Aaron on the Google Blog wants to give Google some kudos. He writes of "Google's Genius":

Google had three different pressures on them. They had investors who wanted desperately to send Google money. They had shareholders who wanted to cash out. And they had founders who didn't want to give anything up and wanted to stay honest. Their IPO cleverly manages to solve all three problems.

The founders keep honest by telling folks they have no respect for investors and that Google is probably a bad investment (and also by bypassing the comically corrupt investment bank system). They keep control through the dual-class stock system. And then they let the investors hand their money to the shareholders.

A couple of quibbles. Having investors who want desperately to send money is not really a problem that needs to be resolved. That could go on indefinitely and the company would not suffer.

The big issue for Google is not the investors who want to get in, but the investors who want to get out, namely, the venture capitalists. (This addresses Howard Owens' perplexity --"I don't see what Google has to gain by an IPO.") But Aaron is right in saying that the founders and officers wanted to manage this exit in a manner that allowed them to retain control of the company. Thus, the dual-class capital structure. The whole arrangement has been cleverly crafted. It's a marvel, really, and I wouldn't be spending this much time on it unless it were ingenious.

By the way, Aaron makes reference to the "comically corrupt investment bank system," and I see similar sentiments flying elsewhere around cyberspace. While I am no fan of investment bankers, I don't think the system is corrupt. Investment bankers, like intermediaries of all kinds, profit by connecting people. Just like real estate agents, they offer a useful service and charge handsomely for it. You can try to go around them, but most companies that are so inclined fail (just like many FSBOs fail). Google is famous enough to circumvent the traditional strictures of the underwriting industry, but I think it is unlikely that this offering will be the harbinger of a major structural change.

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Much of the talk about Google's IPO has revolved around the distribution method. Not since J.P. Morgan has the method of floating shares attracted so much attention. Of course, Google is not inventing the Dutch auction (see Hambrecht's website for more on that), but it is providing some new exposure to the idea. The auction is painstakingly described in the prospectus, so if you are a junkie for this stuff, read that. You might also be interested in Hambrecht's flash presentation that illustrates the auction process. This post will target some of the highlights.

Qualification. Before potential investors are allowed to bid for Google's shares, the investors must be qualified by the underwriters. As part of this process, the potential investor must access "an electronic form of this prospectus, including the transcript of the presentation by our management team that will be contained in this prospectus." The prospectus access requirement merely satisfies the SEC's delivery rules, but I am intrigued by the transcript. It sounds like an electronic road show (undoubtedly without some of the more outlandish statements, which can only lead to trouble with the SEC). Whether anyone actually reads the prospectus, well, that's doubtful. Many people will read a little bit, I assume, but most prospectuses are pretty dull. (Actually, this one is quite a bit more interesting than most.) By the way, prepare right now for all of the stories about deserving and eager potential investors who don't qualify to buy shares. If you need a history lesson on this, go back and read some stories about Red Hat's IPO.

Bidding. Potential investors submit bids, but this isn't like eBay. You can't see what other people are bidding. Google cautions against speculative bidding, though the whole enterprise is speculative. The most interesting part of the process is the interaction of bids and offers. The company will not fix the number of shares in the offering until it reviews all of the bids.

As part of this auction process, we are attempting to assess the market demand for our Class A common stock and to set the size of the offering and the initial public offering price to meet that demand. Buyers hoping to capture profits shortly after our Class A common stock begins trading may be disappointed. During the bidding process, we and our underwriters will monitor the master order book to evaluate the demand that exists for our initial public offering. Based on this information and other factors, we and our underwriters may revise the public offering price range for our initial public offering as described on the cover of this prospectus. In addition, we and the selling stockholders may decide to change the number of shares of Class A common stock offered through this prospectus. It is very likely that the number of shares offered by the selling stockholders will increase if the price range increases. In an auction process, this could result in downward pressure on the price. You should be aware that we have the ability to make multiple such revisions up until closing of the auction and pricing of the offering.

