Finance

Dutch Auction Method

Dutch Auction Method

Whenever a company plans to go public they go through IPO that is known as Initial Public Offering. An investment bank helps the company with the whole process. It values the price of the whole company and takes the firm to the public. There are various potential investors in the market ready to invest in these companies. There are various auctions through which these shares are sold to the public they are as follows English Auction, Dutch Auction, Sealed-Bid-Auction, philatelist auction, etc. We will focus on the Dutch auction method.

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Dutch Auction Process:

The Dutch Auction is generally used in the IPO to assess the optimal price for the public offering or to buy back shares. In this method, the investor places the order for the no. of shares they are willing to buy and the amount they are willing to pay for 1 share. After all the investors submit their respective bids, the auction is started with the highest bid and is gradually lowered until the bidder accepts the current price at which point the auction ends. The amount at which the last bid is sold will be the final amount that all the bidders will pay for the share. This price at which all the shares are bought by the bidders is called “Successful Bidders”. Dutch auctions are suitable in situations where a large amount of a product is available for sale, as compared to a sole product.

For example, if company A decided to go public with 1000 shares there will be no. of investors ready with their bids they are as follows:

Bidder No. of shares Amount
1 100 15
2 400 12
3 300 13
4 250 10
5 200 20

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The placement will be as follows:

  • Bidder 5 has the highest bid of 200 shares for Rs 20 (1000-200 = 800 remaining shares )
  • Bidder 1 has placed a bid for the next 100 shares at Rs 15 ( 800-100= 700 remaining shares )
  • Bidder 3 has placed a bid of 300 shares for Rs 13 (700-300= 400 remaining shares )
  • Bidder 2 has placed a bid of  400 shares for Rs 12 (400-400= 0 shares left )

Hence, the IPO will be valued at $120 per share because the last bid of 400 shares at $12 contained the total number of shares that the firm is offering. Hence, the bidders 1, 2, 3, and 5 will further buy shares for $120 instead of their original offers. As the number of shares is already filled, Bidder 4 will be out.

Pros & Cons of the Dutch auction method:

Democracy – It is a democratic type of market where all types of investors small/big can bid in the IPO through the Dutch auction method. And there are various section of bidding available for them

Shares – in Dutch auction processes all the shares listed in the IPO are sold as the price is decided on the last share sold in the bid.

Valuation – If the investors wrongly valued the company they might end up paying more than the original value of the price. As there is no proper past data available for the investor it is hard for them to value to company accurately.

Winners curse – A stock price me crash immediately after the sale of IPO, this might bring huge loss to the investor as they had bid the shares at a higher amount. Such investors may try to sell their stocks and cut their losses.

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Bottom Line:

Usually, after making several valuation computations and discussing with potential investors the price of IPO shares is set by an investment bank. Ideally, a Dutch auction is more effective at determining the appropriate price, which correlates to supply and demand. In the Dutch auction, all the shares of the IPO are sold as the amount is fixed from the price at which the last share is sold. This helps the firm to raise a good amount of funds and even successful investors may get a share at a good price.

Author: Hariharan Krishnan

About the Author: Hariharan Krishnan is an undergraduate currently pursuing BAF and also pursuing FRM Course. He is passionate to learn about new things.

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