Silicon Valley Rejects Shareholder Value Theory: Disrupting the IPO

By Michael Olenick, a research fellow at INSEAD. Originally published at Olen on Economics

I’ve written about problems with Shareholder Value Theory (SVT). The constant need to pump an ever-appreciating stock price to anonymous shareholders, the vast majority who contributed nothing to a company, rewards short-term thinking. Buybacks and other financial tricks tower over innovation and growth initiatives.

It looks like Silicon Valley has tired of the nonsense.

Here is an article about a new public company, Social Capital Hedosophia Holdings Corp. (SCH): Fixing the ‘Brain Damage’ Caused by the I.P.O. Process. Their prospectus is here: Social Capital Hedosophia Prospectus.

Missed the IPO? Don’t worry; you were supposed to. Trading on the NYSE the company’s ticker is IPOA.U. Trading opened on September 14 at $10.31; a week later they’re at $10.63. The company has a $600 million pile of cash but no products or services; they exist to buy tech companies.

SCH is a combination of two firms, the well-known Social Capital and stealthy Hedosophia.

Social Capital is founded and managed by Venture Capitalist Chamath Palihapitiya. Their portfolio includes Slack, Forge, Box, Brilliant, and a sizable group of unusually high-quality companies. Palihapitiya sounds like somebody you’d want to stranded on an island with: he’s be interesting company and probably figure a way off. He tends to make a lot of money for himself and the people he works with.

Less is known about co-founder Hedosophia, a venture firm founded in 2012, that filings state has over $1 billion in holdings. The firm’s webpage is retro 1990’s, appearing on the second page of a Google search for the company name and referencing a street address which, on Google Maps, is a nondescript building with no signage. Hedosophia’s founder is 34 year-old Ian Osborne, of Osborne & Associates and Connaught. These firms have apparently acted as financial advisers “for eight of the fifteen most valuable private companies in the technology sector.” It’s unclear why the secrecy is necessary; it gives off a Le Carré vibe.

SCH is a Special Purpose Acquisition Company, or SPAC. The last and only time I came across a SPAC it was used to take the law firm of David J. Stern public. Stern is the crooked foreclosure lawyer who fabricated paperwork to expedite foreclosures, earning himself two yachts, a mansion and, eventually, permanent disbarment. That SPAC initially traded under the ticker CACA (there are some things you can’t make up) then changed to DJSP, David J. Stern Enterprises. DJSP worked out great for the shorts at least: Stern’s firm quickly went bankrupt. Though, I digress…

The purpose of SCH is to to enable flexibility in the cumbersome IPO process. On one hand, it’s impossible to feel bad for 30-something tech executives flying private jets and repeating the same Power Point dozens of times to potential investors. Especially since, absent a disaster, they will reap a fortune at the end of the process. But those rules can also harm ordinary employees who are subject to rules, because of their tiny stock grants, that are meant for Masters of the Universe.

I watched this happen with a number of companies during the first dot-com boom. Regular employees held locked out stock and watched their chance to finally buy a house or pay off student loans vaporize. Many were taxed on phantom income that never materialized under rules I won’t pretend to understand much less explain. These were not top-tier b-school alum; they were writers, computer programmers, online forum moderators — people who knew nothing about capital markets — and ended up owing a fortune. Their bad for not studying the rules more? Maybe, but since the rules exist to protect the clueless those same rules could have done more to protect them.

SCH’s SPAC is supposed to change this. The idea is that one or more companies would be backed into the SPAC and skip the normal IPO process. No roadshow, no lockouts, and fewer worries about pricing. One bucket of capital goes to the company or companies, a controlling batch of stock goes to the SPAC, lawyers prepare lots of paperwork and, voila, the company is public sans IPO.

Another potential model would be multiple businesses put limited shares in the SPAC and it functions more like a publicly traded private equity firm. Social Capital’s hiring of private equity guru Marc Mezvinsky (yes, Hillary’s son-in-law) as vice chairman, and the use of plural verbiage in filings, suggests they might pursue this route. Plus, they explicitly call out purchasing only one firm as a risk factor although that is normally how SPAC’s work.