Pricing. According to the prospectus, the company's goal is to set an auction clearing price, which they describe as "the highest price at which all of the shares offered ... may be sold to potential investors, based on bids in the master order book that have not been withdrawn or rejected at the time we and our underwriters close the bidding for our auction." The company does not commit to fix the price at that level, but leaves open the possibility of setting a price below the clearing price. The decision will be influenced by factors such as the projected volatility of the post-IPO price, the prices bid by professional investors, and their assessment of the company's value. In other words, if the retail investors get out of hand, we might reign them in. This is a standard reservation in these Dutch auctions, and I would be interested to learn whether the issuers and underwriters actually follow through on the threat. Rumor has it that Hambrecht has priced several IPOs below the clearing price (notably Andover.net), but I couldn't find any reliable information on this practice. Perhaps it should go without saying, but this IPO will make for good theater.

Allocating. In allocating the shares among successful bidders, the company said that it will use one of two methods: pro rata allocation or maximum share allocation. The former gives all successul bidders the same percentage of their total bid, while the latter gives small bidders the total number of shares on which they bid and large bidders only a percentage. No matter which method is used, "The allocation process will not give any preference to successful bids based on the extent to which the bid price per share exceeds the initial public offering price."

Bottom line. One can read the auction in a couple of ways. While not unique, it certainly is unusual, and it has been viewed as a method of striking out against traditional underwritings. Early reports suggest that Google negotiated an underwriting fee of 3%, much less than the industry standard of 7%. Kudos to the company for that. Also, rumor has it that Goldman Sachs lost out on the chance to underwrite the offering when it expressed qualms about the auction format. (I'll bet the partner responsible for that gaffe feels pretty stupid right now.) So if you like the idea of tweaking investment bankers (and it's hard not to like this idea), you should have some warm feelings about the auction.

My more cynical side sees trouble, however, because auctions are typically associated with more volatile offerings, and Google has all of the markings of an offering with retail overreaction. Also, as I pointed out yesterday, the auction fits my hypothesis that the company is seeking a more direct line to retail investors because the professional investors would price the deal more modestly.

Let's review: (1) the founders implement a dual-class capital structure to ensure that they have complete control; (2) they sell directly to retail investors; and (3) they "encourage" (read: allow) the venture capitalists to become selling stockholders. I suppose potential investors could just trust them to have good motives, but my reading is that the signals point in the direction of an unhappy ending for IPO investors.

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It's hard to imagine why they waited this long to make the announcement, but Google and Yahoo are severing their relationship. This has been in the works for awhile, so it is not a surprise for either side or for the market. The article in the WSJ ($) ends with this interesting tidbit: "Yahoo was the No. 1 Internet destination in February when it served 72.1% of Internet users. MSN was No. 3, after Time Warner's network, with 71%, and Google was No. 5, after eBay, with 40.3%."

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Google's effective tax rate last quarter was 59%! And that is down from 70% in the quarter before. To get a sense for how high those numbers are, compare them to the averages here. The cause of Google's tax woes? It deducts as expenses the costs associated with employee stock options. This lowers the amount of pretax income, which is the denominator in the ETR calculation. This is the conservative approach to accounting for options, and Google deserves credit for that. (Especially after all of the brickbats I have been throwing their way.)

For the story, see here. Thanks to Paul at TaxProf Blog for the pointer.

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Over the past several days, I have been reading many news reports about Google's IPO, and it occurs to me that you shouldn't have to go through the same exercise to find the real gems. Here is a trio of stories that you shouldn't miss.

Adam Lashinsky writes about "Google's Banker" in Fortune ($)

In 1999, Moritz led his firm, Sequoia Capital, to invest $12.5 million in Google. If Google goes public at the $8-billion-and-up valuation that investment bankers expect, Moritz and his partners will likely reap hundreds of millions of dollars. With that kind of payday around the corner, it is easy to understand the giddy mood in the ballroom of San Francisco's Fairmont hotel in late March. There, 100 or so fund managers for university endowments, charitable foundations, and the like have gathered for updates on their investments in Sequoia Capital. Among other activities, they are dazzled by a Q&A session with Google co-founder Larry Page, pitched on the virtues of conducting IPOs as auctions by investment-banking legend Bill Hambrecht, and enthralled by a peek into Sequoia's latest bets.

