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There’s a Lot More at Stake in this IPO than Just Toxic Financials

, February 6, 2017, 0 Comments

snap-ipo-marketexpress-inSnap Inc., the parent company of SnapChat, filed for an IPO on Thursday. The filing revealed just how toxic this deal is going to be, not just from a financial point of view – a risk IPO investors are willing to take in order to grab the next Google or Facebook – but from a corporate governance and shareholder-rights point of view.

This has implications far beyond Snap: If Snap’s current owners can pull it off and get away with it, other companies will start doing the same thing, and it will forever change what it means to be a screwed stockholder.

Voting rights have already been diluted as our Silicon Valley heroes, such as Google and Facebook, have made a joke out of their common stockholders, but they still get to vote, even if in ludicrously diluted form.

But Snap will take it to the ultimate level: new shareholders will get no voting rights at all. Zilch. That’s a first in the history of US IPOs. These will be the three classes of Snap shares:

  • Owners of Class C common stock, which include co-founders Evan Spiegel and Robert Murphy, will get 10 votes per share.
  • Owners of Class B common stock, the existing investors, will get one vote per share.
  • Owners of Class A common stock will get no vote per share. None.

This vote-less Class A common stock is what is going to be sold to the public at the IPO. Shareholders will get little for their money – other than hope and hype and the financial toxicity of the deal that we can now see thanks to the filing.

Snap plans to extract $3 billion from the “public” by selling these new vote-less class A shares at the time of the offering in the near future, so initially to Wall Street firms at the IPO price before trading starts. These firms then sell their shares to the public when trading starts, hopefully at a higher price. If Snap can pull it off, it will be the largest “tech” IPO since Facebook.

The company currently has a “valuation” of $17.8 billion, established behind closed doors at its last round of funding. The hope is that the IPO price will value the company at $20 billion to $25 billion. That’s some serious moolah.

Now that we have its S-1 filing with the SEC, we can get a feel for the risks. Snap was founded in 2011. For years, it had no revenue model. In 2015, it started putting ads on its service and booked $58.7 million in advertising revenues, most of it in the second half. And it had a loss of $381.7 million. OK, it’s a startup. Fine.

In 2016, with its ad platform fully operational, revenues rose to $404.5 million, of which 98% was from advertising. And its net loss exploded to $514.6 million.

This is the same program Twitter is on. Twitter is still losing a ton of money every year: $521 million in 2015; $577 million in 2014; $645 million in 2013. It has not yet reported results for Q4 2016, but the net loss for the year will likely be between $300 million and $400 million. The company has announced rounds of layoffs and is subleasing a considerable part of its office space. Its shares have plunged 74% from its post-IPO peak.

Like Twitter, Snap has come up with its own metrics. Its key metric is “daily active users” of which it had 158 million “on average” in Q4, 2016. But growth has been slowing over the last few quarters.

The growth rate from Q3 to Q4 2016 was only 3.3%, down from a growth rate of 13.8% a year earlier, and down from 14.5% two years earlier.

The filing explains some of the reasons for this slowing growth in users, including “significant competition in almost every aspect of our business both domestically and internationally”:

This includes larger, more established companies such as Apple, Facebook (including Instagram and WhatsApp), Google (including YouTube), Twitter, Kakao, LINE, Naver (including Snow), and Tencent, … that offer products and services that may compete with specific Snapchat features.

For example, Instagram, a subsidiary of Facebook, recently introduced a “stories” feature that largely mimics our Stories feature and may be directly competitive.

Many of our current and potential competitors have significantly greater resources and broader global recognition and occupy better competitive positions in certain markets than we do.

The filing explains that it’s easy for users to switch to the competition. And turns out, its users, who are primarily between 18 and 34, are not “brand loyal.”

And then there’s somewhat of a cost situation. Snap uses “a capital-light business model,” which means third parties provide the massive infrastructure needed to run the service that is heavy on videos and images. This third party is “primarily” Google Cloud. Snap just “committed to spend $2 billion” with them over the next five years.

So that would be $400 million a year on average, just for having the site hosted in the cloud. Alas, total revenues in 2016 were only $404 million. So that doesn’t leave a lot of room for anything else – much less profits.

OK, it’s going to be tough out there. We get that. The cloud is expensive. Every business should face stiff competition sooner or later to bring out its best. It’s just a question of whether or not the business can make it – and at what valuation investors want to own part of it, and if they want to own it as screwed third-class stockholders with absolutely no voting rights.

This non-voting share scheme is designed to protect top management from the wrath of stiffed stockholders.

Financial risks – a company bleeding red ink for years to come and needing the IPO money to be able to continue to bleed – are why IPOs are so much fun and such a gamble. Some work out. Many take your money down with them.

But there is something much more important at stake: surrendering your voting rights. And if equity investors – this includes institutional investors that will back the IPO – don’t revolt now, it’s going to become pandemic. If Snap gets away with it without a severe drubbing in the share price and ultimate abandonment by investors, they’ll all do it. And third-class vote-less shareholders will become the norm.

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