Like I said, the only time I’ve seen a SPAC in real-life it was a disaster. During its short life I communicated daily to DJSP investors, warning them. At first they weren’t thrilled. “I’ll kill you – no, I’ll have you paralyzed from the waist down,” is how one eloquently put it as I explained my data showing DJSP to be garbage. “Knock it off, look at the data, and direct your anger towards Stern,” I answered.

We continued communicating after the failure — they eventually became more friendly — and said it hadn’t worked out well in the past either. Their business model was to use SPAC’s to take Chinese companies public in US markets. But a disproportionate number of the companies turned out, in hindsight, to have elements of fraud. They purchased Stern’s operation because the two-year window to acquire a company was closing and they wanted to avoid fraud by focusing on a US business. Of course, instead of avoiding fraud, they ended up with arguably the worst SPAC in history. There are benefits to SPAC’s but also risks.

Which brings us back to SCH and Social Capital. Chamath Palihapitiya has the magic touch for a VC. He was an early Facebook employee, introduced to Zuckerberg by Sean Parker. His motives, an ability to focus on long-term value, is exactly what we like to hear. He says the right things, has the right history, and sounds like a person you want to trust. As an added benefit there is nothing that I’ve come across which even hints that you shouldn’t. With the market price of their empty SPAC increasing, despite no news, somebody else agrees.

But is it a genuinely good idea to ditch the traditional IPO path? There’s no question the as-is method is disruptive (in the traditional sense), cumbersome, expensive (though SCH charges 20% of the acquisition cost), and lengthy. Great for investment banks and their insiders; not so great for everybody else. Palihapitiya points out the need to disrupt his own VC industry in the same way tech firms have disrupted and upended dinosaurs. Further, an ability to better protect employees and more equitably distribute stock and options sounds like an improvement, especially after seeing those Silicon Valley employees financially drowned in the undertow of upside-down options.

There are a substantial number of companies rejecting the as-is path to an IPO. SCH’s prospectus highlights that there are 150 private tech companies valued at more than $1 billion but only 200 public tech companies. Firms are actively rejecting the as-is solution for initial public offerings though it remains unclear if that is because they wish to avoid investor pressure or whether they want to avoid the hassle of the IPO process. If their concern is investor pressure are they worried about an unwelcome letter from Carl Icahn or worried about turning into the next Snap or Twitter, with a languishing stock price?

I’m not a finance person but there seems to be a math problem. SCH has $600 million cash. They’re required to buy a controlling interest in voting, and at least 50 percent of outstanding shares, of at least one business worth more than $1 billion — their preference is to buy a company valued at $2-3 billion. Normal IPO’s deal with inadequate demand in the capital markets by selling a lower amount of stock. Need to raise $500 million but require a $2.5 billion valuation? Then sell 20 percent of the business to the public. But SPAC’s have different requirements; they must acquire controlling interests so they cannot take this route. I’d imagine somebody has thought this through.

Disrupting the IPO process to enable a long-term focus rather than short-term financial shenanigans seems worth the risk of innovation, though the risk of blindly betting on an acquisition should not be underestimated.

SCH has the potential to grow into a Y-Combinator like entity for mature companies; the premier go-to place for firms that need an exit but don’t want the hassle and expense of a regular IPO. If so, it’s shares are a chance to buy into a Berkshire-Hathaway at $10. Or it can end up like DJSP. While Stern’s demise was spectacular — everything he does seems to be large — SPAC’s do tend to historically underperform. Still, given Palihapitiya’s reputation and history, I’d bet on the former. But his management team must remain wary to ignore demands from the inevitable parasitic “activist investors” (formerly and more accurately known as raiders) to “derive value” with buybacks and other worthless financial gymnastics.

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12 comments

    1. Vatch

      Hey, the Saudis are progressives, now! Women will be able to drive! Well, maybe not until June, 2018, but only a fanatic would expect women to be allowed to drive in 2017! /s

      Reply
  1. WobblyTelomeres

    How is a publicly traded SPAC buying a controlling interest in a private firm terribly different from a private firm buying a controlling interest in a publicly traded firm? Both ways are a path to the private firm becoming public without going through an IPO.

    Maybe as a way to let the founders out without going through a public grilling?