But leave it to Moritz to pour cold water on the merriment. His narrow face and high forehead make him look like a bird of prey sporting oversized round spectacles, and Moritz stands in the front of the room to deliver a sobering message: Audience members are wasting their time—and, more important, the money they manage—on venture capital. He amplifies his point with a simple image projected on a screen behind him. It shows a billfold below four boldfaced words: sit on it (please!). "The notion that people should load up on venture capital as part of their overall portfolio-allocation process is just a batty idea," says Moritz later. A 49-year-old Brit, he wields his accent with rapier-like effect. "I mean, it's a recipe for disaster for themselves and the venture capital business. Any trustee of a university or any person on the investment committee of a major institution should fire the investment officer who recommends that they invest in venture capital."

...

What does Moritz get out of this act? A lot of scared investors likely to respond to a very comforting message: that to be safe, they should keep betting on him and Sequoia. Sure, Moritz has had high-profile misses, but he has also built a net worth in the hundreds of millions of dollars (by some estimates he's worth more than $1 billion) by finding big scores—often in companies that other VCs have rejected. Venture capital is a nail-bitingly unpredictable business that rewards bold if unexpected moves by unconventional thinkers. And Moritz is as bold, unexpected, and unconventional as they come.

George Mannes of TheStreet.com compares Google to Willy Wonka's Chocolate Factory:

The parallels between Wonka and Google's founders are striking. Both Wonka and the Googlers are legendarily secretive. Both have utter control over their operations and plan to keep it that way -- Page and Brin through a two-class stock structure, and Wonka by giving his factory to a child who will listen to him, not to a grown-up who "will try to do things his own way and not mine."

Both are obsessed with their research labs: Wonka has his Television Chocolate and his Everlasting Gobstoppers; Google encourages employees to spend 20% of their time on research and development, and calls its Google Labs Web site "our playground for our engineers and for adventurous Google users."

Both appear to be beneficent employers with hints of paternalism: Wonka rescues the Oompa-Loompa tribesmen from their bleak existence so they can work in his factory; Brin and Page tell us they provide their employees meals free of charge, doctors and washing machines. "Expect us to add benefits rather than pare them down over time."

Finally -- and most relevant to investors -- neither Wonka, nor Google's Brin and Page, seem all that interested in making money. Google's mission is "to organize the world's information and make it universally accessible and useful," and they're guided by the motto "Don't be evil."

Andrew Orlowski writes for The Register:

In a typically idiosyncratic break with tradition, the S1 application starts with a plea from the company fathers to make the world a better place. "We'd like to build the world a home," write co-founders Sergey Brin and Larry Page. "And furnish it with love. Grow apple trees and honey bees, and snow-white turtle doves." The unconventional sentiments will puzzle Wall Street analysts, but delight Google's teenage fans - and children of all ages who make up its most ardent users. "We'd like to teach the world to sing," they plead. "In perfect harmony." We made that up, of course. But the real "Letter from the Founders" that introduces today's 26-page filing borrows as much from The New Seekers as it does from Warren Buffet....

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Why did Google choose to implement a dual-class common stock structure? Because they can. As noted in today's New York Times leader on the Google IPO, "Google can behave with so little regard for shareholders' wishes because its business is so attractive that investors will be clamoring to buy stock no matter what conditions the company sets." While Page and Brin express their dedication to long-term returns, the dual-class capital structure is a signal that they are more interested in the private benefits of control than the shareholders' interests.

In their already-famous letter to shareholders, Page and Brin assert, "Academic studies have shown that from a purely economic point of view, dual class structures have not harmed the share price of companies." This is true, but it masks the important part of the story. The case for a dual-class capital structure rests on on the notion that the possibility of a takeover may lead to myopic behavior by managers, including the failure to invest in positive NPV projects for fear that the returns come too slowly. Insulating managers from this fear encourages long-term planning. (Like the newspapers discussed below, whose long-term interest in journalistic integrity outweighs the desire to maximize short-term profits.) What is missing from Google's explanation of its dual-class capital structure is a story about why the incumbent managers would be tempted to underinvest. Google is not a business with substantial capital assets. Its eye-popping operating margins suggest that it is living the life of a monopolist who has superior technology. This does not seem like a context rife with risks of underinvestment.

