A Heartbreaking IPO of Staggering Genius - The Google Guys

The Google Guys: Inside the Brilliant Minds of Google Founders Larry Page and Sergey Brin

Chapter 6 A Heartbreaking IPO of Staggering Genius

Statistician: A man who believes figures don’t lie, but admits that under analysis some of them won’t stand up either.

—Evan Esar

Google’s initial public stock offering in August 2004 was supposed to be the event of the decade for Silicon Valley, the way a lavish party at Jay Gatsby’s house was a not-to-be-missed walk on the wild side. The year before Google went public, word had leaked out that it had already reached a profit of $100 million, a blazing contrast to the IPOs of the dot-com boom, when profitless companies went public on little more than venture capital and a prayer. By the time Google filed for its IPO in the summer of 2004, its profit was over $300 million. Wall Street needed the brightness of Google’s financial picture to help boost the market and raise its own sunken bottom lines, and they lined up at Google’s door like drunken sailors moored on the shores of Tahiti after three years at sea.

In October 2003, Bloomberg summed up the sentiment about the rumored IPO, quoting Kevin Calabrese, an analyst at Argus Research in New York: “The demand is going to be someplace between very good and extraordinary,” he said. “Google is one of the premiere names in the Internet.”1

All that seemed to change almost overnight. By the time the IPO took place in August 2004, it had become the most derided IPO in memory. The price had been knocked down to $85 from an original range of $108-$135 when it was first announced, and the public and many large institutional investors avoided the stock as if it came with anthrax.

No wonder the public was skeptical. In the few months before the IPO, the press made the biggest turnaround in coverage of a company I’ve ever seen. The event was described with such phrases as “an extraordinarily high premium,” “sky-high multiples,” “based more on the hype factor than business fundamentals,” and “harkens back to the late ’90s boom” and the “excesses of the [dot-com] bubble.”

And those were all from one article (“Before You Buy into That IPO, Search ‘Lemmings,’ ” New York Times, August 1, 2004). Other headlines were similarly apocalyptic: “Think before you buy Google.”2 “Google This: Investor Beware.”3 “Google IPO? No, Thanks.” 4 “Google IPO: Not Feeling Lucky.”5 (This last article states: “if you’re tempted to buy shares of the company once it finally starts trading, which will probably be next week, here’s my advice. Don’t.”)

The hyperbole reached fantastic proportions. The San Francisco Chronicle refused to give in even after the IPO, as the stock began its astounding three-year ascent, by comparing it to the overhyped, once high-flying stock of Krispy Kreme. Google didn’t have any of Krispy Kreme’s problems (many of them outlined in the article), such as federal investigations into its accounting practices, a sudden drop in earnings, and the low-carb diet fad eating away at the company’s revenue. But, hey, Google had hype.

Despite the public pillory of the IPO, Google management still considers it a success. For one thing, all the publicity had the effect of getting even more people to start using Google, boosting its market share. “We made quite a few mistakes,” Schmidt concedes. “But at the end of the day, the company went public in a way that generated so much publicity that if given the choice of doing it the conventional way or an odd way, I would still choose the odd way today. In the four months before the IPO we got the worst press we’d ever had. But the IPO itself was a marketing event. TheNew York Times wrote about it on the editorial page. Everybody had an opinion. You can’t buy that kind of publicity. I watched our traffic numbers, and our traffic was exploding.”

But how could the press have gotten the story so wrong? Blame it on Larry and Sergey. They were trying to do something right. Instead, they pissed off a lot of people.

The Wisdom of a Crowded IPO

Once again, Larry and Sergey decided to break the rules. There is a well-established method to the madness of taking a company public, one that stretches back nearly a hundred years on Wall Street. The unquestioned rule has been that it must be handled by experts. Before a stock starts trading publicly, private investors who supposedly know what they’re doing set the price.

The investment banks all have a pool of professional investors, mostly investment firms that put up the money from pension funds, government organizations, and other institutions hoping for high returns on their cash. The investment banks that get the contract then take the executives on a dog-and-pony show to pitch the value of the stock to their investors, who price the IPO.