    Reply
    1. Michael O

      SPAC’s are different because investors don’t know what company the managers of the SPAC will buy so they’re essentially trading on the reputation of the managers. Managers are not allowed to pre-pick a company and most don’t. They also have only two years to choose a company and it’s not uncommon to wait until the end, which is how CACA ended up with DJSP; it was a last-minute decision. In reverse mergers investors of the public firm know the private company being merged. Even when the public company is just a shell, and all outstanding stock diluted, investors still know, from day one after the reverse merger, what they’re investing in.

      Reply
      1. WobblyTelomeres

        Thank you! I was reading the article and wondering (having been through that as an employee).

        Managers are not allowed to pre-pick a company and most don’t.

        Your phrase, “most don’t”, captures my suspicions well. Something about Upton Sinclair’s novel, The Moneychangers, is always lurking about.

        Reply
        1. Michael O

          Yeah – they’re not allowed to so none pre-pick their companies (*cough, cough*).

          It’s hard to believe that Palihapitiya didn’t have a good idea of who he’d buy when he took the SPAC public, especially since he’s a VC with a portfolio of companies. But we’ll give him the benefit of the doubt (*cough cough* again) in the interest of seeing if this thing works.

          Of course, for a lot of SPAC’s, they really don’t pre-pick their companies. Then they wait to the last minute and, with limited options, choose losers like Stern.

          Reply
  2. Anon

    I don’t think this article is well researched. A few points:

    1. Social Capital’s best investments were sourced by partners other than Chamath who you claim has the magic touch. In the VC world props accrue to the partner who sources the deal, not the firm. And furthermore, props when they invest early vs. late stage where there’s less talent in picking winners. (e.g. Box: Series E, Slack: Series C – both by Mamoon Hamid).

    2. When your two co-founders leave on the eve of this IPO it suggests all is not well. That includes aforementioned Mamoon Hamid. https://www.wired.com/story/brash-investor-tries-to-blow-up-the-ipo-as-his-partners-quit/.

    3. There is some public backlash against this IPO concept. A more balanced article would consider these points: https://www.linkedin.com/pulse/public-markets-work-just-fine-glenn-kelman/

    As a general guideline, whenever someone says they’re going to “disrupt” an industry be wary please.

    Reply
    1. Yves Smith Post author

      I suggest you read an article more carefully before attempting to critique it. You seem to have either missed or chose to straw man what Olenick wrote.

      The history of the principals is irrelevant to Olenick’s analysis. He’s looking at the structure which the promoters depict as novel and potentially useful. So your comments in points 1 and 2 are basically an effort to depict Silicon Valley gossip as germane when it isn’t. This vehicle (like IPOs) is not targeted to insiders but to rubes. Anyone with a background that a publicist can spin well can raise money, sadly. Just look at the dodgy fund managers that accredited investors like public pension funds invest in.

      As for point 3, you imply that Olenick is a backer of this scheme when he clearly isn’t. Among other things, you read past his remarks on Daniel Stern.

      Reply
    2. Michael O

      Time difference so a delayed response but Yves has it right; the only time I’ve seen a SPAC it was a massive disaster. I don’t think Palihapitiya is a Stern but it’s still a tough sell. I don’t think it’s germane that Palihapitiya’s employees made his best trades – he hired good people which, ultimately, is the key to building a great business. One co-founder left to join Kleiner-Perkins, not a bad gig. Both were worried Palihapitiya was turning Social Capital into more of a high-tech focused PE firm than a VC firm, and it sounds like he is, but is that necessarily a bad thing?

      The Wired article you linked to wrote “most likely, the SPAC will acquire a minority stake in a company worth more than $600 million; it could buy 10% of a company worth $6 billion, for example.” They didn’t read the SPAC’s prospectus; they can’t do that. Unless they can get around that rule I’m guessing this is the biggest problem they’ll have. They don’t explain in the prospectus how they’re going to buy a 50%+ stake in a $2-3B company for $600M while keeping 20% for themselves.

      Reply
  3. audrey jr

    “The Moneychangers” is a wonderful book. It’s by Arthur Hailey. One of my first adult reads, years ago. Interesting post, Yves. Thank you.

    Reply

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