The flip side of dual class common stock is that the threat of displacement can be useful in disciplining managers. Entrenched managers tend to load up on perquisites and become distracted from the business of making money, favoring the private benefits associated with control over profits. In the case of Google, Page and Brin have long been constrained by the presence of venture capitalists with substantial control rights. (For Google's current charter, which contains many of those terms, see here). Upon consummation of the IPO, all of those control rights vanish, and under the dual-class capital structure, Page and Brin will regain almost complete control of the company.

From the outside, it appears that the venture capitalists were persuaded to go along with this plan on grounds that they could get out now. Page and Brin's letter states that they have encouraged the venture capitalists to sell some of their shares in the IPO, a fairly unusual move, but one that the venture investors might demand if the alternative is staying behind in a company with dual-class common stock. The big issue for Google investors should be whether Page and Brin will behave themselves once the venture capitalists are gone. This is scary enough in companies with a single class of common stock. When the company opts to lock control in the hands of the founders, that is a reason to run the other direction ... just as the venture capitalists are doing.

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Trappist monks in Brittany created Port Salut cheese -- named for the abbey of Notre Dame du Port-du-Salut at Entrammes -- having learned the art of cheesemaking outside of France after fleeing the country during the French Revolution. When they returned in 1815, they brought with them the secrets of the semi-soft cheese that today bears the initials S.A.F.R. -- which stands for Société Anonyme des Fermiers Réunis (the monks having sold the rights to the Port Salut name to the S.A.F.R. dairy in Lorraine). Although handmade versions of the cheese are still made at certain French monastaries and trade under the name Port-du-Salut or Entrammes cheese, most of the cheese distributed in the U.S.  is manufactured by S.A.F.R. Last night I had some of this cheese, which is smooth and creamy, a bit like Havarti (both are pressed, uncooked cheeses), through tastier. This is another cheese that doesn't need accompaniment. Just put it on the cheese plate and dig in.

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Given that this blog has become Google IPO Central over the past day, I thought it would be interesting to see what some other bloggers are saying about our favorite IPO. Desite a surprising paucity of interest among the entrepreneurship crowd, I found some interesting things.

Business Pundit is a Google booster, calling Larry Page and Sergey Brin "iconoclasts." BP links to this article from Wired, which states: The prospectus is "remarkable for the candor the founders express. In fact, one can sense a profound contempt for Wall Street types and their clubby ways. Sure, the filing has a lot of figures and tables. But it also has some delightful zingers that come close to giving Wall Street the middle finger."

John Quiggin at Crooked Timber takes on projected valuations of $25 billion for Google:

I started on a standard financial analysis. Although, as a private company, Google doesn’t have to publish annual reports, it’s been estimated that Google has annual revenues of $500 million and profits of $125 million so that the return on equity is about 0.5 per cent. We can expect that to grow reasonably fast in the next few years, but the scope for expansion in Google’s core business is far from limitless. Most people in the developed world are already online and most of the heavy users already use Google (Eszter might have more to say on this). Moreover, there’s no strong reason to suppose that Google will be around in, say, 20 years time. I find it hard to draw a plausible earnings path that would yield a present value of $25 billion at any reasonable discount rate.

This was posted yesterday, and we now know that Google's revenue number is much higher (almost $1 billion in 2003), but its net income is lower. Moreover, we know that Google's operating margins are heading south. Quiggin's basic point, therefore, remains sound.

Marginal Revolution is one of my favorite blogs, and Tyler Cowen chimed in briefly yesterday on the valuation question. He also links to some earlier posts that express the same type of Google skepticism you will read elsewhere on Venturpreneur.

Larry Ribstein definitely gets it: "I'm sticking with index funds."

Mitch Ratcliffe at The Red Herring Blog (The Now) wrote yesterday about "Why I won't be a Google IPO investor." He gets it, too.

And finally, from the Google Blog, this insider's account from a temp at Google:

Apparently the day's announcement was a surprise for Googlers as well. Suddenly this meeting was called via e-mail, causing other meetings in progress to be adjourned; everyone dropped everything and vanished. It was like the plague had struck. We temps were not informed, but had to put two and two together from the sudden exodus and from the e-mail we received announcing that the cafe (which is huge and has a stage with a sound system, usually used for DJs and jam bands at lunch) would be closed until 1 due to "a special event." A coworker and I tried to gatecrash and got as far as walking up to the cafe from the inside hallway, seeing the backs of hundreds of people and hearing the voice of whoever was at the mic, before being turned away by security for having the wrong color (temp) badge.

