Book building has been one of the most widely used methods in the underwriting process. However, over the years, companies have realized that the book-building process is largely controlled by the intermediaries, i.e., the investment banks! The investment banks are the ones building the books. Hence, they can easily control who gets in and at what price.

Over the years, many companies raising capital have alleged that investment banks are corrupt, and many of them do not work in the best interests of their clients. Many companies learned this the hard way. For instance, the technology company Netscape was priced at $28 per share during the IPO process. However, as soon as the share was listed, it zoomed to $75 per share! Similarly, twitter was priced at $26 per share, whereas it went up to $46 per share after listing. In essence, Twitter, Netscape, and many other companies like them were simply leaving money on the table! Instead of companies raising this money during the IPO, secondary market speculators were making humungous profits by flipping the shares.

Over the years, this has led investors to doubt the entire system. In the above case, either investment banks were completely ill-informed that they could not gauge the price for which the stocks could actually be sold. Or, they were hand-in-glove with the speculators and were not acting in the best interest of their clients. The loss of trust in the book building system has led companies to search for alternative modes of price discovery, and the Dutch Auction is one of those modes. In this article, we will have a closer look at what the dutch auction process is and how it helps to overcome the shortcomings of the book building process.

The Problem with Book Building

Over the years, many firms have alleged that investment banks collude with investment funds while selling shares during an IPO process. This is because these funds hire the services of these investment banks in other forms and often pay them millions of dollars throughout the year. Hence, even though the bank is charging money from the client, they are often just doing the bidding of the investment fund! These investment funds, in turn, buy at low prices offered by the banks and then flip the shares on the day of the IPO for a higher price. This is why there is so much trading seen on the day of the IPO. Almost all the shares change hands the day these companies get listed.

The end result is that the investment banker and the investor make a killing. On the other hand, the company loses money since it raises much less than it would otherwise have. Also, genuine retail investors lose money since they get to buy stocks only at inflated prices. The root of this problem is that the investment banker has a lot of control over the IPO price.

How Dutch Auction Solves this Problem?

The Dutch auction process of underwriting helps in solving this problem. This is because it takes away some of the control that investment bankers have in the price-fixing process. As a part of the dutch auction, companies solicit bids from prospective investors. The final issue price is decided based on the actual bids received. Hence, the chances of mispricing happening are quite low.

Also, the dutch auction process has been designed in such a way that it encourages investors to bid higher prices and raises the proceeds of the IPO. Let us understand the Dutch auction process with the help of an example:

Example: Company A wants to sell 300 shares. It has asked investors to bid for the shares and has received four bids.

• Investor B bids for 100 shares at $16 per share

• Investor C bids for 100 shares at $14 per share

• Investor D bids for 200 shares at $12 per share

• Investor E bids for 200 shares at $10 per share

Notice that the company wants to sell 300 shares. Hence, if it were to sell only to investor B, its supply would not be exhausted. If it sells to C as well, then too, it sells 200 shares only. However, when the company sells to investor D, it ends up selling more than 300 shares. There are two points to be noted here.

1. The cut off price will be decided based on the lowest bid at which the company can sell all its shares. In this case, that bid is from investor D. Hence, the strike price is $12 per share. Note that all shares will be sold at $12 per share. Hence, even though investor B made a higher bid at $16 per share, they would have to pay only $12 per share. All winning bidders have to pay the lowest bid price! Hence, this system encourages investors to bid higher prices, which helps in increasing the overall valuation of the IPO.

2. The company wanted to sell only 300 shares. However, until investor D, they have to allocate 400 shares. The bid received from investor E will be discarded. However, the others will be allotted shares based on an allocation ratio. Here, the supply is 300 shares, and the demand till investor D is 400 shares. Hence, the allocation ratio is 300/400, i.e., 75%. So investor B will receive 75 shares even though he/she has bid for 100 shares.

The bottom line is that even though book building is still the most popular underwriting method today, it is facing competition from the Dutch auction method, which many believe is more popular.