Dan Hunter, a professor in Wharton’s legal studies department, happened to be in San Francisco the weekend after Google filed its much-anticipated paperwork with the U.S. Securities and Exchange Commission for a $2.7 billion initial public offering of stock. The mood among the computer cognoscenti was electric, as if the 49ers had won the Super Bowl or the Giants had swept the World Series in four straight.
News of the IPO was all over the place. Denizens of Silicon Valley were genuinely thrilled that the search-engine company’s co-founders, Sergey Brin and Larry Page, were on the verge of becoming billionaires. “The buzz was all about Google,” Hunter says. “The metric by which you value somebody in the Valley is, ‘Can they take a core technology, create a killer application and then cash out?’ These guys are admired.”
Wharton faculty members express deep admiration for Google – its business model, its laser-like customer-focus, its ability to generate revenue and profit. But they say the company faces formidable competitive challenges – from Microsoft, Yahoo! and others – although they differ on how serious those challenges will be. They say that even the act of going public, which will raise capital and reward the employees and investors who have been with Google since its early days, is not without possible drawbacks: a relinquishment of some managerial control and a loss of key employees who, with their newfound wealth, may retire or look for employment elsewhere. Some faculty members say that the IPO itself and its accompanying hoopla are much less interesting and important than thinking about the company’s long-term prospects. In the months and years to come, Google will have to devise ways to generate more revenue without alienating its legions of loyal users around the world.
Few Internet start-ups (eBay and Yahoo! come to mind) have achieved the level of success of Google, whose business is based on patented software called PageRank, a system that employs an algorithm to allow Internet users to search the vast expanse of cyberspace and quickly find websites with information about almost anything. “There is no other company with this kind of vision,” says marketing professor Peter S. Fader.
Unusual Company, Unusual Letter
The company’s Valley-style quirkiness was evident in the tone – at times folksy, at times preachy – of its Form S-1 registration statement, filed with the SEC on April 29. Google’s financial clout was also on clear display in the numbers that laid out, for the first time for public consumption, its robust revenue and profitability. In 2003, Google had net income of $106 million on revenues of $962 million. In 2001, its first year of profitability, Google earned just $7 million on revenues of $86 million. The company, based in Mountain View, Calif., was founded in 1998 when Brin and Page were graduate students at Stanford University. The filing disclosed that the patent for Google’s core search-engine technology, which belongs to Stanford, is to expire in 2011.
The filing contains a letter written by Page and signed by both co-founders. The letter tries to position Google on the side of the small investor while at the same time stating that its executives do not want their disciplined, long-term-oriented management style to be hamstrung by undue investor meddling.
The filing makes clear that Google was eager to bypass Wall Street’s investment banking middlemen by deciding to conduct a so-called “Dutch auction” over the Internet to disseminate and price its shares, thus making more stock available to more people and avoiding the hefty 7% fee that investment banks typically charge to take a company public. By announcing that it would issue two classes of stock and forego quarterly earnings guidance, Google also attempted to stress that it would adhere to the close-knit, collaborative management approach that had made it successful so far.
What do Brin, 30, Page, 31, and CEO Eric Schmidt, the 48-year-old management veteran hired to assist the young co-founders, do now to top what they already have done? Has Google, by deciding to go public, relinquished two elements vital to its already considerable success – its independence and its desire to play things close to the vest? The IPO raises other issues, too. Does the public interest in Google presage a resurgence of the kind of dot-com stock frenzy that went down in flames in 2000? Following Google’s lead, will auctions be used by an increasing number of start-ups that want to raise money from equity offerings?
Faculty members say Google is a superbly managed, highly profitable company run by talented people that has so far done just about everything right. Google has the world’s most popular search engine, a global brand name and legions of devoted customers. It also has a quirky, corporate milieu that emphasizes altruism – one section of the SEC filing is headed, “Don’t Be Evil,” while another is headed, “Making the World a Better Place ” – along with honesty, integrity, informality, playfulness and secretiveness. In addition, it has demonstrated a commitment to old-fashioned hard work and a yearning for profitability to which any 70-something CEO would tip his hat.
“Eric, Sergey and I intend to operate Google differently, applying the values it has developed as a private company to its future as a public company,” the SEC filing reads. It adds: “We will live up to our ‘don’t be evil’ principle by keeping user trust and not accepting payment for search results. We have a dual-class structure that is biased toward stability and independence and that requires investors to bet on the team, especially Sergey and me.”
“This is a company that’s always marched to its own beat in an incredibly wonderful way. I can’t say anything cynical about them at all,” says Fader. “At the height of the dot-com craze, they went into a crowded sector – search engines and portals – and did something difficult without varying from that start one tiny little bit. It’s really tremendous.
