Thomas G. Donlan, writing in this week’s Barron’s in a column Google’s Good: Who’s going to buy a stock that won’t go up?[link - paid site($)] claims that Google’s strategy of pricing their IPO through a dutch auction will be the beginning of the end of venture capital funding for start-up tech companies. Under the old system, investment banks set the price of an IPO below what the estimate is the market clearing price on the first day’s trading.
To the extent that they are correct, the stock will be bid up after the market opens. The investment banks and favored clients capture this gain. Critics of this system have noted that the some or all of the gain captured by the early traders could have been earned by the company itself, which would have been more in the interest of long-term share holders.
Silicon Valley and Wall Street have had a mutually exploitive relationship for many years. On the West Coast, people work in garages for nothing, on the chance it will turn out they’re working for the next Microsoft, which will pay them in stock, which they’ll be able to sell in or after an IPO. On the East Coast, people buy those IPO shares on the expectation that the price will rise — and they know it will, because investment bankers are holding down supply to create scarcity. What will happen to Google shares? They will “achieve a relatively stable price in the days following the IPO [so] that buyers and sellers receive a fair price at the IPO,” Google says.
Where’s the fun and profit for West or East in that? Google will be boring at best. The company warns, “If we satisfy the demand for our shares at or near the clearing price for the auction, market demand for our shares may be significantly limited compared to demand experienced in an initial public offering priced in a more traditional manner. This or other factors could cause the price of our shares to decline following our initial public offering.” Gee, thanks. Without the chance of a quick profit, even the rankest speculator will turn away from the risk of new companies. Without speculators, venture capitalists won’t find their exit strategies and they will be reluctant to put money into start-ups. If Silicon Valley withers without IPOs, it may all be Google’s fault.
There are many things wrong with this argument.
- All capitalists put money in new ventures because they expect a return on their initial investment. All such investments are inherently speculative because the future return is uncertain. Venture capitalists will fund the most speculative investments for the same reason that all capitalists funds all investments. Most of their return comes from the difference in the value of a start-up, that that thy purchase perhaps a 50% interest in for a few million dollars, and a viable business that could be worth tens of millions to billions of dollars. The exact pricing mechanism for the first day’s trading of the stock does not change the fundamental nature of this process.
- The panic buying resulting in first-day gains of several hundre percent on IPO shares is not a permanent feature of the IPO market. It is a byproduct of the credit bubble of the 90s, which was driven by fiat money creation as has been well-document elsewhere on Mises.org. Austrian economists have argued that the easy money policies of the central bank result in a relative over-investment in certain sectors of the economy. This mal-investment is not desirable because it is not consistent with consumer preferences. In a world of scarce capital and finite savings, an over-investment in one sector implies that other sectors that could fulfull more urgently felt consumer needs are deprived of capital. Donlan appears to be arguing that investment would not take place outside of the conditions of a financial mania.
