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In the weeks before its public offering on July 29, Robinhood Markets grandly proclaimed that it was reserving a big chunk of the newly-issued shares for its own brokerage customers. The plan was designed as a special reward for its 22.5 million loyal account holders. But as Robinhood's price plunged on opening day, what amounted to a marketing campaign touting how Robinhood benefits the Main Street investor backfired badly.

In most IPOs, individual investors get a puny slice of around 5% of the offering. The Wall Street banks typically award the vast bulk of shares to their hedge and mutual fund clients. Those customers relish the allocations because the banks systematically underprice the stock sold in the underwriting to create a "pop" at the start of trading, and repay the banks with lots of trading and fat commissions. Those first-day jumps have been especially big in the last 18 months, averaging 33% this year and 42% in 2020. In that elite process, as one CEO who went through an IPO put it, the "Wall Street fat cats get the rich milk."

As a pioneer in commission-free trading, Robinhood is renowned for rallying small investors to the stock market in numbers never seen. For its own IPO, the online-broker trumpeted that legions of its Main Street customers could buy shares at the same insider prices as the big funds. "We are proud to open this offering to our customers on equal terms as institutional investors," Robinhood stated in its July 28 registration statement.

Put simply, Robinhood pitched its IPO not just as a route to becoming a publicly traded enterprise and raising lots of fresh capital, but to putting its small investors on the same privileged footing as the powerhouse funds. No player has done more to lift the folks on the street from a minor to major role in equity investing than Robinhood. Its IPO was targeted as another milestone in its self-described mission to "democratize finance for all."

But so far, the offering's proven a downer for the small investors, and tarnished Robinhood's reputation for championing the little guy.

Robinhood demanded a huge allocation for its customers

Robinhood clearly deployed its leverage with underwriters to secure a larger piece of the offering for the retail crowd––specifically, its own brokerage customers––than in virtually any other major IPO in recent memory. It pre-sold 52.4 million shares in the underwriting, and granted its investment banks rights to purchase another 10.5% or 5.5 million in the aftermarket. In its registration statement, Robinhood stated that the underwriters would reserve between 20% and 35% of the offering for it customers, as much as seven-times the typical share. The exact number was to be determined by negotiations between Robinhood and the banks, and hasn't been disclosed.

Robinhood announced that its account holders could purchase shares through its online platform IPO Access, which offers its customers shares in new issues at the underwriting price, via allocations provided by investment banks. Its parent's debut gave IPO Access far more shares to sell than in the typical offerings it handles. The registration statement disclosed that all customers could apply for shares. It implied that everyone that applied had an equal chance of getting shares.

It's not clear what portion of the offering Robinhood's customers purchased. If they took the full 35%, the number could be as high as 21 million shares. Robinhood and the banks first disclosed a possible range in prices between $38 and $42. But overall demand was tepid, and the shares fetched the low-end of $38. Hence, if Robinhood's small investors bought 35% of the offering, they would have paid a total of $800 million.

Robinhood not only failed to pop, it cratered 11% by around 1 PM to $33 before recovering slightly to $34.82 by the 4 PM close for a loss of 8.4%, giving Robinhood a market cap of $29 billion, below the optimistic estimates of over $32 billion just days before. Robinhood's customers suffered a one-day loss of roughly $67 million. That sounds like a big number. The good news is that although the IPO was a disappointment, Robinhood customers got so few shares each likely suffered only a small hit.

If one-fourth or 5.25 million of Robinhood's customers applied, they'd get an average of just four shares each. Jay Ritter, an economist at the University of Florida who's the nation's leading expert on IPOs, doubts that many applicants received more than about 10 shares. At that number, an investor would have put down $380, and by the end of the day lost just $32. The funds suffered the bigger damage. If the institutions bought 65% of the offering, they initially paid $1.3 billion, and by the close on July 29, suffered a $107 million loss.

The upshot: Robinhood is promoting a process that's the opposite of democratic

The losses give Robinhood a black eye that may be temporary. But where Robinhood's betrayed its own goals is partnering with Wall Street in traditional IPOs. "They're undemocratic," says Ritter. "The banks set the price below the market price, so there's a shortage of shares. The hotter the IPO, the fewer shares both small investors and big funds get to buy." He notes that the powerful funds get sophisticated on research on which IPOs are going to be hot, and use their clout with the banks to get into those deals, while shunning offerings where demand is weak––where shares are likely to open flat, or pop just a little at best. In those less-popular deals, prices can even drop, as in the case of Robinhood.

By contrast, small investors don't know in advance which deal will be hot. They don't cherrypick like the big guys. So they risk getting much lower returns. They get far bigger allocations on the cool deals that do poorly, and far fewer shares of the sought-after deals that deliver a big pop on opening day. The banks also push issuers to sell more shares to institutions and fewer to retail in the hot offerings. It would be interesting to know if the Robinhood customers got an allocation of 35%, say, instead of 20% because institutional interest was so weak.

It's true that overall, Robinhood's customers who buy a lot of IPOs through IPO Access will make a little extra money because for now at least, most IPOs do pop. But they'll be limited to very small numbers of shares because Wall Street controls the process. If they want to buy a significant number, they need to go into the aftermarket and pay the true market price. That price, not the one set by the investment banks, is the "let freedom ring" price.

The truly democratic IPOs, says Ritter, are direct listings where everyone, not just those Wall Street anoints, gets to bid in an open auction on the morning of opening day, establishing a true market price, and preventing the artificial jump orchestrated by the banks. Robinhood should take a stand by endorsing direct listings, and stop partnering with Wall Street on traditional IPOs. That would be striking a blow for true equality in the financial world.