There was a BBQ grill going outside that we were welcome to peruse, though, so we got food and sat down to wait and watch. All we could see were the backs of people visible through the sliding glass doors; the rest of the cafe was under whiteout conditions, with blinds pulled to block all views inside. This is impressive since the entire front facade of the cafe, which is about three stories high, is made of windows! We observed lots of periodic clapping, and there was a Q&A session after the main piece had been said. Eventually people spilled out into the sunshine. Sadly, I saw no one run out of the building yelling, "I'm rich! I'm rich! I'm filthy rich!" I did see Larry Page go by looking bemused but snazzy in a colorful striped button-down shirt - and it looked like he was wearing his best sneakers. We grabbed someone we knew, who told us, "I think we're doing the right thing."

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Selling stock in an IPO is not about convincing people that your present performance is stellar. It is about your growth story. People who invest in IPO shares are hoping that your company will become the next Microsoft. A compelling vision is crucial. I have been reading the prospectus for clues about Google's growth story, and this is what I have found.

Begin with a baseline: where does the company stand? Google is "a top Internet destination." The Google brand "one of the most recognized in the world." Google has "the world’s largest online index of web sites and other content, and [they] make this information freely available to anyone with an Internet connection."

So far, so good. We all appreciate Google's technology, and most people I know use it multiple times every day. That has earned Google profits that are less than half of the level earned by Yahoo on revenues that approach 60% of Yahoo's revenues. Moreover, Google will not be likely to increase its market share in the internet search industry. Yahoo already seems to be catching up, and Microsoft is committed to challenging. So the big question for potential Google investors should be: where will Google be tomorrow?

Google's future: The most surprising thing in this prospectus -- which is full of surprises -- is that the company does not articulate a growth story in the Prospectus Summary. If you are concerned about Google's future, as every investor should be, you want to know what's next. That information is simply absent. Their business model is simply stated: "We generate revenue by delivering relevant, cost-effective online advertising." Later in the prospectus: "Advertising revenues made up 77%, 92%, 95% and 96% of our net revenues in 2001, 2002, 2003 and in the three months ended March 31, 2004." Internet advertising is the only source of revenue! Unbelievable. What year is this?

If you dig into the prospectus a ways, as I have done, you will find these lame attempts at telling a growth story:

* "Our business has grown rapidly since inception, and we anticipate that our business will continue to grow." (p. 38) The basis for this expectation? Not explained. Indeed, the text that follows this assertion emphasizes an ominous point: operating margins are declining.

* "We have experienced and expect to continue to experience substantial growth in our operations as we seek to expand our user, advertiser and Google Network members bases and continue to expand our presence in international markets." Again, the basis for this expectation is not explained. In a world where search is becoming more competitive, Google grows only if the size of the pie grows. While it seems reasonable to assume that the number of internet users will increase over time, we have no indication that the increased number of users will result in more profits for the company ... particularly the kind of profits that would be necessary to sustain a valuation of $25 billion.

* In their discussion of competitors, Microsoft and Yahoo are named. "Most of the products and services we offer to users are free, so we do not compete on price. Instead, we compete in this area on the basis of the relevance and usefulness of our search results and the features, availability and ease of use of our products and services." And as for the future? "We believe that we compete favorably on the factors described above. However, our industry is evolving rapidly and is becoming increasingly competitive. Larger, more established companies than us are increasingly focusing on search businesses that directly compete with us."

Bottom line: The prospectus is worse than I imagined it could be. I assumed Google would have a difficult time telling a growth story, but I thought that they would give it the old college try. Instead, their growth story is nothing more than a celebration of past accomplishments. "Don't you just love our search technology?!"

Yahoo is currently trading at a price/earnings ratio of approximately 125. Google is currently less efficient at servicing the bottom line, and it admits that operating margins will decline. In the face of these realities, it will need to achieve a price/earnings ratio higher than Yahoo's to obtain the kind of valuations projected over the last few days. While it may reach such lofty heights if retail investors get overly enthusiastic, those prices are not sustainable under any scenario contemplated in the prospectus.

