Executive Summary
Google Inc. is a public company providing a host of internet-based products. It is a multinational company quoted on the NASDAQ. Google has specialized in the provision of computing and internet applications that are related to research. It has a worldwide reach that, according to research, includes over a million servers in data centers, and processing search requests in a capacity of about one billion on a daily basis. Google Inc.’s products thus fall under the main categories of; search, which provides information on the query; desktop applications; mobile applications; and the cash cow, ads; which generate the majority of revenue by offering advertisers highly pervasive, measurable and cost-effective means to reach people globally.
Background
Google started out as a research project by two Stanford University PhD students Larry Page and Sergey Brin. The two met in 1995 while they were both studying, and came to discover they had a vision in common. Their work improved the system that was used to analyze relationships between websites, from the conventional ranking systems. This system ranked results by counting the number of times the search terms appeared on the web page. Having initially called their search engine “BackRub”, they subsequently changed the name to “Google”. A misspelled version of “googol”- a word for a one followed by a hundred zeros, in an apparent reference to the amount of information their search engine was capable of handling. Initially, they were running under the website owned by Stanford University. It was later that they managed to register their own name, which is known, to date as “google.com” on 15th September 1997. Google Inc was incorporated as a private company on 4th September 1998 with a public offering following on 19th August 2004 (Vise 15).
From the onset Google defied conventional means both in business and technology for instance: in the choice of its startup capital whereby it chose venture capital; and deviating from the “build brand” tendencies of the dotcom boom, instead of focusing on building a better search engine. The two main revenue opportunities for Google as identified from the start were search services and advertising.
Over time these two revenue channels grew to complement each other with the business model expanding. However, the main drive stayed rooted in the provision of useful and relevant information (Vise 30).
Product profile
Advertising
Google’s 99% of revenue is generated from its advertising programs having reported $10.492 billion in total advertising revenue. Other revenue sources; for instance licensing; accounted for only $112 million dollars. This is attributed to the online implementation of innovative technology in the advertising world making them the largest online advertiser. For instance the use of DoubleClick’s technology they have been able to ascertain user interest enabling the targeting of advertisements in context and relevance; Google Analytics is a technology that enables website owners to track the usage of their websites, facilitating insight into how to lure users to content (Vise 25).
Google Adwords enables the placement of Google Ads on third-party websites. This works on either a cost per click or cost per view consideration. Another service that relates to Google Adwords is Google Adsense. This enables them to generate income every time these adverts are clicked, on the websites.
This arrangement, however, suffers a major problem in the form of click fraud. People or automated scripts click on advertisements without sincere interest thereby earning more money, for those who own these websites. In this respect, industry reports indicate a 14%-20% click fraud rate.
Search engine
In the United States, market reports indicate that Google is the leading search engine with more than 65% share. This has been achieved through the indexing of billions of web pages that makes use of keywords to look and locate appropriate information by the user. The basic model diversified to include for instance image searches, Google News, Google Video, Google Desktop and Google Maps.
Google Books is mired in some controversy, whereby scanned copies of books are uploaded in limited previews giving rise to copyright disputes. This was however settled so Google could only upload books limited to the U.S, U.K, Australia and Canada.
Productivity tools
Google offers various productivity tools. For instance; Gmail is a free email service; Google Docs allows users to create; edit and collaborate on documents in an online forum, and Google Calendar a calendar program linked to Gmail. Other products such as Google translate that serves 35 different languages and enterprise products for instance Google Search Appliance, a search technology for larger organizations.
Growth
Google opened up shop for business in a garage in Menlo Park, California in 1998. Here they enlisted their first employee, Craig Silverstein as the director of technology a time at which they hosted 10,000 searches a day (Scott 31). Moving out of its garage premises, the company moved office to University Avenue in Palo Alto in 1999. Now with eight staff, they were pressed for space notwithstanding business levels were at half a million queries a day. In 2000, there was also an informal office culture that brought about and accelerated the innovation by Google Company. The company received its hallmark first award with a host of others to follow, a time at which revenue started flowing from Adwords and millions of daily queries. Google has continuously and innovatively produced new products in the last six years. This has contributed to Google being the search engine with the fastest growth. At this level the site had a toolbar; there occurred a spread of wireless search facilities globally; adoption of the Usenet archives; and development of image, news and catalog searches.
Towards the end of 2003 Google documents indexed three billion with the queried figure now standing at twenty-five billion.
