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In the heady 1990s, W.R. Hambrecht & Co. introduced what seemed like a heretical idea: Why not price initial public offerings based on what the full spectrum of investors, institutional and individual, has determined at auction to be the company’s fair value? Hambrecht’s “open IPO” process sought to give small investors access to initial public offerings. This would minimize the aftermarket volatility that generally benefits only those large institutional investors who got in on the ground floor of an IPO. The traditional investment banking community disdained the open IPO process when the stock market party was in full swing. No dramatic run-up in aftermarket price? Why bother? Despite early criticism, Hambrecht has continued to use the open IPO process to take companies public. These days, investors no longer expect a stock’s price to rise several hundred percent in its first days of trading. Paying a fair price for long-term value sounds more attractive than it did last year. The current chilly IPO market may have sobered us enough to take a better look at the merits and flaws of the open IPO process. WHAT IS AN OPEN IPO? An open IPO auctions shares of stock in an initial public offering directly to individual investors online. In theory, it uses the leveling effect of the Internet to give small investors as much chance as the large institutional players to participate in an initial public offering. The concept of the open IPO — also known as a “Dutch auction” — is based on a model created by Nobel laureate economist William Vickrey’s price-setting system, emulating the process used at the Amsterdam Flower Market. The Dutch auction process is not new — it is commonly used to sell U.S. Treasury securities, for example. However, its application to the IPO process by W.R. Hambrecht & Co. gored a few sacred cows of investment banking. Consider the description of the process on Hambrecht’s Web site: The auction treats all bids equally. A bid for one hundred shares by an individual investor has the same standing as a bid for one hundred thousand shares by an institution. Your allocation is based on what you are willing to pay rather than on preferential treatment. This creates a market driven by supply and demand rather than influence or artificial demand. If the process works — if the price set at auction accurately reflects what investors in the marketplace are willing to pay for the company, rather than an arbitrarily low offering price benefiting the underwriter — then there will not be a jump in price on the first day of trading. An aftermarket price run-up would suggest that the process had not worked properly, and that money had been left on the table by the issuer. SO WHAT’S WRONG WITH THAT? In a traditional underwriting, the lead managers gauge the interest of institutional buyers in purchasing the issue. The institutional buyers may get some, but not all, of their orders filled, which creates a robust aftermarket and may exert upward pressure on price in the first days that a new issue trades. There are those who take a more cynical view of the traditional IPO process: They say investment bankers underprice offerings to produce a big jump in the share price once the stock begins to trade. Meanwhile, the investment banks arrange, in return for brokerage referrals, for their favorite institutional clients to purchase blocks of shares. When the IPO market was hot, the institutional investors could then rapidly “flip” the shares at a profit. This scenario affects the individual investor in one of two ways: He or she is left out in the cold completely, or, as seen repeatedly at the height of the IPO craze, he buys at a price that has doubled or tripled over the opening price, then gets stuck with the stock once the price takes a nosedive back to its long-term trading range. For example, institutional investors were able to buy Palm at $38, its opening price. The price then rose to $165 during the first day of trading. Individual traders first got a bite at the offering at $145 per share. The stock price then fell to $24 within weeks. The institutional investors who had bought at $38 and sold in the mid- to-high hundreds were largely out of the picture by then. In the IPO frenzy of the late 1990s, aftermarket price volatility also hurt the companies going public. For example, when Theglobe.com went public in November 1998, it priced at $9 but opened at $90. By “flipping” the stock, the institutional investors, rather than the company itself, benefited from the mispricing. HOW DOES AN OPEN IPO WORK? For a couple of months before pricing, the underwriter takes sealed bids over the Internet from its customers. After examining the prospectus, people bid what they believe the stock to be worth. Then, on a prearranged date, the bidding stops and the company and the underwriter determine the minimum price at which all offered shares can be sold — the “clearing price.” Anyone who bid more than the clearing price will receive his or her entire allocation at the clearing price. Anyone who bid at the clearing price will receive some of the shares requested. Anyone who bid below the clearing price receives no shares. Consider the following example: NewStock Co. offers 1 million shares at a projected price range of $9-$14 per share. Working from the highest bid to the lowest, the issuer and underwriter determine that the lowest price that will account for 1 million shares is $12. In other words, of those who participated in the auction, there are enough investors willing to pay at least $12 per share to account for 1 million shares. A few characteristics of the open IPO auction process are as follows: � The higher your bid, the better chance of getting your request completely filled. There is no maximum bid. � If you bid at too low a price, you will get no shares. � Bids can be modified or revoked at any time prior to the closing of the auction. � You can submit multiple bids at different prices. If you place four bids, and two are successful — i.e., they equal or exceed the clearing price — you receive the aggregate number of shares allotted you from the two successful bids, at the offering price. Your maximum potential obligation is capped at the aggregate number of shares from all bids, times the offering price. � If the number of shares bid for exceeds the number of shares in the offering, then the underwriter allocates shares on a pro rata basis, rounding to multiples of 100 or 1,000 shares (depending on the size of the bid). The company may choose to sell the shares below the clearing price. In that case, the number of shares being offered may rise. Some people who bid below the clearing price get to purchase shares. Investors who bid at or above the clearing price only get a percentage of the shares requested, rather than all of them. However, they purchase at the lower offering price, not at the clearing price or at whatever price they bid. BOTH MERITS AND FLAWS There are pros and cons to the open IPO process. Some are no doubt readily identifiable by any seasoned IPO hand. Others have emerged in practice as Hambrecht has conducted a number of open IPOs. Among the merits of the open IPO process are: � Individual investors get access to initial public offerings at a fair