“Neither I nor anyone else you talk to have the right to second guess Google,” Fader adds. “They’re smarter than all of us. And you don’t hear me say that about too many companies. Their credo is, ‘Do No Evil.’ It’s hard to imagine a bigger source of evil than the IPOs of five years ago when only the rich got richer. Google has to set itself apart from that process where the little guy was left high and dry. I think the whole auction system is not only another way of thumbing their nose at Wall Street but another way to [put their principles into practice].”
Pros and Cons of the IPO
The registration statement says Google wants to raise $2.7 billion by selling two classes of stock but does not specify a per-share price. It is not known when the IPO will take place.
Under a Dutch auction (named after a method of selling flowers in the Netherlands), individual and institutional investors alike can bid for Google shares, with the first-day price being set by the level of demand by many bidders. With traditional IPOs, Wall Street underwriters determine the number of shares to be sold and set the price. Typically, favored customers of investment houses have benefited from the traditional arrangement. During the Internet stock bubble of the 1990s, many IPO stocks soared on the first day of trading, resulting in big profits for lucky early buyers.
The Wharton experts say there are pros and cons to the decision to do an IPO. Management professor Raphael (Raffi) Amit, academic director of the Goergen Entrepreneurial Management Programs at Wharton, calls the auction “a clever move” on Google’s part. “Underwriters have an incentive to lowball the value of the firm,” he explains. “Underwriters want to satisfy their customers who buy large blocks of IPOs. They want to make sure these investors make money right away and that they come back to buy future IPOs. The underwriters get paid by the issuing firms, but they’re really looking after themselves.”
Finance professor Franklin Allen says fledgling firms in the United States (but not necessarily companies elsewhere in the world) traditionally have avoided Dutch auctions because it has been felt that investment banks were needed to conduct road shows to drum up interest in a new stock. But that was not an issue with Google, which has a recognizable name and is used by 100 million people each month. “The fees investment banks charge for IPOs are enormous, on the order of 7%,” Allen says. “Google thinks they’ll get enough publicity that they won’t have a problem reaching investors. And they’ll save a fair amount of money.”
David Croson, a Wharton faculty member currently serving as visiting professor of information strategy at MIT, says he and Wharton colleague Lorin Hitt have been advocating auction-style IPOs for years. “Especially for companies where nobody knows what their shares are worth and where different investors might have vastly different opinions of what shares should trade at, a Dutch auction allows companies to raise more money for a given amount of shares because the people [willing to bid the most] for these shares end up getting them the first day,” Croson says. As a result, he adds, “People who buy the Google IPO thinking there will be a first-day pop [in the stock price] will be really disappointed and they might even lose money in the first week or two as speculation gets taken out of [the price of the shares].”
Amit and Allen agree that Google could pave the way for other young companies to go the auction route in years to come. “[Google] may just break the mold and change the way things are done,” Allen says, “but it won’t happen overnight.”
For his part, Fader thinks the media frenzy over the IPO is way out of proportion, saying “I can’t imagine a bigger non-story than this. An IPO by itself means nothing.” People like to speculate on what the stock price may turn out to be, but he says “those questions have no bearing on the conduct or performance of the company. It’s one of those things to talk about around the water cooler. To its great credit, Google has stayed private so long. The company has disclosed the minimal amount of information.”
Dual-class of Stock
Although the auction would appear to put Google on the side of small investors, the company’s decision to create Class A and Class B shares puts the lion’s share of the voting rights squarely in the hands of Google management. The dual-class structure tends to raise eyebrows these days among experts in corporate governance, many of whom believe concentrating too much power in the hands of management can lead to corporate misdeeds.
In its SEC filing, however, Google defends the two-stock approach. “While this structure is unusual for technology companies, it is common in the media business and has had a profound importance there,” Page writes in his letter. “The New York Times Company, the Washington Post Company and Dow Jones, the publisher of The Wall Street Journal, all have similar dual class ownership structures. Media observers frequently point out that dual class ownership has allowed these companies to concentrate on their core, long-term interest in serious news coverage, despite fluctuations in quarterly results. The Berkshire Hathaway company [headed by investor Warren Buffett] has applied the same structure, with similar beneficial effects.”
The filing goes on to say that academic studies have found that, “purely from an economic point of view, dual class structures have not harmed the share price of companies. The shares of each of our classes have identical economic rights and differ only as to voting rights.”
Hunter, who specializes in research relating to Internet law, believes that going public will actually harm Google because the company has relied on a secretive, offbeat culture to become profitable. “I think it hurts them, but [an IPO] is inevitable,” Hunter explains. “It was something they couldn’t do anything about. Having taken the venture capital money early on, it was almost impossible for them not to go public because the venture capitalists were pushing them. The only way was to buy them out. Google became so valuable so quickly. Neither Larry nor Sergey could find a billion bucks and buy out the venture capitalists.”
Hunter says the language in the filing shows that Brin and Page were reluctant to do an IPO. “They’re clearly indicating to the market they’re doing this [because they have to]. But it doesn’t conform to how they think companies ought to be run … I’m not sure to what degree they can keep their autonomy even with this two-class structure.”