Google’s market capitalization climbed to $84 billion with its stock quoted at $ 700 from the initial price of $85; defying the ripples of the U.S economy slump in 2008 to post a 30% growth in profit in the first quarter. In the same year, Google overtook Yahoo as the most popular website in the U.S also being cited by Forbes as the top company to work for.
Angel investors
Larry Page and Sergey Brin met their first investor in the name of Andy Bechtolsheim an angel investor- an individual with enough business experience relevant to a company in a way to enable them to understand the early vision and potential of a product in an exceptionally favorable perspective. Impressed with their pitch, he wrote out a $100,000 check to Google Inc. inexistent then as an entity. More financial resources were gathered from family and friends.
In 1999, having moved into larger premises and signed its first commercial search customer Google Inc. received $25 million from venture capitalists. These were Kleiner Perkins Caufield & Byers and Sequoia Capital.
With stratospheric growth in users and revenue, Google took a major step in appointing Dr. Eric Schmidt as CEO to succeed Larry page. He brought with him experience in strategic planning and management from his time At Novell and Sun Microsystems.
Google IPO
The act of going public was a bitter pill for the Google founders. There were numerous reasons not to yet it was inevitable. Remaining a private company presented enormous advantages and they hated giving them up. Worst case scenario, their rivals Microsoft and Yahoo would get to know just how profitable Google had become, as well as many details about the scope of the company’s operations. On the other hand, the fact that federal rules required the public disclosure of financial results by companies with substantial assets and equity holders, a level far exceeded by Google; and that Larry and Sergey felt obligated to the numerous new employees who had been accorded stock, to offer them a means of converting their paper to cash (Scott 40).
In deciding to go public, the founders opted to do it in a way as to maintain absolute control over the company and the IPO. A plausible explanation for Google’s choice of dual shares method was that most small investors would be unable to invest leaving the IPO to the large institutional investors, investment bankers and their clients.
Five years since the influx of venture capital, Google’s IPO took place on 19th August 2004. 19, 605,052 shares were issued at the price of $85 per share. This share represented a market capitalization of $23 billion. A large majority of the 271 million nominal shares were owned by Google employees with a competitor, Yahoo being a notable shareholder with 8.4 million shares prior to the IPO.
With the IPO Google sought to raise $2.7 billion using the rather unusual auction-style so as to give the founders rare control. In this IPO a company discloses the maximum number of shares on offer and at times the potential price. In turn, willing investors indicate the number of shares and a price bid. If it so happens that the shares bided exceeds the available shares, then a pro-rata allotment that awards a percentage of actual shares based on the percent for or a maximum is applied.
This IPO mode was likely to provide a windfall for the founders and employees as they were bound to encapsulate a high level of market demand into the offering price. Developed by Bill Hambrecht a Silicon Valley banking visionary, the Auction IPO proffers greater buyer efficiency coupled with higher seller revenue relative to the traditional IPO- since the lack of an intermediary means that all surpluses accrue to the seller. In this process, buyers have a week to submit bids that are independent of other investors. At the end of the week, the bids are aggregated by the seller with the option of either taking the clearing price or adopting a lower one with a partial allocation scheme a process referred to as a “dirty Dutch” auction (Olsen 56).
The traditional alternative: book-building
A well-developed system, this process takes approximately 5 months till the closing of the offer and involves a company developing its initial audited financial statements. Partisan to the procedure is company representatives, the underwriting investment bank and attorneys from both sides. It is a lengthy negotiation process that seeks to determine the eventual shape of the company with the investment banks’ involvement chained to the promise of a hefty reward.
Aside from about 7% of the total capital raised, that the banks usually make in consideration of carrying out due diligence and executing the sale, they do stand to profit from the upside of the stock happen there is excess demand over allotted shares. This is possible through the exercising of a “Greenshoe” option to allow an additional 15% of shares. The profits on these extra shares accrue directly to the banks. This is a trend since most shares are oversubscribed 2X to 10X.
This additional profit channeled to banks thus presents an opportunity cost to the company, especially in the high-growth situation. This could be part of the reason Google opted for an auction IPO.
The IPO decision stirred controversy on Wall Street. On one hand, this was a much-awaited offering not only due to the fact that Google was a highly profitable company but also since other IPOs in 2004 performed poorly. On the other hand, Investment bankers cried foul, raising concerns as to its probable failure, citing the onset of competition in the form of Microsoft and Yahoo. Another concern arose as to Google’s dual share system, which was cited as unfair. Apart from the fact that the banks were unhappy about losing the gains encompassed in the Book-Building system, the subsequent success of the offering was a testament to the misplaced concerns.
