29 May 2019

The real problem with tech companies that go public

By John Buni

If investor confidence was affected by the stock market slides of ‘Red October’, it seemed to have returned with the arrival of spring 2019 and a highly anticipated series of IPOs. Following Lyft’s going public in March, around $5.1 billion came to the market in the first half of April. Pinterest followed; so did Uber. By late May, the consensus was that this was the ‘year of the tech IPO’.

No sooner had the phrase escaped the lips of commentators than the problems started. Lyft’s share price promptly tanked, while Uber’s mammoth IPO was so disastrous that CEO Dara Khosrowshahi had to reassure his 22,000 employees that things weren’t as bad as they looked.

Some may point the finger at the US-China trade skirmishes and financial operators such as Michael Grimes, but there is growing agreement the IPO market is overheated. That certainly seems to be the opinion of the powers-that-be at Slack, which has chosen to list its shares directly.

This series of IPOs has been described as a kind of mania. For the best part of 10 years, private tech companies have insisted that remaining private is a good thing. But, partly because many of these companies have exhausted late-stage investment, it suddenly seemed to be the time to go public, and a glut of listings forces smaller start-ups to do the same. It’s less like a domino effect than a virus—and Uber and Lyft, given their sliding stock, might agree with that wording.

There’s a problem here, however, one that goes beyond the woes of Uber and Lyft to the nature of the offerings themselves. For one thing, the term ‘initial public offering’ can be slightly misleading. IPO implies that the shareholders will become the new decision-makers, or at least will have an influence over decisions in proportion to their share ownership. But the rise of so-called super-shares changes that, in that there is a dual-class structure that gives preferential treatment to founders and, sometimes, early investors. In other words, a founder may only have five per cent of the stock, but a number of votes that implies they have 10 times more.

Lyft’s two co-founders own seven per cent of the stock. But together they hold a near-majority of shareholder votes. It’s a natural result of what OZY calls the ‘founder-knows-best’ ethos—a phenomenon that surely helped the disgraced Theranos founder Elizabeth Holmes to carry on her fraud unimpeded. (It’s worth noting her super-shares were worth 100 votes each.) I write this as someone who has sought investment and had to yield some control of a tech company as a result. It isn’t easy to do when you’ve built something from the ground up, but before long it becomes hugely valuable, because for the first time you’re under scrutiny and being challenged.

Facebook is undoubtedly the most famous tech company that has a dual-class structure. Its Class B shares, which are controlled by Zuckerberg and a handful of insiders and early investors, represent 18 per cent of all the shares, but each is worth 10 votes. This is why, despite numerous scandals, Zuckerberg is impossible to shift from his post: he personally controls nearly 60 per cent of the stock. Even if Facebook cannot resolve its problems surrounding data, privacy, election interference, content moderation and everything else, the founder remains untouchable.

It’s easy to see how this can pose a problem. Various groups, including the Investor Stewardship Group, have called for the total elimination of dual-class stock, in part because they infringe on investor rights. Others have called for limitation, rather than an outright ban. But neither looks likely any time soon, because founders always fall back on the same defence: a dual-class share structure is more conducive to a long-term strategy; stockholders tend to focus on short-term rises in share value. This was how Alphabet, parent company of Google and pioneer of the tech company supershare, rationalised its decision to adopt a dual-class structure.

Facebook’s recent woes and the Theranos fiasco are making that argument look shaky. Indeed, you could see it as suggesting that a dictator might be preferable to a democracy. Political parties will focus on keeping themselves in power. A dictator can look to the long term. To paraphrase the most famous wartime prime minister in British history, democracy is the worst form of government — except for all the others.

In the ‘year of the tech IPO’, this debate has been reignited. As Wei Jiang, a Chazen Senior Scholar at Columbia Business School, puts it, once dual-class stocks are traded publicly, unicorn companies can find themselves ‘instantly unpopular’ with their investors. We can only speculate as to the role these voting structures played in the latest series of underwhelming IPOs. But perhaps we can expect further problems for Lyft, Pinterest and their like down the line.

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John Buni is co-founder and CEO of CleanCloud and Tailor Made London.