Dutch Auction

Meaning of Dutch Auction

A Dutch auction is a type of auction for buying and selling goods that are available in substantial quantity. This type of auction is not suitable for an item that is scarce or very limited in number. The selling or buying price is not fixed whereas the available quantity of the commodity is usually known in advance. The seller starts with the price that he deems to be the highest for that particular commodity. He keeps lowering it gradually until the entire lot is sold. The seller may also stop at the reserve price point even if the lot stands unsold. As below the reserve price, he is not willing to sell. And this reserve price is very well made known to all the participants in advance. 

This practice is the opposite of what happens in regular bids. Unlike Dutch auctions, the sellers start from the minimum price of the product in regular auctions. The price keeps going up when the participants of the auction keep bidding for the product, pushing the price upwards. And finally, the highest bidder gets the assets/goods auctioned. Dutch auctions have proven to be a successful alternate and often result in the seller getting higher proceeds for his goods than regular auctions. This is so because there is higher uncertainty in the minds of the bidders as the auction usually ends abruptly as soon as the available quantity of goods gets over in the bidding.

Due to such unique nature of such an auction, it is also called a price discovery auction. In other words, here the auctioneer tries to get an optimal price to liquidate the assets/goods. 

How do we Conduct a Dutch Auction for an IPO?

Companies often use the Dutch auction for their Initial Public Offering or IPO issue. The investors who want to buy the shares of the company submit their respective bids for the number of shares they want to purchase at the price of their liking. Then the company prepares a list of interested investors in descending order, with the highest-priced bid at the top. The next lower bid will come after it and so on. The company will allot the shares to the bidders in the same sequence until the allotment quota gets over.

Dutch auctions are unique because each and every bidder has to pay the amount equal to the last successful bid for the shares in an IPO. It is irrespective of whatever price they may have quoted during their bid for the shares. Hence, there remains uniform pricing for all the allotted shares at the time of allotment.  Every successful bidder has to pay the same amount for the shares that have been assigned to them. Let us understand this process with the help of an example.

Dutch Auction

Example

Let us take an example of ABC Inc. which is looking to issue an IPO of 1000 shares by using the Dutch auction process.

The company receives a bid from the investors in the following pattern:
Investor A for 200 shares at $200 per share;
300 shares from investor B at $180 per share;
Investor C for 300 shares at $155 per share;
Investor D for 200 shares at $150 per share;
300 shares from investor E at $160 per share;
Investor F for 200 shares at $175 per share.

The company will sort out the list of the bidders in descending order, with the bid amount being the criteria for the same. Hence, Investor A will come at the top, followed by investor B, investor F, and investor E. The issue quota of 1000 shares is exhausted after allotment of shares to these four investors only. The lowest successful bid is $160 per share. This becomes the final price of the issue for all the successful bidders. Investors who had bid for shares at a higher price stand to gain and save money from the deal. Investors C and D do not get any share in the allotment process as their bid amount was lower than the last successful bid.

There is a possibility that the total quantity of shares demanded by the bidders is higher than the total issue size after including the last successful bid. In such cases, companies allot the shares on a pro-rata basis to the bidders at the price of the last successful bid.

Other Uses of Dutch Auction

The Dutch auctions are also used for various other purposes than the issuance of an IPO. A common and important use of such an auction is at the time of issuance of government treasury bills and securities. Governments issue treasury bills, notes, and bonds to raise funds for their working and paying off their debt. They make use of the Dutch auction to sell these treasuries and raise funds. They ask the investors to submit bids stating the amount of investment they are willing to make along with the yield rate that they expect.

The issuer then sorts the bids with the bid having the lowest yield rate coming first. This is logical as the issuer will want to pay the lowest yield rate on its issue. The subsequent bids with higher yield rates are sorted in chronological order. The bids with yield rates sorted in a low to high manner will be accepted by the issuer till the issue amount is fully raised. The yield rate of the last bid or the issue price of the last bid that has been accepted becomes the yield rate or the price for the issue. Every investor will get that same yield on their investments.
Companies also use the Dutch auction process sometimes when they want to repurchase their shares from the investors. Some E-commerce companies have also made use of this method of auction.

Advantages of the Dutch Auction Process

Beneficial to Small Investors

The Dutch auction process at the time of an IPO is very beneficial for small investors. In a normal IPO, the control of the issue rests with big investment banks. They channelize the issue to their clients, and the small investors do not get any share in it. The Dutch auction process ensures that even small investors get a share of the pie of the total issue and actively participate in the issue process.

Finding the Equilibrium Price

The Dutch auction process can also help to find the correct equilibrium price of an issue. Investment bankers who handle an IPO for a company use their valuations and judgment to set the issue price of shares. They may sometimes be wrong about it and undervalue or overvalue an issue. The Dutch auction process involves bids from investors who bid at the price that they deem to be right for the issue. Hence, this is a suitable method to arrive at the correct equilibrium price where demand for shares equals its supply.

Disadvantages of a Dutch Auction

Let us now have a look at some of the disadvantages of the Dutch auction process.

High Price for Shares

Dutch auctions may result in high prices of shares since there is no underpricing by the investment bankers in such cases. In regular issues, the investment bankers may underprice the issue due to the pressure of selling the entire stock inventory in the issue. This does not happen in a Dutch auction and hence, investors may have to pay a higher price for the share offering rather than benefiting from lower prices.

The Danger of Poor Analysis

There is a danger of poor analysis of the company fundamentals and the issue of its shares by the investors in the case of a Dutch auction. The investors in this process are not specialists or trained to arrive at the correct pricing of shares, unlike specialized investment bankers. They may place bids at high values, resulting in high and unrealistic issue prices. Also, they may realize their mistake after the issue opens and sell the shares. This can result in a sudden sell in a company’s shares in huge quantities, resulting in a market crash and heavy losses to the investors.

Frequently Asked Questions (FAQs)

What do we mean by a Dutch auction?

The Dutch auction is the opposite of what happens in regular bids. The seller starts with the price that he deems to be the highest for that particular commodity. He keeps lowering it gradually until the entire lot is sold. The seller may also stop at the reserve price point even if the lot stands unsold. And this reserve price is very well made known to all the participants in advance.

How do we conduct a Dutch auction for an IPO?

The investors willing to buy the shares submit their bids for the number of shares they want to purchase at the price of their liking. Then the company prepares a list of interested investors in descending order. The company will allot the shares to the bidders in the same sequence until the allotment quota gets over.

What are the other uses of Dutch Auctions?

A Dutch auction is used under the following circumstances:
1. Issuance of an IPO
2. Issuance of government treasury bills and securities

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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