To say Google was entirely unperturbed by the controversies clouding the IPO would not be entirely true, on the day preceding they reduced the estimated price per share from $108-$135 to $85-$95 per share. The shares plotted to sell were also scaled down to 19.6 million, from 25.7 million.
Auction IPO
The Dutch auction’s framework adopts the pricing system by William Vickrey, a Nobel Prize-winning economist. It adopts its name from the famed Dutch Tulip events that took place in Holland in the 17th Century. Also referred to as the descending price auction, it employs an efficient bidding process so as to arrive at the optimal market-clearing price for the commodity. The price herein represents that one at which the seller is able to dispose of all the stock. In IPO terms, it determines the offering price at which the issuing company can sell all of the available shares. Subsequent to its use by Google, it has been used in NetSuite’s IPO and US treasury auctions. In this process, the issuing company normally discloses the maximum amount of shares on offer and the potential price range. On the other hand, the investors tender a conditional bid for the number of shares they desire and the highest price they are willing to pay (Olsen 5).
A history of auction IPOs
The historic trend seems to underscore the rare nature of auction IPOs. Several countries seem to have tried it out and abandoned it altogether. In Germany, one research states that of three hundred companies going public only one used the format. Historic data suggests that countries that originally adopted the auction methodology eventually abandoned it in favor of the book-building methodology. Having been tried in Italy, the Netherlands, Portugal, Sweden, Switzerland, and the U.K. in the 1980s; and in Argentina, Malaysia, Singapore, Taiwan and Turkey in the 1990s; it was abandoned in all with book-building prevailing.
Some reasons have been cited as difficulty and cost in valuation; and that the number of potential participants is as large as to put the opportunity at a low level in terms of shares per investor.
Evaluation of the Dutch auction
In light of the revenue equivalence theory used to evaluate IPOs, the auction method should reflect that the seller’s revenue is equivalent under the conditions that: a single indivisible object is sold; the winning bidder has the highest value for the object; values are independent, non-collusive and non-cooperative. In the case of an IPO auction, some of these do not hold true. Firstly in the auction, there are multiple units for sale, creating the need for the seller to efficiently allocate shares using either of: “pay as bid” auction whereby bidders submit bids based on their localized demand at various prices. The seller aggregates the bids thereby setting a clearing price. Each buyer pays their bid amount; and “uniform price” auction the buyers still bid at the localized demand price combinations, in this case however the seller allots the quantity demanded at the clearing price.
Secondly, the auction IPO loses out on the aspect of valuation of the underlying asset, whereby each bidder prices the shares not on the inherent value but on the perceived level of return attributable to the shares.
Advantages and disadvantages
As already mentioned the auction method enables the small investor to participate in the IPO process. Larger investors such as institutions are therefore discouraged. The small investors however are unable to price IPOs efficiently. The major reason is the lack of information caused by the lack of sources that are at the disposal of larger investors. It is also not mandatory for companies to disclose information in online auction.
Another of the merits credited to the auction process is that it minimizes the difference between the offer price and the open price in an IPO. This provides the Issuer with greater value.
For a less reputable company, however, the process may come with a few drawbacks. On one hand, investors could discount an IPO on the perception that the company does not have clear purposes for the funds sought. Such a company may also be undervalued relative to its true value depriving it of the gains accruing to the low offer-opening price difference.
The auction process does also maximizes the failings of the traditional books-building system in which investment bankers award themselves hefty fees and profits.
The pricing of Google
There are indications that the online auction process did not efficiently price the Google shares, as arising from its 2004 performance. This accrues to the fact the increase in Google’s offer price and the open price was greater relative to typical IPOs in the same year. This increase represents the value which the company would have appropriated had the shares been adequately priced. Offering at $85 and opening at $100, the 17.6% rise exceeds typical trends for the year. Furthermore, Google’s peer companies indicated an approximate increase of 10%. This huge post-auction price hike of the stock in the absence of any substantial news releases on strategy is further proof that the auction method could possibly have miss-priced Google.
The source of this apparent pricing error could have been the small investor’s lack of access to sufficient information to objectively price the shares. To a large extent, the online process stood for lack of information as opposed to the traditional process. For strategic issues, Google did consciously carry out the process under a shroud of secrecy.
