LinkedIn stock’s large price jump following it’s IPO last Thursday has caused many to comment that LinkedIn was “ripped off” by its underwriters by pricing the offering too low.  LinkedIn used the standard offering process where the its underwriters, Morgan Stanley and Bank of America, offer the stock to their clients and set the offering price.  Most of the commentary has missed the underlying economic fault in the traditional offering process which is having individuals price anything especially when they have competing incentives is asking for a poor outcome.  The underwriters benefit by giving their best clients a big instant return on a hot IPO as they extract part of that gain through high fees on those clients.  Pricing too high will lead to a failed offering which the underwriters will be blamed for.

There’s a better way as Google demonstrated  in its 2004 IPO.  A modified Dutch auction will set a market price for the IPO and maximize the value the company and the shareholders participating in the offering receive.  For those not familiar  with the procedure, a modified Dutch auction is pretty simple.  Everyone interested in buying shares makes a bid saying they will buy X shares at a price of Y.  The auction prices at highest price, called the clearing price, that will sell all the shares on offer with everyone biding the clearing price or higher getting their bid filled.   The US Treasury uses the process to sell Treasury Bills and Bonds so it’s empirically proven in addition to being a theoretically sound.

To compare the two alternatives I normalized the offering prices of LinkedIn and Google to 100 and looked at the relative returns over the first 3 trading days.  Google returned 18% over its offering price versus 109% on the first day for LinkedIn.  Much more money could have ended up in LinkedIn coffers if they had priced as close to the market price as Google did.

There are too few examples of high demand IPOs being Dutch auctioned to do a statistically significant comparison.  However, the available evidence suggests it’s a much better pricing mechanism and economic theory is solidly behind that conclusion.  I doubt Dutch auctions will become anymore common though.  For non-hot IPOs, it’s not clear would be enough bidders.  The underwriters will be opposed since it both marginalizes their role in the process and reduces the amount of value they can capture for their clients and ultimately themselves.  Underwriters can not be eliminated from process since the securities laws require them.  Corporate executives aren’t likely to clamor for it either.  While a Dutch auction will benefit their shareholders, doing something unconventional always carries more risk of negative personal repercussions if it goes wrong.  It’s lot easier to blame the underwriters for a unsuccessful IPO if their advice for  traditional offering is followed rather than actively discarded.