Twitter IPO favors corporate insiders, bankers

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(MoneyWatch) With Twitter shares expected to price tonight between $25 and $28 a share, investors are gearing up for the social network's hotly anticipated IPO on Thursday.

On the eve of trading, company executives and other insiders know what the stock will trade for. Institutional investors, such as pension funds and insurance companies, know what they will pay to own a piece of Twitter. The only thing left to learn is how big a "pop," or jump in value, the stock gets in its first day of trading on the New York Stock Exchange.

Put another way, the main question now is how much average investors will lay out tomorrow to make a massive payday possible for bigger players. That's because any IPO is ultimately designed to transfer money from retail investors to the company, bankers, early investors and other insiders who were issued stock at a preferred price.

To be sure, many average investors have bought a stock immediately upon a company going public and seen the value of the stock ultimately rise. But there are just as many, if not more, who got caught up in the hype of a splashy IPO and lost money.

The process of how an IPO happens and is priced is fairly well known. But what is often forgotten is that a big first-day pop is not a success for the company, but rather for the investment banks that help take a company public and the institutional investors that were allowed to buy shares before the initial offering.

If nothing else, an IPO comes down to savvy salesmanship. The more hype and excitement a company like Twitter and its underwriters can generate, the higher they can ultimately drive the initial price of the stock. But here there is a divergence of interests.

The company and its insiders understandably want to make as much money as possible. However, so do all the big buyers in the IPO. The more the company makes, the less the bankers and institutions make. One reason Facebook's (FB) 2012 IPO was criticized was the lack of a big first-day jump in its stock price. Because the company sold so many shares and got a high enough price for them, the first wave of demand was kept in almost perfect balance by that first price.

Wall Street didn't like the result because without that pop, the investment banks and big investors can't immediately sell off some shares and make a solid profit. The bigger the pop in a company's stock price, it the clearer it is that the underwriters under-valued what the stock would command. That reduces the amount of money the company and insiders made from selling their shares.

In other words, every IPO involves a trade-off between a company and insiders on one hand and the underwriters and big institutions on the other. Notice who isn't part of the equation: the little guys who pay whatever the market will bear once a company goes public. The difference between the price they can get on the market and the IPO price is all profit going to the banks and investors, which effectively serve a middlemen in selling shares into the  market.

And the higher the pop, the more you see the effect of the bigger fool theory, a model of investing that says you're golden so long as you can find someone to take shares off your hands at a higher price. It's also a good way to get burned, which is why many financial advisors suggest waiting at least 90 days before buying a new stock.

  • Erik Sherman On Twitter»

    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.

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