Capital Structure
Dual-class stock
This is a scenario whereby a single company has varying classes of stock depicting different voting rights and dividend payments. The classification adopted by Google comprises: Class A shares often mistaken to carry more voting power than Class B shares, albeit; Class B shares carry more voting rights. This replicates the desire to maintain control as seen in the IPO process, whereby a dual-class share ownership system is a move by the founders to maintain decision-making authority. In Google, votes are stipulated according to the class of shares on has. Google’s current market capitalization stands at $125.4723 billion with $318.5 million, and it has zero debt equity.
Google- Saudi companies comparative, a case study
Saudi Arabia has the largest stock market in the Middle East, also being the most active IPO market. The rapid development of financial markets has found its way to the Arab economy. This advancement has however encountered some unstable periods as caused by incessant high price volatility and market crises. Major setbacks have been suffered including the de-listing of numerous firms and the fact that a portion of the Arab stock market in the world market is limited to the extent of not exceeding 1.7% of the market capitalization. It is also below 2.4 % of the world stock trading value as of 2006. With none of the Arab stock markets being listed among the top 50 world markets as per market capitalization, the dire situation is apparent.
The only exception is the Saudi Arabia Market whose formation was intended to make it easy to float companies while providing an opportunity for Saudi citizens to invest their money domestically and increase the capital available to companies for expansion and development. As a result, there has been an explosion in Saudi share ownership. Happening even before the passing of the new Capital Markets Law in 2003, it was driven by the new liquidity in the market owing to the rise of oil revenues and government expenditure. The deterioration of US-Saudi relations after 9/11 caused Saudis to be reluctant to risk investing abroad, thus also contributing to the increased share ownership.
The Tawadul All-Share Index (TASI) stood at 3000 points in July 2003, rising to surpass the 9000 mark in August 2004. It proceeded to 15000 at the end of February 2005, peaking at 21000 in 2005, 6 %&.7. The market capitalization rose from $ 158 billion in 2003, through $307 billion in 2004 to a total of $745 billion in 2006, seemingly a level at which it equals the value of all other Arab stock markets combined. With the price/earnings index standing at a high of 44% in 2005 as compared to the London Stock exchange at 18% and even less elsewhere, more than half of the adult Saudi population became involved in share trading. Many took out huge loans to finance their share purchases, with figures on consumer debt giving a picture of the situation. The result was the achievement of the stock market’s purpose; raising substantial amounts of money for the development of companies while creating shareholder wealth.
All this success however represented a bubble that busted in 2006, a period in which following the peak, a dramatic and continuous decline in the TASI index took place. The diagnosis was that the high market capitalization lacked a foundation due to unrealistic investor expectations. By the beginning of April 2006, the index plummeted to 15000, staging a short-lived rally then proceeding to fall below the 7000 mark towards year-end. In this period market capitalization suffered a decline of $500 billion. The price-earnings indicator also suffered, coming down to 15%. Also to blame were imperfections in the regulatory framework inherent in the market.
In 2004 71 companies were listed on the TASI, the number rising to 87 in 2007. The severe problems of 2006 notwithstanding, the market was still effective to a large extent with an increasing number of companies coming forward with IPOs. In 2005 4 took place; National Cooperative Commercial Insurance, Bank al-Bilad, SASAFCO and al-Marei. In 2006, 9 more IPOs took place; Yansab Petrochemicals, Al Drees Petroleum and Transport Company, Saudi Research and Marketing Group, Paper Manufacturing Company, Emaar Economic City Company, Red Sea Housing, Saudi International Petrochemicals Company, Al Babtain Power and Telecommunications and Fawaz Abdulaziz Alhokair Company.
The situation has changed progressively; The CMA has developed a reputation for working with the market towards ensuring that the number of listings increases annually. The conditions have changed dramatically since the formation of the CMA. Now there is a defined transparent system resulting in the predictability of profits in taking companies public. In the first quarter of 2007 2 new companies were listed with 7 more following the cue. With each additional company on the stock exchange, the market is afforded depth. Expectations of more companies joining the market are high (Nayantara 70).
The market correction of 2005 did not particularly impact the ability of Saudi companies to raise capital. It is however important to focus on avoiding a future reoccurrence, which was mainly due to the retail-oriented nature of the Saudi market. In these situations, there exists an irrational expectation that the markets are a pathway to quick riches. To adjust this situation it is required that investor education and a focus on fundamentals be instilled. This lacks to date due to the small size of the Saudi domestic Institutional investors and restrictions on direct foreign investment in Saudi shares by foreign institutional investors, thus depriving supply of international standard equity research. The lack of sufficient institutional investors negates the possibility of price guidance to retail investors while making it hard for IPOs to be priced on standard methodology.
