These are all very good questions. About how one gets in on the ground floor -- the IPO is done by an underwriter, which usually an investment bank. Before the IPO the investment bank sets up sales sessions with a lot of their friends/big clients, and gets them to promise to buy shares at the initial offering price. When the IPO happens every one that was initially approached by the bank and promised to buy shares sends in their money and gets their shares and then they are free to resell the shares on the open market.
So about how you get onto the ground floor -- you have to be one of those special people the bank calls. (note that this is the "classic" way things happen, some IPO's, such as the Google one were different).
There have been some accusations that the underwriters use IPOs to make a lot of money in addition to their deserved fees. The accusation is that the underwriting Ibank will sell and IPO to a friendly investor for a very depressed price, so that the friendly investor is guaranteed to make money selling the stock as soon as trading opens. To express his thanks, the friendly investor will then find a way to pay the ibank for its trouble. For example, the friendly investor can use the ibank as a broker for his stock trading, even though the ibank has sky high fees. And of course the victim is the company that does the IPO, which as you said, gets screwed out of a whole bunch of capital, and even worse they end up with a market capitalisation that is much higher than the actual capital and assets that they own, so they will face unfairly high expectation as to their future profits.
This theory was first and best articulated by professor Coffee of Columbia Law School in an NYT article. So if you are curious you can try to do a search (I could not find the article myself). Prof. Coffee is a very smart guy and happened to be my securities law teacher.
The banks of course dispute the theory. The banks' argument is that they need to place the initial shares to their friends and known clients, and they need to have the price somewhat depressed in order to sell all the stock of the offering. Otherwise it would not be certain how much stock they can sell for what price, so they run a risk of having the offering fail (i.e., not sell all the offered shares). If an offering fails it is considered a disaster for the company doing the IPO.
There is however an alternative. It is called a Dutch auction, and in it potential investors bid for the initial shares in an auction. Thus, the proper price can be discovered and it is more likely the offering will succeed. Also, in a Dutch auction much more people can take part in the initial offering.
Google did their offering by dutch auction and it was much easier to get in on the offering for the Google IPO. You just needed to have a brokerage account in one of the banks that did the IPO (and this included most major ibanks) and you could bid for IPO shares. The ibanks were not very happy with Google's choice to do a dutch auction, but they were Google, so the banks did it anyways.
Otherwise it would not be certain how much stock they can sell for what price, so they run a risk of having the offering fail (i.e., not sell all the offered shares).
To clarify: usually the underwriters take the risk of selling the shares. If they don't sell all of offered shares to the public, they have to buy the remaining shares themselves.
I don't understand the conspiracy theory. The investment bank will only agree if kickback > shortfall, and a big investor will only agree if kickback < shortfall. Obviously I'm missing something. Why can't the investment bank sell directly on the market in the first place?
It's the company going public that is offering the shares so the IB doesn't suffer as much if the price is lower. The shortfall is the company's while the kickback goes to the IB.
As I see it it's not so much a 'conspiracy' as a set of misaligned incentives, which cause some parties to 'naturally collude' against the offering company, even if they (colluders) don't explicitly agree on this.
I think it is to try to avoid the appearance of impropriety even while still having the appearance of impropriety for anybody who (like us, presumeably) is not totally incapable of keeping track of which peanut the shell is under in the shell game they're playing.
You can describe much of Wall Street and Washington, DC as a shell game. So my pet theory goes. :)
So why don't other companies doing the IPO organize an auction for their shares like Google then ? Cause in theory an auction is one of the efficient ways to get the market cleared, or shares are priced accordingly to their value.
So about how you get onto the ground floor -- you have to be one of those special people the bank calls. (note that this is the "classic" way things happen, some IPO's, such as the Google one were different).
There have been some accusations that the underwriters use IPOs to make a lot of money in addition to their deserved fees. The accusation is that the underwriting Ibank will sell and IPO to a friendly investor for a very depressed price, so that the friendly investor is guaranteed to make money selling the stock as soon as trading opens. To express his thanks, the friendly investor will then find a way to pay the ibank for its trouble. For example, the friendly investor can use the ibank as a broker for his stock trading, even though the ibank has sky high fees. And of course the victim is the company that does the IPO, which as you said, gets screwed out of a whole bunch of capital, and even worse they end up with a market capitalisation that is much higher than the actual capital and assets that they own, so they will face unfairly high expectation as to their future profits.
This theory was first and best articulated by professor Coffee of Columbia Law School in an NYT article. So if you are curious you can try to do a search (I could not find the article myself). Prof. Coffee is a very smart guy and happened to be my securities law teacher.
The banks of course dispute the theory. The banks' argument is that they need to place the initial shares to their friends and known clients, and they need to have the price somewhat depressed in order to sell all the stock of the offering. Otherwise it would not be certain how much stock they can sell for what price, so they run a risk of having the offering fail (i.e., not sell all the offered shares). If an offering fails it is considered a disaster for the company doing the IPO.
There is however an alternative. It is called a Dutch auction, and in it potential investors bid for the initial shares in an auction. Thus, the proper price can be discovered and it is more likely the offering will succeed. Also, in a Dutch auction much more people can take part in the initial offering.
Google did their offering by dutch auction and it was much easier to get in on the offering for the Google IPO. You just needed to have a brokerage account in one of the banks that did the IPO (and this included most major ibanks) and you could bid for IPO shares. The ibanks were not very happy with Google's choice to do a dutch auction, but they were Google, so the banks did it anyways.