price. � The offering price, while not likely to see a dramatic run-up in the early days of trading, is more likely to predict a price that will be sustainable over the long term. This discourages participation by traders merely seeking to “flip” stock for a quick profit, and encourages investment by those who take a longer view. Theoretically, this should reduce market volatility in initial offerings. � No restrictions on who can participate, except that there is a minimum 100-share requirement. This opens the process to the individual investors who, for example, now account for about 60 percent of the activity on the Nasdaq. � There is no arbitrary allocation of the offered shares based on special business relationships. Theoretically, a single investor who bid high enough could receive 100 percent of the offering. � The issuer gets a price realistically based on market demand, not the sometimes artificially low price set by underwriters. And it is the company, not institutional investors, that receives the benefit of the price the market sets. There is less money left on table by the company. � Underwriting fees are often much lower: 3 percent to 5 percent instead of the traditional 7 percent to 10 percent. Nevertheless, as good as the model sounds — at least from the view of the issuer and the small investor — there are also some weaknesses in the open IPO model: � Because it is the unfilled demand that typically sends prices higher in the IPO aftermarket, use of this procedure may suggest to the trading public less than robust demand. Indeed, by determining and answering demand prior to trading, some say the open IPO process actually diminishes demand in the aftermarket. � While no issuer wants to leave part of the offering price on the table, many companies find value in the attention that goes with a big run-up immediately following an IPO. The open IPO process makes the run-up less likely. (But in the current economic climate, fewer issuers expect a skyrocketing aftermarket price; thus, the open IPO process becomes less unattractive in this regard.) � Hambrecht has had problems getting analysts to follow companies taken public through the open IPO process. This may be because it lacks the analyst horsepower that is typically affiliated with the traditional investment banks, or it may be that in the absence of an aftermarket price run-up, analysts fail to pay attention to a new issue. Whatever the cause, subsequent low trading volume is likely to accompany a lack of analyst attention. � Issuers may face the damaging assumption that they used the open IPO process because they could not attract more traditional underwriting of their offerings. � If the only companies that use the open IPO process are those with less than stellar financials, the process becomes associated with poor performance. This is likely to hinder widespread acceptance even in the absence of any true causal connection. A MIXED TRACK RECORD SO FAR Hambrecht has completed a number of open IPOs — some at the height of the IPO frenzy, such as Salon.com, Ravenswood and Andover.Net, and a few in calendar year 2001, notably Peet’s Coffee & Tea and Briazz. SALON.COM Salon.com, an Internet magazine that was one of Hambrecht’s early open IPO attempts, did poorly in the IPO aftermarket. It lost nearly 5 percent off its initial offering price in its first day of trading — at a time when other Internet stock prices were skyrocketing. Nevertheless, Salon.com had revenue reporting problems that resulted in negative publicity during the offering. Subsequently, its share price dropped 80 percent in the year after it went public, mirroring the market conditions generally afflicting Internet content companies. This combination of internal financial issues and external market conditions makes it difficult to judge the role of the open IPO process, if any, in Salon.com’s poor performance. RAVENSWOOD Ravenswood, a winery, had a better open IPO experience in 1999. Its share price rose about 10 percent in the year following the IPO. The company expressed satisfaction with the IPO results, because they would have viewed a big aftermarket run-up as money left on the table in its deal with the underwriters. But trading volume was low after the offering. While Ravenswood opened at $11.13 a share, it is now trading at around $29, so there has been a gain for those investors who purchased for the long haul, rather than for a quick profit in the IPO aftermarket. ANDOVER.NET Andover.Net, a Web site for Linux users, chose the open IPO process in part because its philosophy resonated with that of the “open source” software movement, under which programmers freely share, modify and distribute software. By all accounts, the Open IPO process served Andover.Net well. Its stock opened at $18 per share (although the clearing price was $24, the company exercised its option to price lower for the benefit of participating investors). Thus, anyone who bid more than $24 for the stock was allotted all requested shares at $18. Then the stock more than quadrupled during its first day of trading. As might be expected, however, the market has not been as kind to Andover.Net in the long term. PEET’S COFFEE & TEA This competitor to Starbuck’s was the first IPO of 2001, hitting the market at a time when IPOs were all but nonexistent. Peet’s used the open IPO process to offer 3.3 million shares at a price range estimated between $10 and $14 per share. This range had been determined the prior autumn, when the IPO picture had been much more favorable. Just prior to the offering, Peet’s cut the proposed auction price range to between $8 and $12, in light of general market conditions. Peet’s priced at $8 per share, then rose about 17 percent in its first day of trading on the Nasdaq, despite the adverse market. It retained a premium of about 20 percent over its opening price in the months following the IPO. As of mid-June, it had dropped back to about $8. BRIAZZ This newcomer to the public markets is also in the food industry and seeks to emulate Peet’s success. It offered 2 million shares in an open IPO at an $8 to $12 suggested price range. It started trading in early May 2001 after pricing at $8. In the weeks since it has gone public, Briazz initially hovered around its offering price, trading within a range of $6.75 to $9.04, but by mid-June had dropped to around $4. JUDGING SUCCESS OR FAILURE It is difficult to judge the performance of an open IPO, since the success of an initial public offering traditionally is measured in terms of the aftermarket price jump — the very criterion an open IPO seeks to avoid. Perhaps long-term stability or a modest but dependable gain in stock price — such as has been displayed by Ravenswood and may be displayed by Peet’s — is the better measure of success. Although the economic interests ranged in opposition to the open IPO method are formidable, one cannot help but applaud the goal of the process: opening up the initial public offering process to participation by smaller investors. However, given the trauma experienced by smaller investors in recent months because of market volatility, one wonders how many still have an interest in participating. Eileen Smith Ewing is a partner in Kirkpatrick & Lockhart’s Boston office.

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