This isn’t just a promise of what the investors think it’s worth. They actually have to put up the money. The stock is sold to the institutional investors before the IPO. As soon as it starts trading, they may lose money if it turns out the public isn’t so optimistic, and can instantly make money if the price is bid up on the open market. The competition to get in on an IPO—and to price it conservatively—is intense. But with enough investors committing their money, competitive bidding should set the price just right.

That, anyway, is the theory. In the late 1990s it started to go haywire. With rabid demand for dot-com stocks, the usual metrics for valuing a company no longer applied. Investment banks would take companies public and then see the stock double, triple, quadruple on the first day. This became a rite of passage for a dot-com company. If its stock didn’t soar immediately, it wasn’t considered a hot prospect.

But Larry and Sergey listened to unconventional wisdom. During the boom years of the late 1990s, one storied investment banker came up with what he thought was a better idea. William R. Hambrecht had cofounded a San Francisco investment bank called Hambrecht and Quist in 1968, three thousand miles from the financial center of Wall Street.

Bill Hambrecht left the company in 1998 to start a new firm, WR Hambrecht and Co., with the promise of setting IPO prices at the price the public was actually willing to pay. Instead of shopping the IPO to big institutional investors, WR Hambrecht signed up individual investors, allowing them to trade online for both public companies and new stock offerings the company handled. For IPOs, WR Hambrecht let its individual investors bid on what they thought the stock was worth. The bank then set the price based on the highest bid that would still bring in enough investors to buy all the offered stock.

It seemed like a good idea to Larry and Sergey. They liked the notion of taking control away from large institutions, which always got the best deals, and handing the opportunity to individuals. In 2002, they consulted with Jay Ritter, a University of Florida finance professor who has studied IPOs for years, and asked what he thought of the IPO auction system. He pointed out that it was less likely to present a conflict of interest. “I told them an auction would be best because the allocation of shares doesn’t depend on what kind of commissions (a professional investor) generates for the investment bankers,” Ritter said.6

Besides, Larry and Sergey liked the fact that prices would be set by the wisdom of crowds, the principle they use to determine search results. And an open IPO favored their primary constituency—individuals—over elite investors. “In general, Larry and Sergey don’t value conventional wisdom the way I do,” says Schmidt. “Whatever the conventional wisdom is, they’re suspicious of it. They felt that if we’re going to go public, it might as well be in a way that addresses the apparent unfairness of the process.”

In a letter written by them for the prospectus filed for the IPO, Larry and Sergey explained, “Google is not a conventional company. We do not intend to become one . . . . It is important to us to have a fair process for our IPO that is inclusive of both small and large investors . . . . This has led us to pursue an auction-based IPO for our entire offering.”

When the investment banks made their pilgrimages to Google in search of the Golden IPO, they found that they didn’t like what they would have to put up with to get it. Larry and Sergey were treading on too many Italian leather shoes.

Grudge Match

In early 2004, Larry and Sergey sent a team of financial executives and lawyers, led by corporate counsel David Drummond, to WR Hambrecht for more information. Clay Corbus, co-chief executive officer at Hambrecht, says that the Google team was reluctant to make such an unusual jump. “There is no way this is going to happen,” he says the team told him. “They went back to Larry and Sergey, who told them to try again and come back with the right answer.”

One Google executive on that original team, however, says that this isn’t true. They simply found the bank to be too small and poorly organized to handle such an important transaction. Either way, they decided to conduct a hybrid IPO, using the auction system, but inviting many banks to participate.

Their golden fleece status gave Sergey and Larry enormous leverage over Wall Street, and they demanded a lot. Not only did they want to bypass the investment banks’ main customers to offer their stock to average small investors, but also they said they would pay only half the usual 7 percent fee demanded by the participating banks. Thus began a Caesar-and-Cleopatra love-hate relationship with Google. Reportedly, one large investment bank, Goldman Sachs, appealed to Google board member John Doerr, who was an investor in Goldman, trying to convince him to drop the open IPO.

Two of the largest investment banks, Morgan Stanley and Credit Suisse First Boston, took the lead position. Twenty-nine other banks, including WR Hambrecht, were also allowed to participate, as long as they allowed their individual clients to bid and participate, too. Interestingly, Goldman, one of the biggest and most important investment banks, was relegated to minor status in the IPO, leading many to speculate that this was revenge from Larry and Sergey for Goldman’s trying to go over their heads. Schmidt insists this is not true. “You typically don’t have three top banks take the lead,” he says. “Our IPO was such a unique design, we went with the ones who showed the most flexibility in getting the design to work.”

