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On Filters and Votes: Examining Snap's IPO

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About The Author

Claire Wallace (Guest Contributor)

Claire is a Medical Sciences graduate from the University of Birmingham. Before beginning her GDL in September, Claire worked as an Analyst with one of the ‘Big 4’ accountancy firms. Outside of law, Claire is a keen hockey and tennis player.

The difference between playing the stock market and the horses is that one of the horses must win

Joey Adams

Snap Inc’s Initial Public Offering (IPO) has been unconventional, to say the least. Capturing the imagination of investors, it nonetheless invited sharp criticism; Snap was operating at a loss, undergoing a decline in user share and facing significant competition from technology giant, Facebook. Yet, despite such concerns featuring prominently in the lead up to Snap's stock being listed on the New York Stock Exchange (NYSE), they seemed to have little impact: the IPO was a success, with the ‘camera company’ closing its first day of trading at $24, up 44% from its initial offering price.

When a company joins the public market, this marks the start of a relationship between the company and a diverse range of investors. A good corporate governance framework will ensure directors and managers act in the best interest of all parties involved.

Interestingly, investors who bought shares in Snap will be subject to a seemingly unfriendly corporate governance structure: shareholders can expect to have little say on how the company is run and will not benefit from any profits in the form of cash dividends for the ‘foreseeable future’. This challenge to conventional governance is a growing trend among tech companies; using Snap as an example, this article will discuss the main issues arising from alternative governance structures.

Snap's Shareholder Structure

Snap has a three-tier shareholder structure made up of Class A, Class B and Class C stock:

  • Class A Stock - this was available on the NYSE and was the primary source of controversy: it gives no voting rights to investors.
  • Class B Stock - with one vote apiece, this has been reserved for Snap’s executives and those who invested early on in the company, including venture capital funds Benchmark, Lightspeed and Lask.
  • Class C Stock - this carries 10 votes per share. These are exclusively and equally shared by Snap’s CEO Evan Spiegel and CTO Bobby Murphy.

Effectively, this multiple-class share structure concentrates voting power with the young co-founders who hold 88.6% of voting rights. Voting restrictions like this entrench management and make it virtually impossible to remove a director, thereby reducing their accountability levels to minority shareholders. 

Furthermore, Snap have also issued restrictions on some stock in the form of lock-up periods. Lock-ups allow companies to counterbalance and moderate stock volatility by preventing shareholders from selling stock for any given period of time – an entire year for 25% of Snap stock offered in the IPO (most lock-ups expire between 90 and 180 days)! This lock-up period is over double that of early investors of Snap and employees, who can sell their shares 150 days post-IPO. The founders are asking for a big vote of confidence in the young company, which has yet to turn a profit and faces fierce competition from the likes of Facebook’s Instagram stories. However, this agreement between Snap and investors also indicates the popularity of the IPO.

Having Your Cake, and Eating It Too

So why do companies offer stock in IPOs and why do investors buy it? Young companies looking to raise capital for expansion often issue IPOs. In return, when a company earns a profit, shareholders are entitled to a dividend payment of this profit. Furthermore, owning stock in a company gives investors voting rights, and with that, the opportunity to have a say on significant issues that could affect the value of their shares – such as corporate elections. Snap stock comes with neither of these benefits, at least for the ‘foreseeable future’ according to Snap filings.

By using multiple voting classes, the founders of Snap are able to retain control over their company whilst diluting their financial stake. A simple example can illustrate this disconnect between financial risk and control. A company can have a share class structure where by the founder has one million shares with 10 votes and four million shares with 1 vote controlled by other shareowners. The founder can control all the decisions; they have 71.4% of the vote, but with 20% of the economic risk and will enjoy almost complete protection from accountability.

Issues of Indices

Different investors have different expectations depending on their aims. Broadly speaking, there are two types of investors – active or passive. Active investors in Snap stock could see their capital fall and have no grounds on which to complain. The real problem lies in the possibility of Snap becoming part of stock indices such as the S&P Dow Jones Indices and MSCI Inc.

There has been a growing shift in the market over the last decade – passively managed funds have significantly increased their ownership share of the US stock market. Moreover, a large proportion of all mutual funds and exchange-traded funds (ETFs) are index-tracking funds. Essentially, passive funds buy and hold stock in an underlying index, for example, the S&P 500. Index funds, as a result, own certain stock irrespective of their performance and prospects. Many active investors argue that the growth of passive funds has a negative effect on governance; companies with a large number of passive fund investors can too easily operate outside the scrutiny of engaged shareholders. However, others argue that because index funds stay invested in a company as long as it is part of an index, it is in their interest to advocate long-term shareholder value and engage with board members. In contrast, actively managed funds can adopt the traditional method of “voting with their feet” and sell stock if a company is underperforming.