Hunter says it also is possible that Google engineers and other employees who will become millionaires from the IPO will quit the firm to pursue other interests because being publicly traded may alter the company’s culture. “This is one reason they didn’t want to do an IPO,” Hunter suggests.
Preparing for Competition
Fader is optimistic that Google will continue to muster the continued creativity to withstand competitive pressure from Microsoft, Yahoo! and others. “Google has not only established technical superiority but customer trust,” Fader says. “Even if Microsoft could come up with something better, why bother? If Google gives you everything you need, there is no reason for people to go elsewhere. That’s more important than the quality of the search. This company understands its customers better than any other company I can identify.”
Fader notes that Google has already built upon its core search-engine foundations to expand its business. It offers Froogle, a way to shop for goods online, and the recently announced Gmail, a free, search-based service that includes one gigabyte of storage. What makes Gmail different from other e-mail offerings is a search engine that allows users to get any message they have ever sent or received, eliminating the need to file messages away to locate them in the future. Privacy questions have been raised about Gmail because Google would review the content of people’s messages to determine how to target ads to their interests, but several faculty members say they think Google’s integrity would outweigh privacy worries.
Fader is certain that Brin and Page have other ideas in the works to grow the company. “It’s hard to imagine the things they’ll be doing [in the future to stay ahead of competition], but I think they’ll do it. Their outlook is extremely bright.” Fader does suggest, though, that Google consider charging users a fee, perhaps $10 a month, for some kind of premium service that adds value beyond what users get now. “People might grumble about it but they’ll pay it,” he says. Some 95% of Google’s revenue comes from advertising.
Croson echoes Fader’s suggestion, noting that Google for too long has undervalued the service it provides. He says the company should think about charging fees to professors, business people and others who use the search engine for serious research.
“Google’s main risk has always been the challenge of collecting the value they’ve created,” Croson says. “I’ve been a Google user for years. Instead of going to a library, I use Google to find [academic] citations because it’s [much faster]. I had lunch with Larry Page at a conference in 2000 and I offered him $1,000 a year to use Google if I was the only person at Wharton allowed to use it. I was serious. He said, ‘Why in the world would you want that?’ I don’t think they know how to harness 1% of the value they’re creating for customers. What they need to do is figure out a way to charge people who are searching for deep, relevant searches. This is the path they have not gone down yet.”
Croson admits that such a move would carry its own risks – the potential for alienating users. “I don’t know what it would take for them to implement this plan without causing disruption to their business model.”
Amit is less sanguine about Google’s ability to fend off the likes of Microsoft and Yahoo! “The Google story reminds me too much of the Netscape story,” Amit warns. “They had a browser but were eaten alive by Microsoft, which developed Explorer, and Netscape was later sold to AOL. Google has a fantastic algorithm and it is synonymous with search engines today, but at the same time it is extremely vulnerable. Strategically, it is very vulnerable.”
Amit says that Google’s IPO is big by any standard but especially large for an Internet company. According to Thomson Financial, raising $2.7 billion would make Google’s IPO the sixth largest in history, excluding spin-offs of existing companies. Google would follow UPS’s $5.5 billion IPO, the $3.2 billion raised by both Charter Communications and Goldman Sachs, and the $3 billion and $2.9 billion raised by Prudential Financial and MetLife, respectively. (The largest IPO ever, $10.6 billion, was that of AT&T Wireless, a spin-off of AT&T Corp.)
“The remarkable thing about the Google offering is it is so big and it’s an Internet company,” says Amit. “The frightening thing is this may be the beginning of a new bubble. We’ve learned some hard and costly lessons about bubbles. Many other companies are in the process of filing for IPOs. I think chances are we will see more tech offerings coming our way following this offering. That will set up new pricing metrics or structures for stocks. Prices have been depressed for a broad range of tech companies but they’ve come back, not to levels we used to see them at but there is more stability now. Investors are getting more comfortable with the stocks. After all, tech companies are responsible for the productivity gains in the U.S.”
Amit praises the accomplishments of Brin, Page and Schmidt, but says Google’s culture is the kind of “loose environment” that can be problematic as well as beneficial. “You run a publicly held company a lot differently than a privately held company,” he notes. In addition, he says, Google users do not spend as much time on Google’s website as on the sites of Yahoo! and Microsoft. And then there is the question of whether Google’s search technology will some day be superseded by that of another company.
The SEC filing left unstated the number of shares Google will sell to raise its $2.7 billion. But Wall Street analysts have estimated that the company could be worth anywhere from $20 billion to more than $40 billion, according to various news reports. By comparison, eBay is valued at about $54 billion and Yahoo! at about $35 billion. At such lofty valuations, Amit says he would not invest in Google. “You can take that to the bank.”