluate a company’s financial records, and present market conditions, so as to help determine the final price and number of shares to be issued. Investment banks buy the shares of the issuing company before it goes public, and distribute them on the IPO date in the stock exchange (Brigham & Ehrhardt 2008). The issuing corporation receives the proceeds after the sale of the stock. Underwriters also assist the issuing company in preparing a preliminary prospectus for the company. Of late, these banks have diverged from their traditional roles by seeking to stabilize the share prices in the secondary market, and providing analyst coverage.

How banks make their money

Investment banks receive an underwriting fee from the assistance they provide in the issuance of new securities. The fee is usually expressed as a percentage or gross spread, that is, the difference in price the syndicate has bought the new securities at, and the price the price offered to investors in the market. Underwriters can also be remunerated with a combination of shares and options to buy shares, in addition to a smaller spread (Sharpe, Alexander & Bailey 2008).

Risks to Google and the investment bank for an under-pricing

In the event of an under-pricing, both Google and members of the syndicate risk losing out on money they could have attained had they set a higher price. Google loses potential capital, while the investment bank loses potential revenues, had the shares been sold closer to their value.

Risks due to an overpricing

The major risk surrounding overpricing of new shares is the prospective liability towards shareholders. Overpriced shares result into a decline in prices in the aftermarket. Investment banks who offer a firm commitment bear all the risk, and may end up with unsold securities if the public is not willing to purchase them at such a cost.

Comparison

Both overpriced and under-priced IPOs have disadvantages, but overpriced IPOs are more risky since the underwriters may experience loss if the prices of the unsold stock sell lower than the IPO price. Consequently, the issuing company’s marketability in the stock market and value could be lost. Investors will be attracted to shares they feel are under-priced, so the only loss made to the underwriters and issuing company is an opportunity cost.

Threat to investment banks by Google IPO process

Google, having chosen to conduct its IPO through a Dutch auction, rather than the conventional book building exercise, gave the lead investment banks; Morgan Stanley and Credit Suisse First Bottom (CSFB), less control in the pricing decision. A decreased role for the underwriters meant that Google could pay fewer fees for the exercise. The lead underwriters in Google’s IPO received 2.75 percent fees, compared with the US average underwriter fees of 7 percent (exhibit 14) in that particular period.

Can companies time the capital market?

Companies can analyze the mood in the market before they decide to issue new securities. This can be done by considering past IPOs, in a move to assess the behavior of investors in the market. The country’s economy should also be evaluated; the company will attain more success if it issues an IPO in a period of boom rather than in a recession.

Can investors time the market?

Investors can time the primary market if they feel that the stock price of a particular company is undervalued. In the secondary market, investors can use fundamental and technical analysis to assess the current or future share price and act accordingly, while considering all potential risks.

Expectations on Google IPO in the long term

A duo share structure, such as the one used by Google, protects the company from the need to achieve short-term financial targets, which can be damaging to the long-term objectives. From a long-term perspective therefore, Google’s shares are expected to perform positively, if the example set by Berkshire Hathaway is anything way to go by.

Pricing processes-fixed price, auction and Dutch auction

In a fixed price process, the issuing company and its underwriters settle on a specific price for the new stock. Investors willing to purchase the stock will do so at the determined price, hence there is a degree of certainty for both the investors, and the issuing party.

For an auction pricing system, the internet is used to open up the number of potential buyers willing to purchase the stock. A reserve price is set, though investors bid for the price and number of shares they are willing to purchase. A Dutch auction sets a higher price target than an auction format. Investors bid with their respective prices, and the number of shares they want to purchase. The price settled at is the highest possible price at which the total number of shares offered can be issued. The price investors pay is the last successful bid.

Dutch auction in terms of governance

The Dutch auction process reduces the role investment banks play in the IPO. Traditionally, banks contributed by setting a price, and were also involved in the share allotment to favored investors or clients. The Dutch system, on the other hand, opens up the opportunity to even small retail investors. The Dutch auction system therefore gave Google the final decision regarding the IPO price, size of issue, and the allocation of shares. (IMD International Institute for Management Development 2004).

References:

Brigham, E. F. & Ehrhardt, M. C. (2008). Financial management: theory and practice. 12^th ed. Boston, MA: Cengage Learning.

Draho, J. (2004). The IPO decision: why and how companies go public. Northampton, MA: Edward Elgar Publishing.

IMD International Institute for Management Development. (2004). Google Case Study – Preparing for the Google IPO: A revolution in the making? Lausanne, Switzerland.

Sharpe, W. F., Alexander, G. J., & Bailey J. V. (2008). Investments. 6^th ed. New Delhi: Prentice-Hall.

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