But the overwhelming majority of the banks were reluctant participants, and they did something Larry and Sergey did not anticipate. Although they had to let in small investors, they had the right to determine whether an investor was sophisticated enough to participate. This was necessary, since if it turned out that the price dropped precipitously after the IPO, the banks could be sued for luring naïve investors into a risky transaction. Most small investors were rejected. Some reporters tried to participate in order to write about the experience but could not get in, even when using money put up by their publications. WR Hambrecht was the one that let small investors participate.

Most small investors didn’t want in anyway. The IPO, which would have been enthusiastically sold by the banks to their institutional investors, was instead widely criticized in the investment banking community. I talked to one financial adviser at an investment bank participating in the IPO who said he was told to warn off individual investors because the whole thing was too much of a “mess.”

Part of that reaction was simple fear. The banks had never done anything like this before and were genuinely scared of how it would all turn out. But part of it was just a reflection of their anger at Larry and Sergey and their demands. “Part of the reaction was Wall Street anger because we were doing it our way, not their way,” says a former Google executive who followed the public reaction. “But part of it was fear in the brokerage community. Nobody knew how it would come out. It was a hassle for the brokers, and they encouraged people to stay away.”

Larry and Sergey did make some mistakes. They never seemed to take the IPO process very seriously. Months before they set the process in motion, they gave a lengthy interview to Playboy magazine, one of the last they ever gave. By the time the article hit the streets, the IPO was already announced and the stock’s valuation was being discussed. The Securities and Exchange Commission started an investigation into whether Larry and Sergey had violated the “quiet period” before an IPO, the time between starting the IPO process and the actual event, in which the company is not supposed to do anything that will hype the stock. The company is also not supposed to give any information to a limited audience that is not available to everyone. Most companies simply don’t give any interviews before a planned IPO in order to avoid this problem. Finally, Larry and Sergey agreed to ensure that everyone interested in the stock would have the same information by including the Playboy interview in the prospectus sent to potential investors. It did not include any of the magazine’s pictures.

They also didn’t take very seriously their IPO tour to investment bank clients. They were more interested in talking about the great things they were doing for the world than in explaining the company’s financial prospects. Their financial reports to the SEC included sections titled “Don’t Be Evil” and “Making the World a Better Place.” It made them look like amateurs.

To this day, Larry and Sergey refuse to follow the example of almost every other company and give “advance guidance” of future company performance to Wall Street analysts. They’re actually following the intent of SEC rules that prohibit giving information to select individuals that is not given to everyone. Wall Street considers a company that refuses to give guidance to be a company in trouble. And analysts consistently do a terrible job of predicting Google’s earnings before they’re released.

The result of all this was to drive down the IPO price, which led Google to reduce the number of shares available for sale to 19.6 million, down from the 25.7 million originally planned. Larry and Sergey cut the number of personal shares they were selling in the IPO by half, while the venture capitalists who funded the company pulled out of the IPO entirely. One Wall Street Journal article quoted one hedge fund manager who decided not to participate: “[Google] managed to tee off the broader constituency of Wall Street, and it’s obviously hurt them,” he said. “Wall Street wins again.”7

Nattering Nabobs of Negativity

The real problem, though, was that the press took the bait from Wall Street like hungry wolves looking for a juicy meal in the dog days of summer. The wisdom of crowds can only come up with the right answer if the crowds have the right information to start with. Says a former Google executive who followed the reaction to the IPO, “It’s more important what the press thinks of you than what Wall Street does.”

In the publicity surrounding the IPO, Google suddenly seemed full of flaws. First on the list was the specter of looming competition, primarily from Yahoo and Microsoft—despite the fact that both companies had been releasing new versions of search engines for years without this having the smallest effect on Google’s increasing market share. Professional investors insisted that Yahoo was the better investment, since it had more sources of revenue than Google, which was entirely dependent on advertising. Yahoo was also supposedly more profitable than Google. Reporters expressed incredulity that the IPO would give Google a market value comparable to that of General Motors.

