Why You Should Wait to Invest in Twitter

A company's initial public offering is similar to a new restaurant's opening week. The plans are in place, but it just takes a while before execution rises to the desired level. And while there is no defined time for when things begin to really gel for a new restaurant -- if they begin to gel at all -- a newly public company has a very defined date when all the jitters should have shaken out.

Twitter (TWTR) investors should take note of this date: the day of the lock-up expiration.

Locked-up shares' future
After an IPO, the executives, directors, and employees typically have an agreement not to sell their shares for a specified amount of time. For Twitter, only about 13% of its shares are traded publicly. The rest of the shares are restricted from sale until two specific dates. On Feb. 15, 2014, another 1% to 2% of shares can be sold to help insiders cover their income taxes. Then the remainder of the shares, about 85% of the company, will be eligible for sale after May 6, 2014.

What effect does this have on the stock?

Locked-up shares' past
Delving into past lock-up expiration dates of similar high-tech stocks demonstrates the wisdom in waiting awhile. For example, an investment in Facebook (META 1.54%) on its first trading day would have returned 26% to date. However, if you waited until the largest of its multiple lock-up expiration dates in mid-November 2012, an investment would have returned more than 150%.

Another great example is LinkedIn (LNKD.DL). An investment on its first day on the market back in May 2011 would have netted a return of 132% so far. But near the end of November 2011, the stock hit its all-time low and closed at $59. Investing at that point today would have returned more than 240%.

Such examples don't mean that Twitter will follow the same path, but broad studies also show that IPOs typically underperform their peers. Why?

Lock-up shares' present
There are several reasons why IPOs underperform, especially with regard to the lock-up expirations. For one, it's the simple economics: Given an increase in the supply of shares available to be sold and a constant demand, the price will fall.

Another reason is that employees need to diversify their own portfolios. It's likely a great deal of their net worth is tied up with the company's prospects, and while that's good for investors when those incentives align, an employee -- just like you and me -- would not want their investments to be overly weighted in the same place that issues their paycheck.

This also doesn't account for the shares that will be issued as compensation, further diluting share value. While Twitter's share-based compensation was $20 million in 2012, for the first nine months of 2013, that number was $79 million. Such compensation helps the company's cash balance but at the expense of stock dilution.

Since January, Facebook's outstanding shares increased 3.5%, and LinkedIn's increased nearly 9%. There's also a trend for increased stock-based compensation at both Facebook and LinkedIn:

Stock-Based Compensation by Year (Millions)

Watch and wait
With these negatives in mind, investors may want to find a different place to stash cash until May of next year. There's always the chance that market sentiment fends off any lock-up-related stock drops, but if you believe history tends to repeat itself, waiting to invest in Twitter might be the best route.