For this reason, some investors want to stop companies who offer non-voting stock from getting into benchmark indices. Indeed, large passive funds such as BlackRock and Vanguard, the globes biggest providers of index-tracking funds, have spoken out about the brazen shareholder structure of Snap. They are calling out for improved governance to give shareholders voting rights “in proportion to their economic interest.”

Technology Trend – Method in the Madness?

Snap is not the first technology company to issue unusual share classes. Other technology tycoons, such as Google and Facebook, have floated shares that carry restricted voting rights. In fact, Facebook issued voteless shares in order to avoid dilution of control in an acquisition (but Facebook were established and turning a profit at the time!). 

In the quickly evolving and competitive technology sector, it is particularly important to innovate and take risks. When Instagram introduced a new feature, Instagram Stories, it had an instant impact on Snapchat’s customer base, which saw an 82% decline. The concentrated voting power will allow Snap to have greater agility in decision-making through bypassing shareholder approval and the constraints of traditional governance. Young companies continually face disruption and change in order to grow, so this level of control will better allow Snap to keep up with competitors.

One primary reason Facebook CEO, Mark Zuckerberg, introduced non-voting shares was to preserve founder control. Tech companies argue that management needs to be protected from investors focused on short-term returns, allowing key individuals to act in the long-term interests of the company and its stakeholders/shareholders. Without the power to vote, investors have limited ways of influencing management and the direction of the company. It has not been uncommon for activist investors to throw their weight around having accumulated stock in publicly traded companies. An individual or group of investors can purchase a large quantity of ‘one share one vote’ stock in a public company, often with the goal of effecting change in the management and strategy of a company.

This is a concern for the likes of Twitter, which has a single-class stock structure with equal voting rights. Indeed, some campaigning shareholders recently submitted proposals, to the company’s annual shareholder meeting in May, encouraging Twitter to consider becoming co-operative owned and leaving the stock market. Although it is unlikely the proposal will be successful, given Twitter’s board have openly opposed it, it provides an example of how Twitter’s one share one vote stock structure allows room for shareholder activism.

However, as things go, the technology market is notoriously volatile and investors in young public companies have been disappointed many times before by concentrated founder control. Groupon, Zynga and GoPro all went public with a dual-class structure, receiving high ratings for governance risk from the Institutional Shareholders Service (ISS) and all saw a significant slump in share price following their IPOs. 

Even if Spiegel or Murphy leave the company, they will still maintain control over Snap and all matters submitted to stockholders. Their power will only be diluted if the founders die or sell nearly 70% of their shares. Proportionality has often been a key component of securities-voting structures, ensuring any given shareholder has voting rights in line with economic ownership. Any diversion from the principle of proportionality can ring alarm bells for investors: differences between ownership and control can result in a conflict of interests between controlling and non-controlling shareholders. Controlling shareholders can exercise a level of control that does not correspond to a similar level of risk. Abuse of this control could manifest in a variety of ways, from excessive executive pay to rejecting lucrative buyouts that could benefit minority shareholders. With such entrenched management and zero voting power, investing in Snap is ultimately an investment in the co-founders. Will the young Spiegel and Murphy be able to turn the substantial losses around and point the company in the right direction, or do they need more “adult” supervision?

Market Dynamics and Integrity

Different stock markets have different rules and regulations that look to balance ethical, governance and commercial dilemmas. This is exemplified by the Stock Exchange of Hong Kong (SEHK) refusal to list Alibaba, China’s biggest e-commerce company. The offering documents outlined an unusual ‘partnership’ structure that would allow the Alibaba Partnership to cherry pick the board of directors, despite the partners having a minority stake in the company.

The SEHK has a great reputation for investor protection and participation and is unique, in that it operates with both commercial and regulatory functions than most other developed markets. Alibaba was one of the most anticipated listings since Facebook, and the refusal to list Alibaba had big commercial implications; the Chinese technology giant floated on the NYSE in September 2014 and raised over $20bn. After discussions ceased with the SEHK, Alibaba looked to pursue a listing in New York. The US Securities and Exchange Commission (SEC) allows listed companies to issue shares with no votes or diluted voting power, on the NYSE. In turn, exchanges with stricter regulatory limits or governing principles may appear to lose out on lucrative listings. 

