On November 7th, 2013, Twitter opened on the New York Stock Exchange at $26. By the end of the day, the price had soared 73% under the symbol TWTR to a closing price of $44.90.
Institutional and wealthy investors who bought the stock at $26 made a very healthy “paper” profit.
Did the underwriters make a huge error in setting the initial price for the IPO? Who are the underwriters? And, what does that term mean?
Let’s start with the history of the word “underwriting”.
Lloyd’s of London, the Home of Underwriting
I have been a Lloyd’s of London correspondent over three decades. During my years with them, I’ve noted that there is a much higher regard for insurance in Great Britain than in the United States. The Brits are bound in a long history of insurance tradition that started in the 17th century at a coffeehouse in London.
Edward Lloyd had a coffeehouse whose clients included merchants, shipowners and ship captains. Because the conversation at Lloyd’s was a goldmine of information, those who wished to insure ships and cargo congregated there to meet with people who wanted to assume their risk.
Some people inaccurately describe Lloyd’s as the birthplace of insurance. Actually “insurance” in many forms has been around since long before it was acknowledged in the Babylonian Code of Hammurabi in about 1750 B.C. Insurance is a system of handling risk, all the way from avoidance, to spreading, and on to actual transfer by contract.2
Lloyd’s of London might accurately be described as the genesis of modern insurance as many of the techniques and terms used today started at Lloyd’s.
As things progressed at Lloyd’s, cargoes and ships became much more valuable (increased exposure), shipping perils became more treacherous through pirates, wars, and length of journeys (increased risk). People became less and less willing to assume the entire amount of any one loss. A system was developed at Lloyd’s whereby a piece of paper would be presented to those who wanted to accept the transfer of risk to them for a consideration (premium).
At the top of the paper would be information about the shipping journey. Such things as name of captain, name of ship, kind of cargo, shipping route, estimated date of departure, and estimated date of arrival would be included.
After each person looking to accept risk for a consideration would decide what percentage of the risk they wanted, they would “write” their name “under” the description of the risk with the percentage of risk they would accept.
Those taking the paper from table-to-table in Lloyd’s coffeehouse, trying to fill out the “line”, would soon determine who amongst those taking risk carried the most prestige with the other risk bearers. They would go to those people first, and they consequently became known as “lead underwriters”.
That system is still in place today at Lloyd’s. Although, in most instances, the actual placement of most insurance is handled by general agreements that are covered through overriding guidelines with agents around the world.
Underwriting As Regards Public Radio and TV
You also will often hear the word “underwriter” in regards to charitable giving for non-profits, such as public radio or TV. In that setting an “underwriter” is differentiated from a “sponsor” by the amount of public exposure given to the individual, foundation, or corporation who is donating funds. It is a difference of nuance.
An IPO is the first time stock for a company is offered to the general public through a securities exchange.
With Twitter, investment bankers were contacted to establish the initial price for the initial public offering (IPO) and to provide marketing to assure that a certain percentage of the stock would be sold at that price. The investment banks involved are called underwriters.
They pledge that they will use their contacts to sell a set percentage of the stock at the set initial price. With Twitter they had to sell a pledged number of shares at the agreed upon price of $26. If the underwriters cannot sell the amount of stock they pledged, they are said to have to “eat the stock” or purchase it themselves and sell it for what they can get. Obviously the underwriters are taking a risk. They would be fairly certain that the amount of stock they can sell is enough so that any stock they have to purchase would not create more of a financial loss for them than the amount of their fee.
In the case of Twitter, the IPO fee was 3.25 percent of the amount raised There were 70 million shares sold at $26, so the total fee was $59.2 million, split unevenly according to the amount sold by investment bankers (underwriters) according to how many shares each sold and their actual involvement in the process.
The underwriters set the price as high as possible as they were getting 3.25 percent of the proceeds. They didn’t set it too high because they wanted to make sure they could sell the vast majority of the 70 million shares.
Goldman-Sachs was the lead underwriter with help from several other firms including Morgan Stanley and JP Morgan Chase & Co.
Had the investment bankers missed on the pricing and only been able to sell 60 million shares at $26, they would have had to buy the other 10 million shares at $26. Had they eventually been able to sell those 10 million shares at an average of $20 a share they would have lost a net $800,000 on the sale.
It appears to me, their odds of losing on this transaction were remote.
I have been an underwriter’s assistant, and assistant underwriter, an underwriter, and a senior underwriter but have never had a $59.2 million payday. When I started in insurance, I had to fly to Chicago for my interview with the insurance company who hired me as a management trainee. I went to a bank to borrow the cost of an airline ticket that would be reimbursed. The bank president was the father of a fraternity brother and he thought I was worthy of the $200 risk. It seems now I would have been much better off had I borrowed the money from an insurance company to go to an interview with a bank.