How a Dutch Auction IPO Works

Some companies, such as Morningstar (NASDAQ:MORN) and Google (NASDAQ:GOOG), have opted for a so-called Dutch auction when pulling off their initial public offerings. There�s even buzz that Facebook might try it.

But aside from a funny name, what is a Dutch auction IPO? Well, to understand it, let�s first take a look at the traditional approach to pricing an offering.

Traditional IPOs

In the IPO process, a company will hire one or two lead underwriters who will help draft the necessary documents, as well as come up with the presentation materials.

But they also perform another crucial function: They help determine the valuation of the company. This is not an easy task, and can be more art than science. The underwriters will use sophisticated valuation techniques — such as analyzing future cash flows — and also look at comparable company valuations.

Thus, the results can be wide price ranges. This especially is the case for companies in emerging industries, such as social media. This is a key reason for much of the volatility found in IPOs like Zynga (NASDAQ:ZNGA), LinkedIn (NYSE:LNKD) and Groupon (NASDAQ:GRPN).

So to get a better sense of the valuation, the underwriters will take the company on a roadshow. This can last from one to two weeks and involves presentations to hundreds of institutional investors. Through this process, the underwriters will come up with a price range.

Interestingly enough, the final price actually will be at a discount to the market value. Why? The reason is to create a “pop” on the first day of trading. Think of it as a reward for investors who take a risk on a new company. In some cases, first-day returns can be 50% or more (which certainly is more common for companies in emerging industries).

Dutch Auctions

The process for a Dutch auction is somewhat similar. The underwriters will help with the documentation preparation, prepare a valuation and go on the roadshow. However, the pricing of the deal is a much different process.

The underwriters will set up a website that allows investors to make bids on the offering. For example, an investor might say he or she will buy 1,000 shares at $12, or 2,000 shares at $11 (yes, investors can make multiple bids).

The online system then will process the bids and determine a clearing price. In other words, it will find the offer price that will achieve the capital amount a company wants. The computer system then will give a pro rata share of stock for each investor who bid at the offer price or higher. So in our example, the investor might have received 500 shares at $12 each.

Keep in mind that the Dutch auction IPO system is based on some complicated algorithms, which are�based on the work of Nobel Laureate William Vickrey, whose approach also is used for the sale of Treasuries. Investment bank WR Hambrecht owns the patent on the process, which is called OpenIPO.

However, there’s usually no pop on the first day of trading after a Dutch auction. After all, the valuation of the offering tends to be in line with the market value.

So why do it? The Dutch auction tends to favor the companies going public because it usually raises more money. At the same time, it can be more democratic — individual investors often have more participation because of the online system. And companies like Google — and Facebook — have a huge amount of users who might want to get their hands on some shares.

But the reason you don’t often hear about Dutch auctions is because they’re fairly rare. Major Wall Street banks like Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) want to keep control of the process. And by achieving first-day pops, they can build loyalty with their institutional investors.

Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of �All About Short Selling� and �All About Commodities.� Follow him on Twitter at @ttaulli. As of this writing, he did not own a position in any of the aforementioned securities.