2016 has been a slow year for tech IPOs, but 2017 is set to see a surge in tech companies going public. Some worry that Snap’s listing could encourage stock exchanges outside the US, such as Singapore, to reconsider their ban on dual-class listings in order to win IPO business. In fact, at the start of this year, the Singapore Stock Exchange began a consultation process looking at whether it should allow companies that are looking to list on the exchange to adopt dual-class share structures. A similar review is also taking place in the UK.

There are many factors that a company must consider in deciding what market to list on: raising the company’s profile in the jurisdiction; the profile of other companies traded on the exchange; entry requirements of the market; the level of regulation and disclosure required; accounting requirements; index inclusion; and desired investor type. There is no one size fits all corporate governance structure, but a framework must be found that balances both commercial interests and governance concerns. It is important to consider the long-term reputational consequences for the market and not succumb to the short-term benefits of attracting a larger number of new listings that could expose investors to unfriendly corporate governance structures.

Corporate Governance is always Evolving

In order for the US and UK to maintain their position as an attractive capital market, it is essential to have an effective governance framework. There has always been much debate amongst policymakers, corporations and the law with regards to gold-standard corporate governance. There is no one size fits all framework and unsurprisingly, given the economic and political stakes, the corporate governance landscape is constantly evolving.

Public disquiet and distrust in business have been on the up in Britain after scandals including Sports Direct, accused of paying its employees below minimum wage, and BHS, the UK retailer that went under administration and with a collapsed pension fund came to fruition. Theresa May has been considerate and respondent to public concern surrounding excessive pay and corporate misconduct, issuing the corporate governance Green Paper last year.  Proposed changes include: increasing shareholder influence over executive pay, empowering the employee, strengthening customer and supplier voice at the level of the board, and extending the UK Corporate Governance Code to large privately-held businesses. The aim of the Green Paper is to consider what changes to the current corporate governance regime would be beneficial in creating an economy that works for all.  

Conversely, the future of corporate governance in the U.S. is uncertain amid a Donald Trump presidency.  In the wake of the 2008 financial crisis, Obama introduced the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act that set out an array of banking and financial sector provisions to improve transparency and accountability in this sector. For example, once every three years, the majority of U.S. public companies are required to offer shareholders with an advisory vote on executive pay (also known as “say-on-pay”). The Trump administration have publicly criticised the legislation and have begun plans to scale back the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. The majority of changes will be to loosen regulations placed on banks, which is a far cry from the promises Trump made on his campaign trail to stand up to Wall Street.  

Executive Pay

High executive compensation has been a hot topic for some time, particularly in relation to under-performing companies – of which Snap is no exception thus far. Typically, enhanced shareholder voting has sought to address concerns surrounding executive pay, to ensure management are paid in line with performance. However, Snap will not be subject to shareholder votes on executive pay, or the Say-on-pay provisions of the Dodd-Frank Act. This is a further example of just how much control the founders have over the now publically listed Snap.

According to Snap filings, Spiegel’s salary will be reduced to $1 post-IPO. But between the founder’s majority voting share and total compensation in 2016, totalling $2.4 million, Spiegel is one of the most well-compensated technology gurus.

It is important for decisions on compensation to be communicated to all stakeholders, which includes shareholders. Arguably, boards should be engaging with shareholders, having an honest and transparent dialogue with regards to executive pay amongst other matters. Snap has completely removed any viable channels of communication (bar annual meetings) for shareholders to voice an opinion on such matters. It will be interesting to see how Snap’s pay programmes materialise and how reactive the company are to shareholder input in the future.

Conclusion

The question remains, will Snap’s non-voting class offering become the norm for other large anticipated tech IPOs in years to come that disenfranchise shareholders and allow management to answer to no-one but themselves. It appears that investors are happy to overlook the non-proportional share voting structure of Snap, in the hope that the investment will be financially rewarding in the future. We must remember that Snap is much bigger, faster-growing and millennial-focused than most other private tech companies that may seek to go public in the future. Because of this, it may be difficult for other tech companies to ride on the coattails of Snap’s successful IPO and get away with such a governing structure.

It will be important for Snap to engage with shareholders and convey the message that they are protecting their interests and can constrain the possible shortcomings of the dual-class stock structure. Investors, on the other hand, must keep a close eye on how the company is being run with their finger on the trigger ready to sell if they believe Snap is heading in the wrong direction. Important channels, such as media coverage, monitoring by analysts and participation in corporate governance by active large outside investors may help keep Snap management in check, ensuring shareholder interests are maintained.

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Tagged: Banking & Finance, Commercial Awareness, Commercial Law, Company Law, Technology

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