So you missed out on Twitter’s meteoric first-day rise because the stock gapped up to $45 from the initial public offering price of $26 and you couldn’t get in. With a market capitalization of ~$25 billion everybody is screaming bubble because the company is not profitable and only has $500 million in revenue. But who cares? Twitter has changed the way we communicate and you could have made a whopping 73 percent if you could have gotten some shares!

Outrage by the investment community quickly ensued about the preferential treatment institutions and wealthy individuals received in the IPO process. Phrases such as “The rich get richer” and “Shut out again” were commonplace. CNBC reported that 50 percent of the Twitter allocation went to only a handful of institutional investors despite thousands clamoring to own.

In this post I’d like to help explain the IPO process and clear up some misunderstandings along the way. To provide some background, I worked on placing over 100 IPOs to institutional shareholders during my 13 years on Wall Street. Most of my deals were international deals, but I was also present for U.S. deals such as Google way back in August 2004. It certainly seems like the good times are back again!

The Purpose of the IPO

When you go IPO you go public. You are selling a portion of your company to public investors who can buy your shares on a stock market exchange such as the NASDAQ or NYSE. Stock market exchanges make money through listing and trading fees, so the more companies that go public and the more volume that trades, the more money stock market exchanges make.

There are three main reasons why private companies go public.

1) To create liquidity for early investors and employees

An IPO is one of the biggest “liquidity events” a company can go through. We’ve learned from the 2000 dotcom bust that it’s always a good idea to diversify your holdings. Venture capitalists, private equity investors, angel investors and senior management who’ve been with the company since day one would love to monetize some of their profits. It’s generally a great sign if management announces to the public they won’t sell any shares, so pay attention to this fact during the IPO process.

2) To raise money

An IPO generally issues primary shares (new shares) to the public. Primary shares dilute existing shareholders, but it’s usually not enough to make a negative impact. Companies often use IPO proceeds for working capital, research & development, capital expenditure, and acquisitions to hopefully grow the company and make more money for shareholders. It’s important to differentiate between primary shares and secondary shares. Secondary shares are existing shares owned by investors and employees who are cashing out as we discussed in point #1. Pre-IPO companies are generally limited to 500 investors total. Going IPO vastly expands the shareholder base.

3) To build reputation

Our financial system is built on reputation, otherwise everything falls apart. Going public on a reputable stock exchange such as the NYSE builds a company’s reputation because the company is now subject to the scrutiny of the Securities & Exchange Commission (SEC) and Generally Accepted Accounting Principles (GAAP). With a better reputation, you can attract higher caliber employees, do business easier, and continue to raise money or cash out existing shareholders due to higher levels of trust. Nobody knows what goes on behind closed doors with private companies. A reputable public company will be filing quarterly reports and hosting conference calls with shareholders for the sake of transparency.

The Pricing Dynamics of an IPO

Not all IPOs are created equal. There are many factors that affect the pricing and after-market trading of an IPO. The main issue is the simple law of supply and demand.

1) Reputation outweighs IPO size

Everybody has heard of Twitter, but Twitter’s IPO was relatively small at $2 billion. Let’s say you were the fund manager of a $110 billion international fund. You could easily take down the entire $2 billion position with your own fund. But there are literally thousands of mutual funds, index funds, and hedge funds out there that all want a piece of the action. Then there are retail investors like you and me who’d like some shares too. You can easily see a situation where the IPO becomes multiple-times oversubscribed, and careful allocation deliberation must be put in place.

2) Pricing is based on existing comparables

The main way IPOs are priced is by comparing the firm’s growth rate, profitability, size, and potential to existing publicly traded companies. Generally, there is an IPO discount relative to growth due to the lack of a trading track record. Investment banks that take companies public want to provide some cushion so investors don’t get burned. At the same time, investment banks don’t want to price the IPO too low and leave money on the table. There will be intense pricing discussions after the books have closed. Twitter could have raised $1.6 billion more dollars from investors by pricing the stock at $45 instead of at $26. But if they priced at $45, the chances are high the stock would have tanked on day one, thereby sullying the reputation of the bookrunners and the company.

3) The strength of the sector

IPOing telecom companies with little growth in this market is probably not going to receive a lot of demand. IPOing tech and Internet companies today will certainly receive a lot of interest because everybody is searching for the next Google, Apple, Facebook and so forth. I’m a proponent of investing in growth stocks if you are a younger investor due to time and your ability to recover from a downturn. Companies and bankers are opportunists who want to raise money when valuations are highest. But they also want to ensure that investors make some money as well. In a bull market, almost every single sector should increase in value. It then becomes a relative game of which sector is most in demand.

4) Allocation goes to a few blue-chip investors

The amount of the IPO is also called the float. The float is what’s traded on the stock exchanges that reflects the entire value of the company. A company’s public float is usually less than 30 percent. In Twitter’s case, they floated about 10 percent of the company. By allocating the IPO to a handful of blue-chip investors, the hope is that they will be less inclined to flip the stock and cause volatility in the after market. Blue-chip investors are usually large mutual funds that also pay Wall Street the most money because they have the most assets to trade. You don’t want to allocate the majority of shares to tiny, fast-money hedge funds that go in an out of stocks all day long. You also don’t want to allocate all the shares to retail investors who are deemed less sophisticated than professional money managers either.

5) Only a small portion of an IPO gets allocated to retail investors

The only way you and I can get stock allocation in an IPO is usually through an online broker. The more assets we have with them, the higher the relative allocation. But the reality is we still won’t get much allocation in an enormously oversubscribed deal such as Twitter. But we shouldn’t blame big institutional investors for getting allocated the majority of the deal because such institutional investors are representing us. Hence, the main way to participate in an IPO is to buy a fund that plans to participate. For example, you may want to buy an Internet Fund if you like Internet IPOs.

The Market is Very Efficient

I urge everyone to be very cautious when trying to invest in a company that goes public within the first three months. There’s no trading track record and management is almost always in the “quiet period” where they cannot say anything about their business or results to the public. Sure, you can make a bet that management will say something positive in their next quarterly earnings conference call, but it’s usually best to wait before the hype or the negativity settles before making an investment.

It’s a reality on Wall Street and perhaps in life that the more money you have, the more attention you will get. I’m a shareholder in Apple just like Carl Icahn is a shareholder in Apple. But Carl gets to have filet mignon with CEO Tim Cook because he owns a $2.5 billion position. I can either fight for equality, or I can join the giants by investing in the giants. Just don’t forget to take profits! The good times almost never last forever.

If you have any follow-up questions on the IPO process, feel free to ask! From my last post, I received feedback from a couple individuals that I should spell out everything as much as possible, given the community is not used to investing-related posts. I’m happy to clarify any terms that you have.