All these flags were red herrings that any business reporter should have known to discount. They should have known, for example, that comparisons to slow-growth companies in completely unrelated industries are irrelevant. When compared to Yahoo or Microsoft, Google’s valuation was reasonable, if not overly conservative. Google’s net revenue ($962 million in 2003) had nearly tripled from the previous year, while Yahoo’s net revenue ($1.5 billion) had grown by 68 percent, clearly putting Google on a track to quickly bypass Yahoo.

But profit, not revenue, is the primary metric for valuing a company’s stock. And there, the press got the numbers wrong. Every article said that Google’s 2003 profit was $106 million, while Yahoo’s was $238 million. That’s what the companies reported. But the press—and apparently the Wall Street analysts—overlooked one important fact. The two companies applied vastly different write-offs to their earnings.

This was due to a decision by Larry, Sergey, and the financial team at Google to make their financial reporting squeaky clean before the IPO. Accounting rules require companies to write off different expenses before reporting net income, such as the depreciation of the value of the equipment they own. One of the biggest expenses is stock options, incentives to keep employees by allowing them to buy company stock at a discount. Yahoo had been writing off stock options for years. But, about to become a public company, Google wrote off a huge number of stock options in 2003—$229 million versus $22 million for Yahoo. Since many of these discounts do not reflect actual expenses, many analysts use operating income (before expenses) to value a company. In 2003, Yahoo’s operating income was $296 million, while Google’s was $342 million. Google was already more profitable than Yahoo, and growing faster. None of the Wall Street analysts or reporters mentioned this fact.

The press also soundly criticized Google for creating a two-class stock system. The common stock shareholders were to get one vote per share on important issues, while Larry, Sergey, and CEO Schmidt got ten. In their letter in the prospectus, Larry and Sergey explained why: “[T]he standard structure of public ownership may jeopardize the independence and focused objectivity that have been most important in Google’s past success and that we consider most fundamental for its future. Therefore, we have implemented a corporate structure that is designed to protect Google’s ability to innovate and retain its most distinctive characteristics.”

This was seen as bad “corporate governance,” allowing the executives to ignore stockholders’ demands when running the company. The press neglected to mention that most of their own parent companies—including those of the New York Times, Washington Post, and Wall Street Journal—have similar two-class stock systems for exactly the same reason. Management does not want shareholders to pressure them into maximizing profits and stock prices quarter to quarter while sacrificing long-term goals.

And in their letter to shareholders, Larry and Sergey clearly warned prospective buyers of the consequences:

We believe a dual class voting structure will enable Google, as a public company, to retain many of the positive aspects of being private. We understand some investors do not favor dual class structures. Some may believe that our dual class structure will give us the ability to take actions that benefit us, but not Google’s shareholders as a whole. We have considered this point of view carefully, and we and the board have not made our decision lightly. We are convinced that everyone associated with Google—including new investors—will benefit from this structure. However, you should be aware that Google and its shareholders may not realize these intended benefits.

This did not go a long way toward making investors feel more comfortable with the stock. The business reporters writing about the IPO actually thought their reporting was fair. BusinessJournalism. org even reported on this conservatism as a good thing, quoting David Callaway, editor in chief of CBS MarketWatch .com, as saying, “The media is more balanced in their approach to the Google IPO than they were five years ago. They’re reflecting a public that’s been burned before by these tech IPOs.”8 This time, the public was burned by a press that was overly skeptical, backed by a bitter Wall Street and Larry’s and Sergey’s refusal to provide any information beyond the prospectus, which took time and knowledge to analyze.

So what do Larry and Sergey think of the whole process? There’s a clue to their attitude in Google’s IPO prospectus. In that document, Google’s original estimate of the value of the stock it would sell in the IPO was an unusually precise $2,717,281,828. Most companies round it off to the nearest million or so and the press reported it as simply “over $2.7 billion.”

But mathematicians recognize the joke—the figure’s similarity to e, a famous “irrational” number (one whose digits go on forever after the decimal point without ever repeating a pattern). Known as “Euler’s constant” or the “natural logarithm,” the value of e, rounded to nine decimal places, is 2.717281828.

In other words, Larry and Sergey tried to set their IPO price at a valuation of exactly $e billion, to the nearest dollar. They have shown, in more ways than one, that any stock valuation is, inherently, irrational. As irrational, perhaps, as executives who put doing great things for the world above shareholders’ interests.