The much anticipated IPO of Twitter came to the market today.  The initial public offering price was $26, and it opened up trading today at $45.10.  After trading in the range of $44.00 to $50.09 for the day, it closed at $44.90.

So why didn’t everyone on the globe buy Twitter at $26 and “flip” their stock at $46 and make a $20 profit?  It sounds so easy, and almost the easiest investment that anyone could ever make in their investing career.  Well, the answer lies in the process of a company “going public”.

How an initial public offering (IPO) works

Here’s how an initial public offering (IPO) works in its simplest form.  We say “simplest form” only because there are  lot of details, and parts to the story of initial public offerings, but we wanted to keep it simple and cover the basics.

Let’s use an example of a “make believe” company named MacDaddy.  MacDaddy is privately owned by Fred, who started the company many years ago.  Now that he no longer wants to own the company, he wants to sell it.  Smart folks (investment bankers) calculate the value of the company based on sales, revenues, earnings, assets, etc.  After much analyzing, calculating, and negotiating, Fred agrees on the selling price of $9 million.  The investment banking firm is expecting to profit from their work of taking this privately owned company to a publicly owned company (“going public”).  They decide on profiting $1 million.  So they now decide to sell the company to the public.  They offer 1 million shares at $10 a share to public shareholders.  From the offering, they will generate $10 million ($10 per 1 million shares) to pay the current owner, Fred, ($9 million), and the investment banking firm their fee of $1 million.  The company is no longer owned by Fred, but rather owned by shareholders.

In many cases, the million shares that we sold at $10 were “given” to the “best of customers” of the investment banking firm (and the other syndicated firms).  In some cases, those clients with the biggest accounts get “handed” IPO shares, or maybe a client is “owed” a favor for referral of other business.  In some cases, investment banking firms and their advisors will offer shares of an IPO to kick-off an initial business relationship.  I’ve heard of advisors giving IPO shares as a “thank-you” to clients for their long lasting relationship.  There are many reasons for certain clients to get IPO shares, but whatever the case is, the IPO shares usually are handed to those that would qualify based on potential business or previous business.

Once the initial public offering takes place, the shares can now be traded on the exchanges.  Those that received the IPO shares can sell.  In the majority of cases, the stock trades close to the initial public offering price if the investment banking firm did their calculations properly.

Today, Twitter handed out shares at $26 per share.  It appears that investors wanted to buy the stock and was willing to pay as high as $45.10 at the first trade.  Meanwhile, no owner of the IPO shares was willing to sell at a lower price, at least not yet.  So the first trade started the trading, and investors/traders bought and sold the shares of Twitter all day.  No one was willing to pay less than $44 a shares and no one was willing to buy shares higher than $50.09.  Sure, those that were dealt shares at $26 and sold on the exchange at $46 made a $20 per share profit.  And then there was the investor who paid $50 a share today, and it closed at $44.90.  He’s losing money, but probably is willing to hold onto the stock for better days.

So here’s lies the issue.  How did the investment banking firm decide the price should be $26 per share, and then investors pay almost twice the price on the exchange.  Did they misprice the value of the company?  Think of it as getting World Series tickets at a face value of $200 a ticket, but then StubHub is selling them at $800.  Why doesn’t Fenway Park sell the tickets at $800?  Or at least $400?  The truth is, many of those Red Sox fans paid only $200 for their seats, and a few paid $500, and some even paid $3000.  However, Fenway and MLB was happy to sell out and get $200 per ticket.  If others wanted to “scalp” their tickets to willing buyers at much higher prices, then let them.  Twitter felt the same way.

However, keep in mind, the “smart folks” think the company is worth $26 per share.  Who’s right?  Stay tuned.

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