From Wolf Street, by Wolf Richter
The scam around the shares of Snapchat’s parent, and a revolt by institutional investors that may have to buy the shares.
The publicly traded shares without any voting rights in a company totally controlled by just two guys should be labeled “junk equity,” said Anne Simpson, an investment director at the California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the US.
“You’re constraining the capital markets in a way you’ll come back to regret,” she told the SEC’s Investor Advisory Committee on Thursday, as reported by the LA Times. “Innovation, we’re interested in that; but this is an immature attempt to avoid accountability.”
They were discussing the non-voting shares issued during the IPO of Snap Inc., parent of Snapchat. It was the hottest tech IPO in three years when it went public last week, though its shares have had a very rough time this week.
Snap was on the forefront of financial “innovation,” bravely going where no other IPO had dared to go before: issuing only shares without voting rights. The two founders retain total control. Some early investors have very diluted voting rights. But those who own the publicly traded Class A shares just have a pile of hype in a company that, according to its pre-IPO S-1 filing, is likely to lose money until the end of its days.
Normal ownership rights – having a say on the company’s strategy, the pay of its executives, the board of directors, etc. – would threaten the two founders, given the financial performance of the company. It’s better to keep the mob of frustrated shareholders at bay.
Ken Bertsch, executive director at the Council of Institutional Investors, which represents pension funds and large institutional investors, told the SEC meeting that input by investors has led “to the vitality of American capitalism … even when egos are bruised, strategies are upended, and executives” get forced out.
If Snap gets away with this, issuing non-voting shares will become pandemic, and shareholders will become helpless dupes.
In early February, when Snap filed its S-1 with the SEC, I published a scathing report about Snap’s planned IPO, its slowing growth of users, its ludicrous valuation, and the disclosure that it would pay Google Cloud $400 million per year on average over the next five years to host the site. Snap’s 2016 revenues were only $404 million. That doesn’t leave any money to cover employee compensation, office expenses, and a million other things companies pay for. Hence losses as far as the eye can see.
These are the risks IPO investors are willing to take. Lose nine, win one big. That’s the hope. I wrote:
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.
And now institutional investors have woken up. The revolt has started.
The Council of Institutional Investors has come out against non-voting shares in recent days. Its point of attack is where it hurts: Pressuring the providers of major stock indices, such as the S&P 500 index, to exclude non-voting stocks. When S&P Dow Jones Indices and MSCI said they’ll review the inclusion of Snap in their indices, its shares plunged for two days in a row.
Much of the hype was focused on inflating Snap’s market capitalization so much ($24 billion on its first day of trading) that it would have to be included in the S&P 500 Index and the MSCI USA Index. And that itself became the selling point of the IPO.
The whole thing resembles a scam, as I wrote on March 6 [Investor Group Attacks Snap’s No-Vote Shares, Stock plunges]:
The bet was that once the shares are in the index, the real buying would commence by funds that track those indices and would therefore have to buy the shares. Given the relatively small number of shares traded, this buying pressure across the globe would push up the price even further. It was simply a matter of creating a lot of artificial demand.
It’s not uncommon that voting rights are stacked against holders of publicly traded shares. The founders of Google and Facebook have set up such systems to protect themselves against the wrath of investors. Companies with disproportionate voting power represent about 12% of the S&P 500. But only Snap has created a structure where all its publicly traded shares are non-voting.
Even the SEC is finally waking up. Kurt Schacht, who chairs the SEC’s Investor Advisory Committee, warned at the meeting on Thursday that issuing non-voting shares “might be the next big thing.”
Kara Stein, one of the two current SEC Commissioners (there are normally five), told the meeting, according to Reuters: “Unequal voting rights present complex and new issues that need to be understood and addressed.”
“We also must be mindful of the precedent being created,” she added. The SEC should study companies that in their IPOs offer shares without voting rights, with a “focus on how some innovations may prove detrimental to investors.”
“In the long run, we need to critically assess our regime for initial public offerings,” she said. “The current structure is premised on taking investors’ capital while giving the investor rights to hold that company’s management accountable of that capital.”
The Investor Advisory Committee didn’t reach a conclusion on Thursday; and deeper discussions will follow in a subcommittee hearing.
On the surface, it seems there’s a solution right now: Investors could just stay away from Snap’s toxic non-voting class A shares, letting them fall into penny-stock territory where they could languish until the company figures out how to make money, or until it folds, whichever comes first.
But that option might not be possible for institutional investors, such as index funds and pension funds that track stock market indices. They have to buy the shares once they’re included in the index. And that’s where the scam comes in: hyping the stock and driving up the price to where market capitalization is high enough for the stock to get included in the S&P 500 and other indices which would then force these pension and index funds to buy the shares.
This forced buying creates artificial demand, which allows early investors and insiders to exit at peak valuations, and it allows the company to issue more shares and raise more money to cover its losses for years to come. In the end, it’s in those funds, forced to buy the shares with other people’s money, where the shares will wither until they get dropped from the index on their way to oblivion.