IPOs are seen as a means of asset redistribution among ordinary Saudis, especially those stemming from privatization. These IPOs are considered a bargain since they are relatively lower than what a book-building process would objectively realize. Thus despite the market downward spiral, most companies are still trading well above their offer price. IPOs are also mostly only open to individuals; the institutional investors thus drive the trading demand.
The high profitability accruing to IPOs has caused huge investor interest leading to oversubscriptions. For Instance, the Emaar Economic City IPO drew overwhelming interest with a threefold oversubscription. The frenzy witnessed was triggered when the government offered the 30% stake in the Saudi Telecom Company in 2003, representing its first major sell-off of state assets since the partial privatization of SABIC in the 1980s. More privatizations followed suit; 70% of National Company for Cooperative Insurance, 35% of Yaribu National Petrochemical Company; and the expectations of Saudi Arabian Mining Company, the Saudi Kayan Company and Saudi Arabian Airlines.
Pricing IPOs
The conventional practice has been the floatation of companies at a fixed IPO price. The price set is arrived at based on the company’s assets, cash flow and future profitability. This has been done by the big four accounting firms, with the regulator thence reviewing the valuation method so as to approve the price. With this method, the company valuation is divided into a given number of shares at an established nominal price.
This method is mainly meant to benefit retail investors, being a legacy of a time when only new companies could float their shares. In that period most listings comprised startups and green-held companies, it was thus complicated to cap a premium on the share price. Upon floating the share prices would shoot up on trading thereby benefiting investors. This encourages participation by both retail and large institutional investors. The fixed price method however seems to dissuade companies seeking to go public in the hope of realizing a fair value for their offering.
The alternative, book-building is still rather rare in the Middle East, except for the Dubai International Financial Exchange, the Egyptian Stock Market and the Saudi Stock Market. This method implicitly determines the fair market price that would attract sufficient investors for the floatation. It is an equilibrium price where a balanced supply and demand ensures that there is no suppressed demand that would translate into a guaranteed surge in the trading share price.
The price arrived at reflects the true value of the company with the leading investment banker leading the process of company valuation to arrive at a price range of which investors would be asked to pitch their bids. It is thus possible for investors to know the amount and price of shares they stand to receive.
Dutch auction in Saudi Arabia
In the wake of the above considerations, the Dutch auction method of issuing an IPO has not been applied in Saudi Arabia. This is because this system favors the retail investor and the Saudi Market is deviating from entrusting the pricing mechanisms to the individuals. This is in light of the relative market ignorance of the Saudi investing public and the avoidance of market corrections as encountered in 2005.
The Saudi IPO process has predominantly relied on the fixed price mechanism that seeks to benefit the retail investor. The Dutch auction also works to the same end thus its application would be contrary to the objective of having a more objective company valuation. The market instead heavily favors the book-building process to curtail the risk of a market correction.
Saudi Telecommunication Company
This company has however replicated Google’s pattern of targeting retail investors. Being Saudi’s biggest privatization in over two decades, the IPO offered 30% of the country’s only telecoms provider at the time. The IPO was severally oversubscribed having been targeted mainly at Saudi individual citizens instead of corporations in anticipation of high private demand. Under the government’s privatization plan 20% of the shares were on offer to Saudi citizens with the remaining 10% being reserved for public pension funds.
Plans as to the IPO were announced earlier in September 2002. Local banks played a huge role in offering loans to citizens for the purchase The IPO was deemed a huge success by the government with reports of massive oversubscription. Investors offered to buy approximately $19 billion shares’ worth. The 90 million shares went for $45 and were sold in lots of 10 shares. As per the plan 60 million were sold to individuals with the rest ending up in the hands of pension funds.
This is the IPO that kicked off stock markets enthusiasm in the Saudi Population leading to increased listings and share ownership in more than half the adult population. It also led to a fickle market caused by the effects of fixed pricing and irrational shareholder expectations that eventually led to market corrections in 2005.
Works Cited
Nayantara, Hensel. “Are Dutch auctions right for your IPO?” Harvard Business School. 2005. Web.
Olsen, Sterhanie. “Google Files for an Unusual $2.7 Billion IPO”. CNet News. 2004. Web.
Scott, Virginia. Corporations That Changed the World: Google. West Port, CT, 2008.Print.
Vise, David. The Google Story. New York: Bantam Dell, 2005. Print.