UPDATE: After I took a closer look at the financial numbers in the prospectus, I realized that my initial statement about Google's ability to service the bottom line cannot withstand close analysis. The current numbers are impressive, no doubt about that. But you don't get a P/E ratio of 125 or more without a compelling growth story, so my main point stands.

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The first sentence of the prospectus is the most crafted sentence in the document. The drafters realize that most readers do not read very long after this sentence, and they want to make a lasting impression. The first sentence positions the company in the competitive marketplace. Google's first sentence: "Google is a global technology leader focused on improving the ways people connect with information."

Kudos to the drafters. Notice that they did not position Google as just a search engine, even though that is how most of us think of them. They are going for a bigger story here. Moreover, this is a feel-good sentence; connecting people seems noble and right and meaningful and aspirational. Connecting people through technology is cool, and Google is definitely cool.

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Someone else who is on the same page with me on Google's IPO. The writer quotes Tim Loughran, a finance professor at Notre Dame who has made a career of studying IPOs, opining that "Google is basically a one product company, and hence very vulnerable to 'some other company coming along and inventing a better mousetrap.'" Hmm, sounds familiar.

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Rick Garnett and Nate Oman are talking about the pulls of capitalism and community. Rick writes:

Generally speaking, I believe that markets work, that efficiency matters, and that property- and entrepreneurship-rights are both practically and morally important. At the same time, I have a soft spot for anti-consumerism social critiques, agrarian nostalgia, "crunchy conservativism," the "family farm," and the "old neighborhood." ... Is there a way to combine the Burkean stance [with] exhuberant celebration of the many ways in which capitalism improves our lives?

Nate's angst-filled (but ultimately self-assured) response captures well how I feel about this:

The agrarian past, the family farm, and the old neighborhood largely survived and thrived because society lacked high levels of mobility and a host of rent-seeking institutions allowed some to profit at the expense of the economically stagnant. Finally, while I enjoy indulging in a bit of nostalgia and angst, I don't have it in me to "pull the trigger." When these sympathies get translated into concrete legal and policy proposals, I balk. Despite my occasional misgivings about freedom and markets, I can't help but believing at the end of the day that they hold out a better hope for the future – particularly the future of those at the bottom – than anything else, and too often nostalgia simply leads to vicious nonsense when it becomes law.

By the way, this discussion began with a thoughtful post by Steve Bainbridge, which he was drafting at the Uncorporations Conference.

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Last fall I wrote about an example of the classless competition among law schools that is inspired by rankings. Yesterday, Brian Leiter added two data points. According to Brian, admissions officers at two schools who feel slighted by his lukewarm evaluations -- Brian's alma mater, the University of Michigan, and Northwestern University -- are telling prelaw students that Brian's views are animated by bitterness at having been rejected for a faculty appointment. Brian is justifiably disgusted, and so am I.

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Larry Ribstein just started a debate with Steve Bainbridge (despite his cold) about state and local taxes on internet access. This little debate was prompted by the larger debate currently being staged in the Senate over the Internet Tax Nondiscrimination Act, which proposes a permanent ban on state and local taxes on internet access. Steve supports the proposed act, but Larry argues that his is missing a crucial point: "state regulation usually beats federal regulation despite frequent cries of balkanization." Larry is worried about the prospect of federal intervention, and he is undoubtedly right to be concerned. A tax-free zone looks like a vacuum to Congress ... it's only a matter of time. Still, it is tough to back away from an act that promises permanent bans on certain state and local taxes. Larry seems to assume that the advent of such taxes will crowd out federal involvement, but whose to say that the feds won't simply pile on? If I were a Senator (Heaven forbid!), I would be inclined to take my chances on future federal action and vote now for the ITNA.

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The WSJ ($) is reporting that tech hiring is up, and "[f]or the first time in several years, more workers are being hired than are being fired." Google's IPO will undoubtedly spur additional public offerings by technology companies, and venture capitalists have already begun to feed the pipeline: "Investments in venture-backed companies are up 29% so far this year, to $8 billion, compared with the same period last year." This is good news for the economy and good news for President Bush. Wouldn't it be ironic if Dubya lost the presidency over the war in Iraq, despite a burgeoning economy? "It's the war, stupid!"

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