RESTON, VA, May 29, 2011 – Hey, Mr. or Ms. Small Investor—were you able to get in on the recent LinkedIn IPO? No? Wonder why? The answer is simple: you’re not important enough, or rich enough, or both.
Investment banks, hedge funds, and big kahunas were the primary beneficiaries of this IPO, the hottest of hot stock market opportunities in recent memory.
What’s an IPO and How Does It Work?
For the uninitiated, “IPO” is Wall Street shorthand for “Initial Public Offering.” It’s the process whereby a private company goes public, making a previously agreed upon number of its shares available to trade in public on one or more stock exchanges.
The mechanics of an IPO are relatively simple, but generally unknown to the public at large. Say that the upper management of the privately held XYZ Corporation decides they need to get a lot bigger in order to offer more products or increase market share. They get together with their board of directors and/or the venture capitalists who initially funded them and approach one or more investment banks with their idea. Or, in many instances, it’s the investment banks that approach the company and offer to do a deal.
Once it’s decided to do the deal, this ad hoc committee of management, investors, and investment banks decide how many shares to offer to the public, and works with accountants and investment analysts to determine what a company’s worth on the open market. It’s at this point that the fun starts.
It’s generally understood that the offering needs to be objectively at least slightly underpriced so that prospective investors can feel like they’re getting a good deal. In addition, traditionally, these investors are further incentivized by not having to pay their brokers a commission on this initial transaction.
When the outlines of the deal are set, a mandatory prospectus is made available to prospective investors outlining the terms of the deal. The prospectus also carries plenty of warnings about the risk of putting money into a hitherto untested investment. It’s at this time that a price range for the offering is generally announced—a price range that, in the end, may have little or nothing to do with the exact price at which the IPO is actually offered.
When the players are ready to go, the investment banks—actually a team of them, known as underwriters or the “underwriting syndicate”—purchase the entire issue at the final, agreed upon price and offer it to the public at the public price they’ve set, usually during the evening before the stock starts trading publicly.
The art of the IPO is to slightly underprice the deal relative to public demand. Once the shares are available to trade, a significant number of the investors/investment firms who’ve gotten in on the original deal look for an upward “pop” in their share prices at which point they immediately sell their shares, pocketing a pretty profit for themselves in just a minute or two. Or, with today’s computer-driven program selling, in milleseconds.
Objectively, pricing a new issue like this is a little tricky. As we’ve mentioned, the underwriters want clients to get at least a decent “pop” out of the stock so they’ll be happy with their absurdly easy profits and will come back for more of the next hot offering, thus making such offerings easier to sell. Problem is, if you price the deal too low and get too big of a pop for your investors, you’ve essentially screwed your underwriting client—in this case, XYZ—out of a chunk of capital they could have used for their own corporate purposes, which is why they chose to go public to begin with.
So What About LinkedIn?
Which gets us back to the LinkedIn IPO. For those unfamiliar with the company, LinkedIn is known, in polite circles at least, as the Facebook for the Boomer Generation. It’s essentially an elaborate resume posting site that also allows you to expand and grow your contact list (your “friends”) with at least a partial aim of keeping you in the hunt, business-wise. It arrived early in the social networking game, and its users tend to skew toward the older demographic.
With all the buzz surrounding social networking these days, it was almost a foregone conclusion that LinkedIn would be a hot offering, i.e., one where the number of shares offered didn’t come close to meeting the potential demand for those shares. Since showier companies like Facebook and Twitter have yet to come public, investors wishing to cash in on the social networking craze immediately had nowhere else to go but to LinkedIn, currently, the only such game in town, public trading wise.
But now here’s where this deal got cynical. In the first place, only a minority of available shares were made public. This accomplished two objectives:
- It assured that LinkedIn management and major inside investors kept overwhelming majority control of LinkedIn—not the companies and/or individuals who bought stock on the offering.
- It made the stock extraordinarily scarce on its initial trading day in the open market.
The benefits of achieving the first objective are obvious. With overwhelming majority ownership, company and investment poohbahs remain assured that the public, especially socalled “activist investors,” could be outvoted on any corporate issue.
The second benefit is perhaps less obvious but perhaps even more important. By offering a ridiculously low amount of shares to a public that was clamoring for them, the laws of supply and demand in and of themselves would almost certainly result in a greater-than-usual opening day trading pop.
What in fact did happen was that the LinkedIn IPO experienced an almost unprecedented, ginormous pop. It certainly made a lot of the rich dudes happy. But it probably also steamed the average investor who couldn’t get any of the shares. It’s been a tough climb for individual portfolios who’ve been trying to get back the poker chips they lost big time in the Twin Crashes of 2008 and 2009.
Some LinkedIn IPO shares might have helped close that gap. But not if you didn’t get any.
Next Time: What happened with the LinkedIn IPO and why this needs to stop.
Read more of Terry’s news and reviews at Curtain Up! in the Entertain Us neighborhood of the Washington Times Communities. For Terry’s investing insights, visit his WT Communities column, The Prudent Man in Politics.
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