Stephen Foley: Groupon's share collapse highlights the big paradox of the small float

Outlook: I take no pleasure in having seen Groupon shares tumble below the price of their initial public offering this week.

No, that's a lie. Regular readers know that I think investors are going to get their fingers burned on this one. Fingers, hands and all the way up to the elbow, probably. For all the hype over the "daily deals" pioneer, Groupon hasn't proved yet that it is a business that will last.

But we will see. In the meanwhile, the spectacular collapse of Groupon shares, and the shares of several other recently floated internet superstars, illustrates an interesting problem: the paradox of the small float.

When Groupon came to market last month, it floated less than 6 per cent of the company. Pandora, the popular but barely profitable internet radio business, whose shares are down about one-third from their float price, made just 9 per cent available. Both took their cue from the social networking giant LinkedIn, which was out the gate in May, also selling less than 10 per cent of the company.

The lure of the small float is obvious. The artificial scarcity creates a frenzy of demand for the tiny supply of shares on offer, causing investors to drive the price sky high. Except that this is exactly the wrong way investors should respond.

Very little is certain about the future for these speculative internet ventures, but there is one thing you can count on. And that is that shareholders accounting for more than 90 per cent of the company are itching to sell down their holdings.

LinkedIn shares, in contrast to its peers, are still comfortably above the IPO price, but they have taken a battering over the past two weeks because of insider share sales. With the expiry of the six-month lock-in, early investors and management cashed out a further $700m (£450m), all in the name of "increasing liquidity". When early employees were also freed to sell, at the start of this week, the stock took another leg down.

It is no coincidence that Groupon's share price slide accelerated this week as speculators took a look at the situation at LinkedIn. Groupon's founders and early investors have not been shy in cashing out of the company at every opportunity since its creation three years ago, and being a public company makes it even easier for them.

So, this is the paradox of the small float: investors bid a premium for the few shares on offer when, because of a giant overhang of future sellers, they ought to demand a discount.